On July 19, 2012, the Second Circuit vacated a district court order granting summary judgment in favor of Grant Thornton LLP (“GT”) in a securities fraud action arising from GT’s audit of Winstar Communications, Inc.’s 1999 financial statements. Gould v. Winstar Commc’ns., Inc., 2012 WL 2924254 (2d. Cir. July 19, 2012) (Lohier, J.) (Winstar).1 The Second Circuit found that “genuine issues of material fact exist[ed]” as to whether GT acted with scienter for purposes of the plaintiffs’ Section 10(b) claims, and whether there was actual reliance for purposes of the plaintiffs’ Section 18 claims. Id. at *1. The court also found that the plaintiffs had presented sufficient evidence for a jury to infer loss causation.  


“Winstar was a broadband communications company whose core business was to provide wireless Internet connectivity to various businesses.” Id. “GT served as Winstar’s independent auditor from 1994 until Winstar filed for bankruptcy in April 2001, and GT regarded Winstar as ‘one of [its] largest and most important clients.’” Id. “In 1999, however, the relationship deteriorated.” Id. Winstar warned GT that it might terminate their relationship. “[A]t least one member of Winstar’s board of directors openly urged … that the GT partner overseeing the audit of Winstar be removed from the Winstar account.” Id. GT ultimately re-staffed the Winstar account “so that the 1999 audit was managed by a partner, Gary Goldman, and a senior manager, Patricia Cummings, neither of whom had previously reviewed or audited the financial records of a telecommunications company.” Id.

The court found that “GT’s audit for 1999 included several ‘large account’ transactions that Winstar consummated in an attempt to conceal a decrease in revenue associated with Winstar’s core business.” Id. Together, these transactions accounted for “approximately 26 percent of Winstar’s reported 1999 operating revenues and 32 percent of its ‘core’ revenues that year.” Id. “At the time, GT considered these transactions to be ‘red flags,’ warranting the firm’s ‘heightened scrutiny.’” Id. “However, GT ultimately approved Winstar’s recognition of revenue in connection with each of these transactions.” Id. On February 10, 2000, “GT issued an unqualified audit opinion letter stating that Winstar’s annual Form 10–K for fiscal year 1999 complied with GAAP and fairly represented Winstar’s financial condition at the end of that year[.]” Id. at *5.  

In March 2001, Asensio & Company, an investment firm and well-known activist short seller, issued press releases questioning Winstar’s revenue accounting practices. On April 16, 2001, Winstar publicly disclosed the cancellation of its $2 billion credit facility and announced that it was considering a Chapter 11 reorganization. “[T]he [Asensio] press releases, coupled with the subsequent announcements of Winstar’s financial troubles, were followed almost immediately by an additional steep decline in Winstar’s stock price[.]” Id. at *6. “On April 18, 2001, Winstar filed for bankruptcy.” Id.

Plaintiffs brought suit against GT under Section 10(b), and a subset of those plaintiffs (the “Jefferson Plaintiffs”) brought suit against GT under Section 18 of the Exchange Act.2 After discovery, GT moved for summary judgment. In September 2010, the Southern District of New York granted GT’s motion on the grounds that “(1) the [p]laintiffs had failed to demonstrate that a genuine dispute of material fact existed as to whether GT acted intentionally or recklessly, as required under Section 10(b) of the Exchange Act, and (2) the Jefferson Plaintiffs had failed to demonstrate that such a dispute existed as to whether they actually relied on GT’s audit opinion letter, as required under Section 18 of the Exchange Act.” Id. The plaintiffs appealed.  

A Genuine Issue of Material Fact Exists as to Scienter

In considering whether the plaintiffs had raised a genuine issue of material fact as to GT’s scienter, the Second Circuit relied on its prior decision in AUSA Life Insurance Co. v. Ernst & Young, 206 F.3d 202 (2d Cir. 2000) (Oakes, J.) (AUSA Life). Like the plaintiffs here, the AUSA Life plaintiffs alleged that Ernst & Young (“E & Y”) had “‘consistently noticed, protested, and then acquiesced in’ the financial misrepresentations of an audit client under pressure from the client’s management.” Winstar, 2012 WL 2924254, at *7 (quoting AUSA Life, 206 F.3d at 205). The Second Circuit in AUSA Life “held that by issuing an unqualified audit report despite its knowledge of accounting improprieties by the client, E & Y ‘intentionally engaged in manipulative conduct’ … in violation of Section 10(b).” Id. (quoting AUSA Life, 206 F.3d at 221).  

