FOR PUBLICATION

UNITED STATES COURT OF APPEALS

FOR THE NINTH CIRCUIT

NEW MEXICO STATE INVESTMENT 

COUNCIL, Lead Plaintiff,

Plaintiff-Appellant,

and

SONAM BAKSHI, individually and on

behalf of all others similarly

situated; BAKERS LOCAL NO. 433

PENSION FUND; MINNESOTA BAKERS

UNION PENSION FUND; TWIN CITIES No. 09-55632

BAKERY DRIVERS PENSION FUND, D.C. No.

Plaintiffs,  2:06-CV-05036-

v. R-CW

ERNST & YOUNG LLP, OPINION

Defendant-Appellee,

and

HENRY SAMUELI; WILLIAM J.

RUEHLE; BROADCOM CORPORATION;

DAVID A. DULL; ALAN E. ROSS;

WERNER F. WOLFEN; GEORGE L.

FARINSKY,

Defendants. 

Appeal from the United States District Court

for the Central District of California

Manuel L. Real, District Judge, Presiding

Argued and Submitted

November 1, 2010—Pasadena, California

Filed April 14, 2011

5033
Before: Johnnie B. Rawlinson and Alfred T. Goodwin,

Circuit Judges, and Jack Zouhary, District Judge.*

Opinion by Judge Zouhary

*The Honorable Jack Zouhary, United States District Judge for the

Northern District of Ohio, sitting by designation. 

5034 NEW MEXICO STATE INVESTMENT v. ERNST & YOUNG
COUNSEL

Thomas A. Dubbs (argued), Joseph A. Fonti, and Stephen W.

Tountas, Labaton Sucharow LLP, New York, New York, for

lead plaintiff-appellant New Mexico State Investment Council.

Robert B. Hubbel (argued), Michael M. Farhang, and Alexander K. Mircheff, Gibson, Dunn & Crutcher LLP, Los Angeles,

California, for defendant-appellee Ernst & Young, LLP.

5036 NEW MEXICO STATE INVESTMENT v. ERNST & YOUNG
OPINION

ZOUHARY, District Judge:

INTRODUCTION

Lead Plaintiff New Mexico State Investment Council, individually and on behalf of all others similarly situated

(“Plaintiffs”), appeals the district court’s grant of Defendant

Ernst & Young’s (“EY”) Motion to Dismiss. The claims

against EY stem from a securities class action complaint

against Broadcom Corporation (“Broadcom”), certain Broadcom officers and directors, and Broadcom’s auditor EY (collectively, “Defendants”), for a fraudulent $2.2 billion stock

options backdating scheme. Plaintiffs specifically allege that

EY, as Broadcom’s auditor, knew of, or recklessly disregarded, Broadcom’s fraudulent backdating actions yet issued

unqualified audit opinions attesting to the validity of Broadcom’s financial statements. The district court granted EY’s

Motion to Dismiss, finding the Consolidated Amended Class

Action Complaint (“Complaint”) failed to adequately plead

scienter against EY.

Plaintiffs contend on appeal that the Complaint contains

well-pled factual allegations sufficient to survive a motion to

dismiss. EY argues dismissal was proper and, in the alternative, the district court’s judgment should be affirmed based on

Plaintiffs’ failure to sufficiently plead loss causation, a ground

the district court explicitly did not reach.1

1EY argues this Court can affirm “on any ground supported by the

record, even if the district court did not rely on the ground.” Livid Holdings, Ltd. v. Salomon Smith Barney, Inc., 416 F.3d 940, 950 (9th Cir.

2005). While correct, the U.S. Supreme Court cautions: “It is the general

rule, of course, that a federal appellate court does not consider an issue not

passed upon below.” Singleton v. Wulff, 428 U.S. 106, 120 (1976); see

also Peterson v. Highland Music, Inc., 140 F.3d 1313, 1318 (9th Cir.

1998). Because the district judge stated explicitly that he did not reach the

issue of loss causation with respect to EY, we will not second guess the

district court in the absence of a record. 

NEW MEXICO STATE INVESTMENT v. ERNST & YOUNG 5037
PROCEDURAL HISTORY and BACKGROUND

Procedural History

This case finds its roots in a large accounting fraud related

to stock option backdating. Broadcom, a semiconductor company with revenues in excess of $2.5 billion in 2006, fraudulently overstated its net earnings, and understated its

compensation expense, by more than $2.2 billion between

2000 and 2006 due to improper accounting of backdated stock

options. 

In October 2008, Plaintiffs filed a Consolidated Amended

Class Action Complaint on behalf of all persons who purchased Broadcom Class A common stock between July 21,

2005 and July 13, 2006. The Complaint seeks damages under

Section 10(b) of the Securities Exchange Act of 1934, 15

U.S.C. § 78j(b), and Securities Exchange Commission Rule

10b-5 for Defendants’ fraudulent accounting practices, alleging they caused Broadcom’s stock price to be artificially

inflated. 

