Document ID: s3://data.kl3m.ai/documents/govinfo/USCOURTS/USCOURTS-ca8-04-01064/USCOURTS-ca8-04-01064-0/pdf.json

Parties Involved:
Ernst & Young
Appellee
Ferris, Baker Watts
Appellant

Document Text:

1

The Honorable Richard H. Kyle, United States District Judge for the District

of Minnesota.

United States Court of Appeals

FOR THE EIGHTH CIRCUIT

___________

No. 04-1064

___________

Ferris, Baker Watts, Inc., *

*

Appellant, *

* Appeal from the United States

v. * District Court for the

* District of Minnesota.

Ernst & Young, LLP, *

*

Appellee. * 

___________

Submitted: November 17, 2004

Filed: January 21, 2005

___________

Before SMITH, BEAM, and BENTON, Circuit Judges. 

___________

BENTON, Circuit Judge.

 Ferris, Baker Watts, Inc. ("FBW") sued Ernst & Young, LLP ("E & Y") for

securities fraud. The district court1

 dismissed for failure to state a claim. The issue

is whether the allegations show scienter under the pleading requirements of the

Private Securities Litigation Reform Act. Having jurisdiction under 28 U.S.C. §

1291, this court affirms.

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I.

MJK Clearing, Inc., a broker-dealer, engaged in securities borrowing. In

securities borrowing, one party lends a security to MJK, which pays cash collateral

slightly exceeding its value. The cash collateral is "marked to market" so that, if the

price of the security rises, MJK pays cash to the lender; if the price of the security

falls, the lender owes MJK cash.

By March 31, 2001, MJK had paid $160 million cash—representing nearly one

half of its accounts receivable and 21 percent of its total assets—to another brokerdealer, Native Nations Securities, Inc., in exchange for borrowed securities. These

securities were mostly from three thinly-traded issuers, including GenesisIntermedia,

Inc. In September 2001, the price of GenesisIntermedia fell; Native Nations did not

pay the cash collateral it owed MJK. MJK collapsed, and the Securities Investor

Protection Corporation began liquidation of MJK.

The complaint alleges that after MJK's collapse, FBW, also a broker-dealer,

could not reclaim $20 million of cash collateral it had paid MJK. According to FBW,

it dealt with MJK relying on E & Y's audit of MJK's financial statements, as of yearend March 31, 2001.

FBW alleges that E & Y's audit violates Section 10(b) of the Securities Act of

1934, 15 U.S.C. § 78j(b), and SEC Rule 10b-5, 17 C.F.R. § 240.10b-5. FBW claims

that E & Y recklessly misrepresented that its audit met generally accepted auditing

standards (GAAS), and that MJK's financial statements were fairly presented in

accordance with generally accepted accounting principles (GAAP).

The district court dismissed, holding that the complaint insufficiently alleges

scienter.

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II.

This court reviews de novo a dismissal for failure to state a claim, accepting

as true all facts alleged in the complaint. Fed. R. Civ. P. 12(b)(6); Kushner v.

Beverly Enters., Inc., 317 F.3d 820, 824 (8th Cir. 2003); In re Navarre Corp. Sec.

Litig., 299 F.3d 735, 740-41 (8th Cir. 2002). The court disregards "catch-all" or

"blanket" assertions not meeting the particularity requirements of the Private

Securities Litigation Reform Act, 15 U.S.C. § 78u-4. See Navarre, 299 F.3d at 742,

quoting Florida State Bd. of Admin. v. Green Tree Fin. Corp., 270 F.3d 645, 660

(8th Cir. 2001).

Section 10(b) and Rule 10b-5 prohibit fraudulent conduct in the sale and

purchase of securities. See 15 U.S.C. § 78j(b); 17 C.F.R. § 240.10b-5. Claims

require four elements: "(1) misrepresentations or omissions of material fact or acts

that operated as a fraud or deceit in violation of the rule; (2) causation, often analyzed

in terms of materiality and reliance; (3) scienter on the part of the defendants; and (4)

economic harm caused by the fraudulent activity occurring in connection with the

purchase and sale of a security." In re K-Tel Int'l, Inc. Sec. Litig., 300 F.3d 881, 888

(8th Cir. 2002), citing 17 C.F.R. 240.10b-5. Only scienter—the intent to deceive,

manipulate, or defraud—is at issue here. See Ernst & Ernst v. Hochfelder, 425 U.S.

185, 193 & n.12 (1976).

The Reform Act embodies the pleading requirement of Fed. R. Civ. P. 9(b).

K-Tel, 300 F.3d at 889; Navarre, 299 F.3d at 742. Under the Act, a complaint must

"state 'with particularity' facts giving rise to a 'strong inference' that the defendant

acted with the scienter required for the cause of action." Green Tree, 270 F.3d at

654, quoting 15 U.S.C. § 78u-4(b)(2). Inferences of scienter must be both

"reasonable" and "strong" to survive a motion to dismiss. Kushner, 317 F.3d at 827.

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Mere negligence does not violate Rule 10b-5. Ernst & Ernst, 425 U.S. at 214.

Severe recklessness, however, may. K & S P'ship v. Cont'l Bank, N.A., 952 F.2d

971, 978 (8th Cir. 1991), cert. denied, 505 U.S. 1205 (1992). Recklessness is

"limited to those highly unreasonable omissions or misrepresentations

that involve not merely simple or even inexcusable negligence, but an

extreme departure from the standards of ordinary care, and that present

a danger of misleading buyers or sellers which is either known to the

defendant or is so obvious that the defendant must have been aware of

it."

Green Tree, 270 F.3d at 654, quoting Camp v. Dema, 948 F.2d 455, 461 (8th Cir.

