On November 14, 2012, Southern District of New York District Judge Shira A. Scheindlin issued a decision setting important precedents for auditors of publicly traded companies. This is one of the first comprehensive decisions addressing auditor liability for audits of China-based companies traded on U.S. exchanges. Dozens of lawsuits have been filed across the country involving such companies and their auditors. The decision’s comprehensive approach is likely to be a blueprint for future litigants and courts in deciding similar cases.

Securities Litigation Involving China-Based Companies

In the late 1990s through the mid-2000s, many China-based companies sought to tap the U.S. capital markets to secure new investment capital and other sources of American investors’ funds. Many of those companies entered into reverse merger transactions whereby the Chinese company was “acquired” by a shell company already authorized to trade on U.S. markets. Often, the shell company’s only asset was its ability to trade on U.S. stock exchanges. Many subsequently disgruntled investors now claim that through this “reverse merger” type transaction, the Chinese company could avoid the scrutiny that would normally accompany an IPO.

In the past few years, several lawsuits have been initiated against such Chinese entities and many of those lawsuits involve those companies’ auditors. The allegations boil down to claims that the Chinese company’s financial statements overstated revenue and assets to fraudulently attract investors. As against the auditors, the claims are usually that the auditors failed to uncover or prevent the fraud, thereby becoming liable for the companies’ fraudulent activity.

The Longtop Financial Case

In In re Longtop Financial Technologies, Ltd. Sec. Litig., 2012 U.S. Dist. LEXIS 162878 (S.D. N.Y. Nov. 14, 2012), the lead plaintiffs brought an action against Longtop Financial Technologies and several of its officers; its auditor, Deloitte Touche Tohmatsu CPA Ltd. (Deloitte); and its auditor’s parent company, Deloitte Touche Tohmatsu. As against the auditor, plaintiffs alleged violations of Rule 10b-5, promulgated under section 10(b) of the Securities Exchange Act. Deloitte filed a motion to dismiss the complaint arguing that the complaint failed to allege a cause of action under the Exchange Act. Judge Scheindlin’s November 14 decision addressed Deloitte’s motion.

To sustain a claim for securities fraud under section 10(b), a plaintiff must establish (1) a material misrepresentation or omission, (2) scienter (the intent to defraud), (3) a connection between the misrepresentation or omission and the purchase or sale of a security, (4) reliance upon the misrepresentation or omission, (5) economic loss and (6) loss causation. The Court addressed two issues: (1) whether Deloitte acted with scienter and (2) whether the audit opinion constituted a material misrepresentation.

The complaint alleged that Deloitte violated Generally Accepted Auditing Standards (GAAS) and that the financial statements violated Generally Accepted Accounting Principles (GAAP). Plaintiffs alleged that, therefore, Deloitte’s statements that its audits were conducted in accordance with Public Company Accounting Oversight Board (PCAOB) standards were materially false. The complaint also alleged that a proper audit would have revealed six “red flags” of fraud. Plaintiffs contended that Deloitte’s scienter, or intent to defraud, could be shown through the recklessness with which they conducted their audits. To establish recklessness based on GAAS violations, a class action securities fraud complaint against an auditor must couple allegations of GAAS departures with recklessly disregarded “red flags.”

The Findings

First, Judge Scheindlin found that the plaintiffs failed to properly allege scienter and that it was more likely that Deloitte was “duped” by Longtop than that Deloitte intended to defraud investors. Specifically, the Court found that plaintiffs failed to allege that Deloitte was actually aware of the purported red flags and that the identified red flags were insufficient to establish that Deloitte’s audit “amounted to no audit at all,” the standard for establishing scienter on the basis of an auditor’s recklessness. Moreover, the Court found plaintiffs’ theories that the size of the alleged fraud, the rapidity with which Deloitte uncovered the fraud and the mere fact that Longtop reported high profit margins to be insufficient to satisfy the strict pleading requirements.

Second, Judge Scheindlin addressed another significant issue in securities fraud litigation against auditors. Specifically, the Court addressed whether the auditor’s opinions constituted “misstatements” or merely “opinions.” Deloitte argued that the auditor’s statement of GAAS compliance is a statement of opinion that could not be a material misstatement unless subjectively false at the time it was made. Plaintiffs, on the other hand, argued that if there is a GAAP violation by Longtop, it must follow that there was a material misstatement on the part of the auditor.

Judge Scheindlin adopted the approach set forth in a recent decision, In re Lehman Bros. Securities and ERISA Litigation, 799 F. Supp. 2d 258, 302 (S.D.N.Y. 2011), finding that: “Under this standard, to allege that an auditor opinion is a misrepresentation, a complaint must show that the statement in question is grounded on a specific factual premise that is false, and that the speaker did not ‘genuinely or reasonably believe’ it.” However, whether a misrepresentation exists will depend on the audit defects and whether it was reasonable for the auditor to hold its opinion in light of those defects. That the underlying financial statements are misleading is not dispositive of the quality of the audit or the auditor’s liability.

Importantly, Judge Scheindlin also found that allegations relating to “short seller” reports do not provide the basis for an adequate pleading of scienter. Several class actions alleging securities fraud have been initiated as a result of short seller reports causing stock prices to decline. Short sellers operate by speculating that the price of a security will decrease. Not surprisingly, after they place their “bets” about an impending decrease in stock price, some short sellers will publish reports critical of the company or its auditors hoping to ”disclose” improper financial activity, which will have the effect of driving the stock price down. The Court found that those reports’ obvious motive to exaggerate makes reliance on such reports improper. The Court noted: “If an auditor were liable every time a short seller issued a report prior to a fraud being uncovered, then the scope of auditor liability would extend well beyond that contemplated by the [Private Securities Litigation Reform Act].”

Impact for Professionals

The Longtop Financial decision reinforces important principles and strengthens the case law in defense of auditors. Although the plain text of audit reports clearly indicates the nature of the conclusion as being the auditor’s opinion based on audit procedures applied rather than a guarantee of the accuracy of the underlying financial data, many plaintiffs have argued that the role of the accountant is more like that of a guarantor of the accuracy of the company’s financial data. Up until now, there was only limited precedent supporting the auditor’s position to the contrary. The Longtop Financial decision, however, clearly articulates that the auditor’s conclusions are to be treated as opinions rather than as statement of fact. Thus, the legal question shifts from focusing on the underlying company’s alleged fraud to whether the auditor actually held the opinion it professed to hold and whether it had a reasonable basis to hold such an opinion.

The decision is especially important for the auditors of China-based issuers, as dozens of other cases have raised securities fraud claims involving very similar allegations across the board. The Longtop Financial decision provides a blueprint for future litigators and courts to resolve future cases with similar allegations.