Defendants moved to dismiss. The district court heard oral

argument in February 2009 and granted Defendant EY’s

Motion to Dismiss, stating: “I think the allegations are deficient on actual knowledge of the defendant . . . , and I think

there’s a little bit of a heavier burden of allegations on

accountants on the question of scienter.” “Plaintiff has failed

adequately to plead scienter as against EY[.]” 

The Complaint

The lengthy Complaint includes nearly thirty-five pages of

allegations that EY, as Broadcom’s auditor, was complicit in

a stock option backdating scheme involving options to purchase over 239 million shares of Broadcom stock between

1998 and 2005. Broadcom used stock options as part of a

compensation package for officers, directors, and key

5038 NEW MEXICO STATE INVESTMENT v. ERNST & YOUNG
employees. The recipient of the option was given the opportunity to purchase a certain number of shares of company stock

at a given price on or after a predetermined date.2 Broadcom’s

option plan provided for a vesting schedule of four years,

meaning an employee could only exercise his or her option

over a four-year period. 

Backdating of options is akin to betting on a horse race

after the horse has already crossed the finish line. Backdating

of options occurs when a company’s officers or directors

responsible for administering the stock option plan monitor

the price of the company stock and then award a stock option

grant as of a certain date in the past when the share price was

lowest, thus locking in the largest possible gain for the option

recipient. 

A backdated option is not in and of itself improper under

the law or accounting principles. See Edward J. Goodman

Life Income Trust v. Jabil Circuit, Inc., 594 F.3d 783, 788

(11th Cir. 2010). However, when a company chooses to issue

such “in the money” options (so called because the options

represent an immediate paper profit), accounting principles

require the company to record an expense for the “profit,”

treated as compensation to the option recipient over the vesting period. If the company does not properly record the backdated options, then the company’s reported net income is

2For example, if the company granted an option to an employee to purchase 100 shares at a “strike price” of $10/share, the employee can purchase 100 shares for $1,000, regardless of the market price for the shares

on the date the employee exercises the option. Thus, if the market price

for the shares on the day the option was exercised was $15/share, the

employee had an immediate paper profit of $5/share. If, however, the market price for the stock is lower than the strike price on the day the option

can be exercised, the option is worthless because the stock could be purchased on the open market cheaper than by exercising the option. Options

typically vest over a set time period. E.g., if the grant was 100 shares at

$10/share over four years, the employee could exercise the option to purchase 25 shares per year (4 years x 25 shares = 100 total shares). 

NEW MEXICO STATE INVESTMENT v. ERNST & YOUNG 5039
overstated for each of the years the options vest, potentially

deceiving the market and investors.

The Restatement and EY Opinion 

Broadcom engaged in an improper stock option backdating

scheme that required the company to restate its financial statements in January 2007 for fiscal years 1998 to 2005 (the “Restatement”). The Restatement acknowledged that Broadcom

had improperly accounted for $2.2 billion in income, largely

due to improper option backdating. Additionally, every financial statement, and quarterly and annual report issued during

the time period covered by the Restatement, was false and

misleading. As a result, Broadcom agreed to a civil penalty of

$12 million in connection with a SEC civil securities fraud

investigation, and various Broadcom officers and directors

face civil and criminal charges. 

The crux of Plaintiffs’ claim is that EY, in its role of auditor issuing the unqualified 2005 Opinion, knew of, or was

deliberately reckless in not knowing, that the 2005 Opinion

was materially false and misleading due to Broadcom’s stock

option backdating scheme. The 2005 Opinion covered three

years of Broadcom’s financial statements (2003-05), stating

that the financial statements “present fairly, in all material

respects, the consolidated financial position of Broadcom

Corporation at December 31, 2005 and 2004, and the consolidated results of its operations and its cash flows for each of

the three years in the period ended December 31, 2005, in

conformity with generally accepted accounting principles

[(“GAAP”)].” The 2005 Opinion also stated that EY had performed the audit in accordance with generally accepted auditing standards (“GAAS”).

Allegations Against EY

Plaintiffs’ allegations that EY had the required scienter for

a fraud claim, namely that EY knew, or was deliberately reck5040 NEW MEXICO STATE INVESTMENT v. ERNST & YOUNG
less in not knowing, about the fraudulent option backdating,

are as follows:

• EY knew the material consequences of a May

2000 backdated option grant that would have

resulted in a $700 million charge to Broadcom’s

financial results but, despite violations of GAAS,

signed off on the grant without obtaining documentation;

• EY knew that several significant option grants

were approved on dates when Broadcom’s compensation committee was not legally constituted

due to the death of one of the two committee

members;

• EY presided over corrective reforms in 2003 to

prevent and detect any future instances of

improper stock option awards without questioning the integrity of Broadcom’s accounting for

options granted prior to the corrective reforms;

• EY knew that there was insufficient documentation for nearly half of the $2.2 billion in backdated option grants in violation of GAAS;

• EY knew that Broadcom’s internal controls were

weak and failed to expand the scope of its audit

procedures as required under GAAS; and

• EY was deliberately reckless in ignoring a number of “red flags” that should have alerted them

to the potential for material misstatements related

to stock-based compensation.