1991). This level of recklessness requires that defendants make statements that they

know, or have access to information suggesting, are materially inaccurate. Navarre,

299 F.3d at 746.

III.

FBW argues it pleaded that E & Y knew of, or had access to, facts that permit

a strong inference that its audit opinion was knowingly or recklessly false or

misleading. It claims E & Y falsely stated that it conducted the audit in accordance

with GAAS, when: (1) E & Y's review of internal control of MJK's securitiesborrowing department—the largest and most rapidly growing part of the

company—revealed a complete absence of internal control, imposing a duty of

heightened scrutiny that E & Y ignored; (2) E & Y failed to investigate whether the

$160 million receivable from Native Nations was impaired; and (3) E & Y failed to

investigate any subsequent events after the audit (but before issuance of the audit

opinion) as to the collectibility of MJK's account receivable from Native Nations,

which investigation would have revealed defaults.

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FBW further alleges that E & Y disregarded GAAP, which a reasonable

accountant follows. Thus, FBW says, a strong inference of scienter arises that E &

Y's audit opinion that MJK's financial statements conformed with GAAP was a

knowing or reckless misstatement of fact. Specifically, FBW alleges that the

financial statements do not disclose as required by GAAP: (1) the concentration of

credit risk in the $160 million receivable from Native Nations; (2) the risk that the

Native Nations receivable was impaired or uncollectible; and (3) the "going concern"

risk from the Native Nations receivable.

Finally, FBW alleges that E & Y failed to disclose—as required by SEC Rule

17a-5, 17 C.F.R. § 240.17a-5—material inadequacies in MJK's internal controls

known to E & Y, permitting a strong inference that the nondisclosure was knowing

or reckless.

IV.

"Allegations of GAAP violations are insufficient, standing alone, to raise an

inference of scienter. Only where these allegations are coupled with evidence of

corresponding fraudulent intent might they be sufficient." Navarre, 299 F.3d at 745

(citations omitted). See also Kushner, 317 F.3d at 827, 831 (affirming dismissal of

complaint alleging failure to establish accounting reserves); K-Tel, 300 F.3d at 886,

894-95 (affirming dismissal of complaint based on overstatement of assets and "sheer

magnitude" of GAAP violations).

Assuming GAAP and GAAS violations occurred here, FBW's catch-all and

blanket assertions that E & Y acted recklessly or knowingly are not "evidence of

corresponding fraudulent intent." See Navarre, 299 F.3d at 745. This is not a case

like Green Tree, where a defendant published statements knowing that crucial

information in them was based on discredited assumptions. Green Tree, 270 F.3d at

665. 

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FBW asserts that the district court misreads Kushner, K-Tel, and Navarre. In

fact, the lower court follows not only this court's cases, but also those from other

Circuits. See, e.g., Novack v. Kasaks, 216 F.3d 300, 309 (2d Cir.) ("[A]llegations of

GAAP violations or accounting irregularities, standing alone, are insufficient to state

a securities fraud claim."), cert. denied, 531 U.S. 1012 (2000); Stevelman v. Alias

Research Inc., 174 F.3d 79, 84 (2d Cir. 1999) ("Allegations of a violation of GAAP

provisions or SEC regulations, without corresponding fraudulent intent, are not

sufficient to state a securities fraud claim."); Chill v. Gen. Elec. Co., 101 F.3d 263,

270 (2d Cir. 1996) (same); Fidel v. Farley, 392 F.3d 220, 230 (6th Cir. 2004) ("[T]he

failure to follow generally accepted accounting procedures does not in and of itself

lead to an inference of scienter."); DSAM Global Value Fund v. Altris Software,

Inc., 288 F.3d 385, 387 (9th Cir. 2002) (affirming dismissal of allegations of a

"seriously botched audit" and "a compelling case of negligence—perhaps even gross

negligence"); In re Software Toolworks Inc. Sec. Litig., 50 F.3d 615, 627-28 (9th

Cir. 1994) (affirming summary judgment for auditor, stating that "mere publication

of inaccurate accounting figures, or a failure to follow GAAP, without more, does not

establish scienter"), cert. denied sub nom. Montgomery Sec. v. Dannenberg, 516

U.S. 907 (1995).

FBW repeatedly asserts that E & Y's audit was so cursory and superficial as to

amount to "no audit at all." See Software Toolworks, 50 F.3d at 628 (auditing that

is "no audit at all" shows scienter). The facts alleged here show otherwise. FBW's

complaint says that E & Y was fully aware of the risks associated with MJK's

securities borrowing and lending operations, and had an audit plan that recognized

the need for closer testing of securities borrowing. FBW states that E & Y did

confirm the account receivable with Native Nations, noting its excess over the value

of the collateral securities, and its concentration in three issuers. According to the

complaint, E & Y did interview MJK's securities-borrowing department manager,

who described the processes and procedures, and represented that he performed credit

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reviews "anywhere from monthly to annually by reviewing other Broker FOCUS

reports." FBW pleads that E & Y examined five files of MJK's (approximately) 60

customers for the presence of signed agreements and annual credit evaluations,

inquired as to deficiencies in the files, and verified that securities-borrowing

personnel prepared numerous reports, including daily "Balance Order Fail Reports."

According to FBW, E & Y conducted tests of internal control activities, and

identified reconciliations of balance-sheet cash accounts to bank accounts, and

balance-sheet securities ledgers to securities accounts. E & Y concluded that internal

controls were effective, and could be relied upon to reduce the substantive audit

procedures (and increase reliance on management's representation that no subsequent

events occurred after fieldwork, but before issue of the opinion). In sum, FBW

alleges a poor audit, not the intent to deceive, manipulate, or defraud required for

securities fraud.

The judgment of the district court is affirmed.

_____________________________

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