Here, the Second Circuit determined that “there was admissible evidence that in the course of its audit GT learned of and advised against the use of indisputably deceptive accounting schemes, but eventually acquiesced in the schemes by issuing an unqualified audit opinion.” Id. at *8. The court found that “[t]his evidence [went] beyond a mere failure to uncover the accounting fraud and, in general, relate[d] to (1) Winstar’s recognition of revenue for the sale of equipment or services without sufficient indicia of delivery, (2) its recognition of all revenue associated with the incomplete sale of telecommunications systems, and (3) its recognition of revenue for sales of [fiber optic network capacity], equipment, and services to financially unstable companies to whom Winstar paid back large sums under separate contractual obligations.” Id. The court also found “evidence that GT [had] failed to confirm Winstar’s representations regarding these transactions or to retain and review documents evidencing each transaction.” Id.  

The Second Circuit concluded that “regardless of the hours GT spent or the number of documents it reviewed in the course of its 1999 audit of Winstar, a jury reasonably could determine that the audit was so deficient as to be ‘highly unreasonable, representing an extreme departure from the standards of ordinary care … to the extent that the danger was either known to [GT] or so obvious that [GT] must have been aware of it.’” Id. at *9 (quoting Rothman v. Gregor, 20 F.3d 81, 90 (2d Cir. 2000)). The court held that “[a]t this stage, the [p]laintiffs ha[d] proffered enough facts constituting evidence of conscious misbehavior or recklessness to survive summary judgment.” Id. at *8.  

A Genuine Issue of Material Fact Also Exists as to Reliance

“Section 18 of the Exchange Act, 15 U.S.C. § 78r(a), requires actual rather than constructive reliance upon a materially false or misleading statement by one who has purchased or sold a security.” Id. at *9. The district court held that the Jefferson Plaintiffs had “failed to show reliance because they could not demonstrate that they or their representatives ‘actually saw Winstar’s 1999 Form 10–K filing, much less read the included independent account report of GT.’” Id. (quoting In re Winstar Commc’ns Sec. Litig., 2010 WL 3910322, at *6 (S.D.N.Y. Sept. 29, 2010)).  

The Second Circuit found that “the [d]istrict [c]ourt’s conclusion somewhat understate[d] the record evidence on this score.” Id. One of the plaintiffs’ representatives testified that although she could not “recall specifically” reviewing GT’s audit opinion letter, “she actively reviewed such letters as a matter of practice in deciding whether to recommend certain stocks.” Id. The Second Circuit held that “from that evidence, a jury reasonably could infer that she actually reviewed the relevant documents.” Id.

The Plaintiffs Presented Sufficient Evidence for a Jury to Infer Loss Causation

“GT argue[d] in the alternative that the [d]istrict [c]ourt’s grant of summary judgment should be affirmed because the [p]laintiffs failed to show loss causation.” Id. at *10. The plaintiffs relied “largely” on the deposition testimony of an expert witness economist and “argue[d] that they [had] adduced proof of loss causation in the form of the press releases from Asensio and Winstar’s April 2001 announcements, which publicly exposed Winstar’s substantial financial weaknesses and together suggested for the first time that Winstar had engaged in improper revenue recognition practices for a period of time that included 1999.” Id. GT “counter[ed] that any decline in Winstar’s stock price that was not caused by” the collapse of the telecom bubble was the result of the cancellation of its $2 billion credit facility. Id.

Although the Second Circuit found that the loss causation question was “a much closer call,” the court concluded that “a jury could reasonably infer based on the expert testimony and other evidence that the precipitous decline in Winstar’s stock price in 2001 was attributable in part to the alleged fraud.” Id.