The Complaint includes additional details with respect to

each of the above allegations, and Plaintiffs argue that these

detailed allegations, both individually and collectively, supNEW MEXICO STATE INVESTMENT v. ERNST & YOUNG 5041
port a strong inference that EY had the necessary scienter to

survive a Motion to Dismiss.

STANDARD OF REVIEW

We review de novo challenges to a dismissal for failure to

state a claim under Federal Civil Rule 12(b)(6). Livid Holdings, Ltd., 416 F.3d at 946. Such review is generally limited

to the face of the complaint, materials incorporated into the

complaint by reference, and matters of judicial notice. Metzler

Inv. GMBH v. Corinthian Colls., Inc., 540 F.3d 1049, 1061

(9th Cir. 2008) (citing Tellabs, Inc. v. Makor Issues & Rights,

Ltd., 551 U.S. 308, 322 (2007)). In undertaking this review,

we will “accept the plaintiffs’ allegations as true and construe

them in the light most favorable to plaintiffs,” Gompper v.

VISX, Inc., 298 F.3d 893, 895 (9th Cir. 2002), and will hold

a dismissal inappropriate unless the complaint fails to “state

a claim to relief that is plausible on its face,” Bell Atl. Corp.

v. Twombly, 550 U.S. 544, 570 (2007).

ALLEGATIONS OF SCIENTER

[1] To adequately plead scienter, a securities fraud complaint must “state with particularity facts giving rise to a

strong inference that the defendant acted with the required

state of mind.” 15 U.S.C. § 78u-4(b)(2)(A). A complaint can

plead scienter by raising a strong inference that the defendant

possessed actual knowledge or acted with deliberate recklessness. Zucco Partners, LLC v. Digimarc Corp., 552 F.3d 981,

991 (9th Cir. 2009). Contrary to the district court’s comment

that scienter allegations against accountants or auditors carry

“a little bit of a heavier burden,” this Court has previously

advised against developing “separate[ ] rules of thumb for

each type of scienter allegation.” South Ferry LP, No. 2 v.

Killinger, 542 F.3d 776, 784 (9th Cir. 2008).

A securities fraud complaint will survive a motion to dismiss under Rule 12(b)(6) “only if a reasonable person would

5042 NEW MEXICO STATE INVESTMENT v. ERNST & YOUNG
deem the inference of scienter cogent and at least as compelling as any opposing inference one could draw from the facts

alleged.” Tellabs, Inc., 551 U.S. at 324. Thus, a court reviewing scienter allegations under the Private Securities Litigation

Reform Act of 1995 (“PSLRA”) must “consider the complaint

in its entirety.” Id. at 322. The court must determine whether

“all of the facts alleged, taken collectively, give rise to a

strong inference of scienter, not whether any individual allegation, scrutinized in isolation, meets that standard.” Id. at

323. Finally, when “determining whether the pleaded facts

give rise to a ‘strong’ inference of scienter, the court must

take into account plausible opposing inferences.” Id. This “inquiry is inherently comparative.” Id. A court must compare

the malicious and innocent inferences cognizable from the

facts pled in the complaint, and only allow the complaint to

survive a motion to dismiss if the malicious inference is at

least as compelling as any opposing innocent inference. See

id. at 324; see also Metzler Inv., 540 F.3d at 1066.

[2] Under Tellabs and Ninth Circuit law, we conduct a

two-part inquiry for scienter: first, we determine whether any

of the allegations, standing alone, are sufficient to create a

strong inference of scienter; second, if no individual allegation is sufficient, we conduct a “holistic” review of the same

allegations to determine whether the insufficient allegations

combine to create a strong inference of intentional conduct or

deliberate recklessness. Zucco, 552 F.3d at 991-92. Arguing

that EY was, or should have been, aware of significant

accounting problems within audit years covered by its 2005

Opinion, Plaintiffs allege scienter based on three specific

points when EY was faced with circumstances that would

compel a reasonable auditor to further investigate and disclose

Broadcom’s backdating of options: (1) a large grant of

options on May 26, 2000 for which EY was given no documentation; (2) options granted in 2001 during a period when

Broadcom’s compensation committee did not have a quorum

due to the death of one of its members; and (3) EY’s direct

NEW MEXICO STATE INVESTMENT v. ERNST & YOUNG 5043
involvement in 2003 with corrective reforms to Broadcom’s

prior options practices.

We hold that these factual allegations were each sufficient

to support an inference of scienter by EY. While a holistic

review is therefore unnecessary, these primary allegations certainly support an inference of scienter when viewed collectively with other claims that EY received no documentation

for many option grants, knew Broadcom’s internal controls

were weak, and ignored other red flags.

EY’s Knowledge of the May 2000 Backdated Option

Grant

Plaintiffs’ most detailed allegations of scienter involve a

series of events surrounding a large stock option grant on May

26, 2000, when Broadcom’s Compensation and Options Committee allegedly granted over seven million options to various

senior officers. At the time, this was the single largest grant

of stock options in Broadcom’s history. The choice of the

May date for the option grant was suspect because, on that

day, not only was the price of Broadcom’s stock at its lowest

point for the entire month of May, but also the lowest closing

price since October 1999 and, as it turns out, until October

2000.

By July 2000, EY started to question the timing of the May

2000 grant, as Broadcom’s stock price had risen from $118

per share on May 26, 2000 to a high of $261 per share in July

2000. Plaintiffs allege that EY knew by July 2000 that Broadcom had not yet allocated the grants to its employees, as

required under GAAS, but failed to investigate. Accordingly,

EY’s issuance of the unqualified 2005 Opinion (including the

accuracy of Broadcom’s 2003-05 financials) represented a

material misstatement. 

The Complaint points to emails sent on July 20, 2000.

Broadcom’s Manager of Financial Reporting informed Broad5044 NEW MEXICO STATE INVESTMENT v. ERNST & YOUNG
com’s CFO that she was “experiencing resistance from [EY]”

and that “[t]he basic concern is the measurement date of these

grants (5/26/00).” The Manager of Financial Reporting also

informed the CFO that “[the auditors] could require us to

record compensation expenses . . . [that] could be over $700

million based on the 5/26/00 price and the current price!”

Later that day, Broadcom’s CFO informed the CEO that EY

was requesting documentation, which did not exist, for the

May 2000 grant, and that EY was “making noise” that the

company will have to take a $700 million compensation

charge.

Concern over the measurement date of the grant was based

on a specific GAAP standard. The reporting of expenses associated with stock options is governed by an opinion by the

Accounting Principles Board entitled “Accounting for Stock

Issued to Employees.” ACCOUNTING PRINCIPLES BOARD,

OPINION NO. 25 (1972) (“APB 25”).3 Under APB 25, if the

options had an exercise price lower than the fair market value

of the stock as of the “measurement date,” the company

would have to recognize a compensation expense over the

option’s vesting period or the period of time the employee

performed services for the company. The expense would be

equal to the difference between fair market value as of the

grant date and the exercise price. APB 25 §§ 12-14. 

Critical to this rule is the option’s “measurement date.”

This term refers to the date on which the fair market value of

the option is determined. The measurement date is the first

date on which both of the following are known: (1) the number of options that each individual employee is entitled to

3The Financial Accounting Standards Board promulgated Rule FAS123

in 1995 with the intent of replacing APB 25 for the accounting of stock

options. However, companies were permitted to continue using APB 25 in

reporting their financial statements. Broadcom chose to continue using

APB 25 as reflected in its financial statements during the relevant time

period. 

NEW MEXICO STATE INVESTMENT v. ERNST & YOUNG 5045
receive, and (2) the option or purchase price. APB 25.10(b).

Frequently, the measurement date is the date the option is

granted to the employee. Id. There are instances where the

measurement date can be more complicated to measure, such

as an option grant conditioned on some other event occurring,

such as a promotion or assuming a new position. See In re

CNET Networks, Inc., 483 F. Supp. 2d 947, 955 (N.D. Cal.

2007). When a company, under proper guidance of the board

of directors and executives, chooses to award a block of

options to various employees, the measurement date cannot

be established until the exact recipients and their respective

number of options are identified. Id. at 955-56 (citing APB

25.10(b)).

Plaintiffs allege that EY violated GAAS by failing to verify

whether Broadcom’s May 2000 option grant was in violation

of GAAP and APB 25. GAAS standards provide, in part: 

[T]he accountant may become aware of matters that

cause him or her to believe that interim financial

information, filed or to be filed with a specified regulatory agency, is probably materially misstated as a

result of a departure from generally accepted

accounting principles. In such circumstances, the

accountant should discuss the matters with the

appropriate level of management as soon as practicable. . . . If, in the accountant’s judgment, management does not respond appropriately to the

accountant’s communication within a reasonable

period of time, the accountant should inform the

audit committee, or others with equivalent authority

and responsibility . . . of the matters as soon as practicable. 

PUBLIC COMPANY ACCOUNTING OVERSIGHT BOARD (“PCAOB”),

INTERIM AUDITING STANDARDS (“AU”) § 722A.20-.21. GAAS

also requires an auditor to maintain independence in mental

attitude during an audit, to obtain sufficient evidence to afford

5046 NEW MEXICO STATE INVESTMENT v. ERNST & YOUNG
a reasonable basis for its opinion, and for financial statements

subject to audit to be presented in accordance with GAAP.

See AU §§ 220, 410; PCAOB, AUDITING STANDARDS (“AS”)

§ 15.04.

The EY audit team, led by partners Blythe and Stump,

allegedly engaged in an “intense discussion” but no follow up

with Broadcom’s executives, and eventually “capitulated” to

Broadcom’s CFO on July 24, 2000, ultimately relying on a

single conversation with him that the option grant was properly accounted. Plaintiffs claim that the CFO told EY that, on

May 26, 2000, the Options Committee had (1) authorized a

fixed number of options to be granted; and (2) approved a

“program” establishing a set “Guideline Matrix” for calculating the number of options awarded to each employee. Plaintiffs allege that the CFO’s oral representation was not

sufficient to satisfy GAAP, and that EY neither received nor

relied on any documents from Broadcom before EY signedoff on the May 2000 grant, thereby violating GAAS.

In further support of EY’s wrongdoing, Plaintiffs point to

another email, sent on September 11, 2000 by Broadcom’s

Manager of Financial Reporting to its CFO, acknowledging

that EY granted Broadcom “flexibility” with respect to the

May 2000 grant, and that “[g]oing forward, we can expect

much greater scrutiny by [the auditors] on our option granting

process.”

As a result of these events, Plaintiffs argue: (1) EY had

actual knowledge that the May 2000 option grant did not

comply with GAAP and that EY’s own audit did not comply

with GAAS; and (2) because the Broadcom options had a

four-year vesting period, the consequences of the May 2000

grant caused material misstatements in Broadcom’s audited

financial statements in fiscal years 2001-04, years expressly

covered in the 2005 Opinion.

Typically, pleading sufficient facts to support a strong

inference of scienter by an outside auditor is difficult because

NEW MEXICO STATE INVESTMENT v. ERNST & YOUNG 5047
outsider auditors have more limited information than, for

example, the company executives who oversee the audit. Further, an auditor exercises “complex and subjective professional judgments that courts are not ideally positioned to

second guess.” In re Countrywide Fin. Corp. Sec. Litig., 588

F. Supp. 2d 1132, 1197 (C.D. Cal. 2008). In examining allegations of scienter, courts have looked at a range of factors for

potential “red flags,” including the interaction of auditors with

company executives and the breadth and scope of the auditor’s deviation from GAAP or GAAS. See In re Enron Corp.

Sec., Derivative & ERISA Litig., 235 F. Supp. 2d 549, 673-85

(S.D. Tex. 2002).

The “red flag” doctrine guides the GAAP and GAAS inquiries: the more facts alleged that should cause a reasonable

auditor to investigate further before making a representation,

the more cogent and compelling a scienter inference becomes.

In re Countrywide, 588 F. Supp. 2d at 1197; see also DSAM

Global Value Fund v. Altris Software, Inc., 288 F.3d 385, 389

(9th Cir. 2002). “Scienter requires more than a misapplication

of accounting principles. The plaintiff must prove that the

accounting practices were so deficient that the audit amounted

to no audit at all, or an egregious refusal to see the obvious,

or to investigate the doubtful, or that the accounting judgments which were made were such that no reasonable accountant would have made the same decisions if confronted with

the same facts.” In re Software Toolworks Inc., 50 F.3d 615,

628 (9th Cir. 1994) (quoting Miller v. Pezzani (In re Worlds

of Wonder Sec. Litig.), 35 F.3d 1407, 1426 (9th Cir. 1994)).

When assessing GAAP violations in connection with auditor scienter, the violations should generally be more than

“minor or technical in nature” and “constitute [ ] widespread

and significant inflation” to contribute to a strong inference of

scienter. In re Daou Systems, Inc., 411 F.3d 1006, 1017 (9th

Cir. 2005). While a violation of GAAP, standing alone, is not

sufficient, allegations of recklessness have been sufficient

where defendants “failed to review or check information that

5048 NEW MEXICO STATE INVESTMENT v. ERNST & YOUNG
they had a duty to monitor, or ignored obvious signs of

fraud.” Novak v. Kasaks, 216 F.3d 300, 308-09 (2nd Cir.

2000).

With respect to allegations of GAAS violations and how an

audit is conducted, “[a]lleging a poor audit is not equivalent

to alleging an intent to deceive.” Ezra Charitable Trust v.

Tyco Int’l Ltd., 466 F.3d 1, 12 n.10 (1st Cir. 2006). Rather,

just as with GAAP, the more likely an auditor would have discovered the truth if a reasonable audit had been conducted,

the stronger the scienter inference. In re Countrywide, 588 F.

Supp. 2d at 1198. 

[3] Against this backdrop, we consider the factual allegations that EY failed to further investigate the May 2000 option

grant. EY had knowledge that the grant was, at a minimum,

suspicious in not only its timing but its relative size. It was the

largest option grant in the company’s young history and the

potential $700 million impact on Broadcom’s earnings was

material. Despite this knowledge as reflected in the specific

email exchanges recited in the Complaint, EY apparently did

not take steps to verify the accuracy of the grant, then or later.

This failure to investigate such a large grant was not minor or

technical in nature, and it is hard to imagine how a reasonable

auditor, confronted with the same set of circumstances, would

fail to obtain some documentation to verify Broadcom’s executive claim of a “Guideline Matrix program” being put in

place on that very day. EY apparently accepted management

at its word, never received requested documentation, and

issued an unqualified Opinion on the accuracy of Broadcom’s

financial statements. These circumstances are sufficient to

support an inference that EY knew, or should have known, the

May 2000 options were not legitimate. See In re Homestore.com, Inc. Sec. Litig., 252 F. Supp. 2d 1018, 1044 (C.D.

Cal. 2003), vacated on other grounds by Simpson v. Homestore.com, Inc., 519 F.3d 1041 (9th Cir. 2008) (finding necessary scienter in denying a motion to dismiss, stating that it

was a “logical inference that because [the auditor] objected to

NEW MEXICO STATE INVESTMENT v. ERNST & YOUNG 5049
some transactions, it knew that the transactions and the

accounting of them were improper” and “[t]he fact that it also

allowed some of them to be reported [improperly] shows that

[the auditor] acted with deliberate recklessness in failing to

properly audit [the] transactions”). 

EY fails to suggest a more compelling innocent inference

from the circumstances alleged in the Complaint. While it

may be true that Broadcom lied to EY’s audit partners about

the creation of the “Guideline Matrix,” and Broadcom may

have even drafted fraudulent documents in support of the

Guideline Matrix, nonetheless EY never received or reviewed

any documents, real or fraudulent.

EY would lead this Court to believe that its failure to further investigate amounts to, at most, negligence. However, an

auditor, in fulfilling duties of public trust, should take a long

hard look at a transaction of $700 million, roughly a quarter

of Broadcom’s reported revenue in 2006 of $2.5 billion. This

Complaint alleges more than negligence. EY, as Broadcom’s

auditor, owes its ultimate allegiance to the company creditors

and stockholders, as well as to the investing public. See

United States v. Arthur Young & Co., 465 U.S. 805, 817-18

(1984). By offering an “unqualified” or “clean” audit opinion,

as EY did in its 2005 Opinion, EY provided the “highest level

of assurance.” In re Ikon Office Solutions, Inc., 277 F.3d 658,

663 n.4 (3rd Cir. 2002). “Accountants will ‘qualify’ their

opinion where discrepancies are identified in a client’s financial statements.” Id.

EY relies on Public Employees’ Retirement Ass’n of Colo.

v. Deloitte & Touche, 551 F.3d 305, 314 (4th Cir. 2009),

where the court held generally that failing to review documentation may not be enough to support a strong inference of

scienter. However, the facts at issue in that case are distinctly

different from this case. In Public Employees’, the documents

were secret side letters that contradicted joint venture agreements. The auditors were, however, provided letters attesting

5050 NEW MEXICO STATE INVESTMENT v. ERNST & YOUNG
(wrongly) otherwise. The court noted, “[w]ith perfect hindsight, one might posit that defendants should have required

stronger evidence of control from [the company].” Id. But the

point remains that the auditors had already asked for and

received some documentation—they could not be blamed for

failing to see secret side letters purposely kept hidden. Furthermore, when the auditor discovered the company had been

lying, the company, two days later, announced it had misstated its revenues. Id. at 309. Here, there were no secret letters; EY noticed there could be a significant issue with the

option grant; EY asked for documentation, but when none

was received, EY still signed off.

Finally, EY wrongly claims that the 2005 Opinion has no

connection to the May 2000 option. As noted previously, the

2005 Opinion expressly covered the 2003-05 financial statements. Because Broadcom’s options vested over a four-year

period, the 2000 option grant would have been accounted for

in the 2001-04 fiscal years, resulting in two years of overlap

between the fraudulent options grant and EY’s audited financial statements.

EY argues Plaintiffs cannot show a concrete connection

between the auditors who performed the audit in 2000 and

those who issued the 2005 Opinion; in other words, that

Plaintiffs cannot rely on a “roving scienter” across the relevant time period. However, EY cannot insulate itself from

accountability for multiple years of approved financial statements with a “right hand, left hand” defense. Clearly, with

any doubts, EY could limit its Opinion to the years for which

it is confident in the audit. EY, despite serving continuously

as Broadcom’s auditor from 1998 until 2008, during which it

attested to the accuracy of Broadcom’s financial statements

for the multiple years noted in the 2005 Opinion, cannot now

disclaim those prior opinions simply because the same individuals were not involved.

NEW MEXICO STATE INVESTMENT v. ERNST & YOUNG 5051
Option Grants Approved When Compensation 

Committee Was Not Legally Constituted

Plaintiffs’ second argument is that the Complaint pleads

sufficient facts to support a strong inference of scienter based

on EY’s failure to audit option grants allegedly awarded on

dates when Broadcom’s compensation committee lacked

authority to act because the committee was not legally constituted due to the death of one of the committee members.

Under Broadcom’s bylaws, the board of directors compensation committee possessed sole authority to issue stock

option grants to Broadcom officers. The compensation committee was required to have a minimum of two members for

a quorum. As of July 2001, the committee was composed of

just two members. One of those members died, leaving the

committee without its required two-member quorum to issue

options. A replacement was not appointed until February

2002 when a resolution, appointing the new committee member, was backdated effective as of October 2001.

During the period between June 2001 through December

2001, Broadcom’s compensation committee allegedly

approved stock option grants on June 24, October 19, and

December 24. During the same time period, Broadcom was

also using unanimous written consent (“UWC”) resolutions to

approve options on dates after the actual date the grant supposedly was approved.

The Complaint alleges that, with respect to the June 24,

2001 grant, EY was presented with unsigned draft minutes

that had been fabricated to approve the June option grant; the

UWC ‘approving’ the June grant was signed after the death

of the compensation committee member, meaning the grant

was not validly executed; and Broadcom specifically consulted with EY on the June 24, 2001 option grant to determine

whether a compensation charge was necessary. Thus, not only

did EY allegedly accept unsigned draft minutes, but also

5052 NEW MEXICO STATE INVESTMENT v. ERNST & YOUNG
accepted later documentation that could not possibly have

been valid. Similarly, EY allegedly accepted a falsified UWC

in March 2002 as support for the October and December 2001

option grants, and a UWC nearly two months after EY had

already signed the unqualified audit Opinion for 2001.

[4] Taking these allegations as true, as required at this

stage, Plaintiffs provide an inference of scienter at least as

compelling as any opposing innocent inference offered by

EY. While the Complaint indicates that Broadcom executives

may have attempted to deceive EY, there is an equal inference

that EY overlooked significant events without further questioning or investigation. The failure of EY to follow up on the

grant approvals, and to sign off on these options months later

after reviewing false documentation, sufficiently pleads an

audit so deficient that the audit amounted to no audit at all.

See In re Software Toolworks Inc., 50 F.3d at 628. 

Moreover, these questionable option grants ultimately

required a compensation expense of $569 million in Broadcom’s Restatement. While EY is correct that magnitude alone

is not sufficient to support a finding of scienter, large GAAP

and GAAS violations can play a role in finding scienter. See

Carley Capital Group v. Deloitte & Touche, 27 F. Supp. 2d

1324, 1339-40 (N.D. Ga. 1998) (“[w]hile alleging a misapplication of [GAAP] standing alone is insufficient, such allegation when combined with a drastic overstatement of financial

results can give rise to a strong inference of scienter . . . .

[and] the totality and magnitude of the . . . accounting violations [may] constitute strong circumstantial evidence of reckless or conscious misbehavior”); see also In re Baan Co. Sec.

Litig., 103 F. Supp. 2d 1, 21 (D.D.C. 2000) (stating the magnitude of the GAAP error can play a role in inferring

scienter).

Involvement in Broadcom’s 2003 Corrective Reforms 

The Complaint alleges that EY had direct knowledge of the

irregularities in Broadcom’s option granting process due to

NEW MEXICO STATE INVESTMENT v. ERNST & YOUNG 5053
EY’s participation in “corrective” reforms undertaken in 2003

to ensure future option grants were treated properly.

In June 2003, the Broadcom board of directors “significantly strengthened [its] options granting practices and put

into place rigorous processes to prevent and detect any future

instances of improper accounting for equity awards.” Press

Release, Broadcom Corp., Broadcom Completes Restatement

of Financial Statements (Jan. 23, 2007). This announcement

was made by the Broadcom CEO in January 2007 in connection with the Restatement of Broadcom’s financial statements.

The Restatement declared the board “made significant corrective changes to its options granting and documenting processes.” 

Plaintiffs allege that EY, as Broadcom’s auditor, presided

over or participated in the 2003 reforms and, by doing so, EY

had knowledge that prior option grants caused previously

reported financials to be false and could not be relied upon.

Despite this knowledge, EY did not investigate the prior

grants and did not encourage Broadcom to submit to a restatement of its financial statements. Instead, EY continued to

issue unqualified audit opinions, including the 2005 Opinion

that validated several earlier years in which the improperly

accounted option grants would have materially impacted

Broadcom’s financial results. Not until the 2007 Restatement

did the 2003 corrective reforms become public knowledge.

EY, citing Zucco, claims the 2003 corrective reforms cannot be indicative of scienter because Broadcom was simply

making changes based on the 2002 congressional mandate of

the Sarbanes Oxley Act (“SOX”). Not so.

First, EY participated in, perhaps presided over, the 2003

corrective reforms. Second, these changes were not simply

part of Broadcom’s SOX compliance because Broadcom’s

2003 proxy statement shows the SOX reforms were completed before the implementation of the corrective reforms

5054 NEW MEXICO STATE INVESTMENT v. ERNST & YOUNG
described in the Complaint. Third, Broadcom’s description of

the 2003 corrective reforms makes it clear the changes were

made specifically to address improper option procedures.

Indeed, all option grants after the 2003 reforms were

accounted for properly. Fourth, and finally, despite these

reforms taking place in 2003, EY apparently took no action

to revisit the audits of earlier grants or to inform creditors,

stockholders, or the investing public as EY was required to

do. See e.g., United States v. Arthur Young & Co., 465 U.S.

at 817-18.

[5] Here, the allegations strongly suggest EY knew of and

participated in the corrective reforms to address improper

stock option grants, but made no communication and took no

action until Broadcom announced its Restatement several

years later. This scenario survives a motion to dismiss.

Plaintiffs’ Remaining Scienter Allegations

Plaintiffs also allege several other grounds that would support finding the necessary scienter with respect to EY. The

Complaint claims EY knew there was insufficient documentation for nearly half of the $2.2 billion in backdated option

grants in violation of GAAS; EY knew Broadcom’s internal

controls were weak and failed to expand the scope of its audit

procedures as required under GAAS; and EY recklessly

ignored a number of “red flags” that should have alerted it to

the potential for material misstatements related to stock-based

compensation. Each of these grounds include additional facts

but also somewhat overlaps with the three major claims presented above. These remaining allegations support an inference that EY’s actions fell far short of the standard expected

of a public company auditor.

For example, the Complaint recites that nearly half of the

$2.2 billion Restatement resulted from option awards for

which there was no contemporaneous documentation. While

not explicitly required under GAAP and GAAS, the auditing

NEW MEXICO STATE INVESTMENT v. ERNST & YOUNG 5055
standards do give strong guidance to auditors to dig deeper

once there are questionable circumstances surrounding such

material transactions. See e.g., PCAOB AU §§ 319.69,

333.02. While EY argues there was nothing technically incorrect at the time each of the questionable grants was audited

individually, EY fails to explain how it could innocently overlook the number and magnitude of the aggregate amount of

undocumented grants, particularly in light of GAAS and its

knowledge of the 2003 corrective reforms. Considering the

number, magnitude, and multi-year financial impacts of these

grants, it is certainly reasonable to infer scienter just as

strongly as an innocent inference.

Finally, the Complaint lists a number of “red flags” that

arguably should have alerted EY to Broadcom’s wrongdoing

and that EY allegedly would have had to purposely or recklessly overlook. These include elements of the 2000 option

grants and the deceased member of the compensation committee, option grant dates that were sporadic, suspiciously long

delays between the award of stock options and the UWC

approving the grant, and option grant dates set at or near the

low stock price for the quarter in which the options were

granted followed by a typical price surge soon after the dates

of the option awards.

As other courts have noted, “[a]t the pleading stage, courts

have recognized that allegations of GAAS violations, coupled

with allegations that significant ‘red flags’ were ignored, can

suffice to withstand a motion to dismiss.” In re Suprema Specialties, Inc. Sec. Litig., 438 F.3d 256, 279-80 (3d Cir. 2006)

(citing cases). However, “[s]uch allegations . . . must be pled

with particularity. It is insufficient, for example, for a plaintiff

to cite GAAS standards without an explanation of how the

defendant knowingly or recklessly violated those standards.”

Id. at 280 (citations omitted).

[6] Here, Plaintiffs have not simply cited GAAS standards

in connection with vague claims that EY failed to comply

5056 NEW MEXICO STATE INVESTMENT v. ERNST & YOUNG
with the standards. The Complaint is loaded with specific

allegations of how and why EY should have investigated deficient or missing documentation. Even after being alerted to

potential problems during the 2003 corrective reforms, EY’s

behavior, and perhaps more importantly, its unqualified audit

opinions, did not change. These red flags further support a

strong inference of scienter.

Holistic Review of Plaintiffs’ Allegations

In addition to reviewing the allegations of scienter individually, this Court has also viewed the claims “holistically.”

When viewed in totality, there is no doubt the allegations, at

this early phase of the proceedings, present at least as strong

an inference of scienter as any competing innocent inference.

As stated by the court in In re Oxford Health Plans Inc.

Sec. Litig., 51 F. Supp. 2d 290, 294 (S.D.N.Y. 1999), the

“[P]laintiffs allege ‘in your face facts,’ that cry out, ‘how

could [defendants] not have known that the financial statements were false.’ ” (citation omitted). EY, as Broadcom’s

auditor from 1998 until being fired in 2008, repeatedly

offered unqualified audit opinions despite an awareness of

large, undocumented stock option grants, and despite having

suspicions of Broadcom’s option grant procedures multiple

times over the years, from the questionable $700 million May

2000 grant, to the three separate 2001 grants when one of the

two compensation committee members was deceased, to

assisting Broadcom in 2003 with corrective actions to “prevent and detect any future instances of improper accounting

for equity awards.” During this entire time, EY failed to

change course. While Broadcom’s bad acts certainly may

have played a role in the overall fraud, this Court’s purpose

at this stage, under Tellabs, is simply to test whether the Complaint provides a sufficient inference of scienter for the case

to proceed against EY. It does. 

NEW MEXICO STATE INVESTMENT v. ERNST & YOUNG 5057
CONCLUSION

For the reasons set forth above, we REVERSE the ruling

granting Defendant EY’s Motion to Dismiss, and REMAND

the case for further proceedings consistent with this Opinion.

5058 NEW MEXICO STATE INVESTMENT v. ERNST & YOUNG