Opinion ID: 175686
Heading Depth: 4
Heading Rank: 2

Heading: Pleading a Strong Inference of Scienter

Text: Plaintiffs allege that Ernst & Young's material misrepresentation, which subjected it to liability under Section 10(b) and Rule 10b-5, was the Accredo audit report dated August 16, 2002. The report, which contained Ernst & Young's unqualified opinion on Accredo's 2002 financial statements, was included in Accredo's fiscal year 2002 Form 10-K that was filed with the SEC on September 30, 2002. The district court held that the allegations contained in plaintiffs' complaint do not raise a strong inference that [Ernst & Young] acted with scienter with regard to the audit report. On appeal, the class members rely on a number of allegations to establish that Ernst & Young acted with scienter. They assert that Ernst & Young knowingly used stale and incorrect data in preparing its audit opinion and that there were numerous red flags that should have placed Ernst & Young on notice about financial improprieties. Further, they contend that the magnitude of the accounting violations by Ernst & Young creates the inference that Ernst & Young acted knowingly or recklessly in ignoring the company's financial misstatements. Plaintiffs also argue that having Ernst & Young in a position to have its fees increase tremendously if Accredo acquired the Gentiva Division, Ernst & Young's post-Class Period statements, and Accredo's firing of Ernst & Young support the inference that Ernst & Young acted with the requisite scienter. Finally, the class members contend that even if the individual allegations in the complaint are by themselves insufficient, when viewed in their entirety they establish that Ernst & Young acted with scienter. We accept the class's allegations as true and address each of their arguments in turn.
Plaintiffs argue that Ernst & Young rendered audit opinions on Accredo's financial statements contrary to the requirements of Generally Accepted Auditing Standards and Generally Accepted Accounting Principles, approving reports that misstated Accredo's true financial condition by millions of dollars. More specifically, plaintiffs allege that Accredo's and Gentiva's estimates and methodologies were available to Ernst & Young at the time of the audits and that Ernst & Young deliberately or recklessly ignored and failed to investigate them. As noted above, in the context of securities fraud, recklessness requires proof that the defendant's conduct was highly unreasonable and involved an extreme departure from the standards of ordinary care, meaning that the danger was either known to the defendant or so obvious that any reasonable person would have been aware of it. PR Diamonds, Inc., 364 F.3d at 681. The standard for proof of recklessness in securities fraud cases is especially stringent when the claim is brought against an outside auditor. Id. at 693. The PSLRA requires plaintiffs to plead the elements of fraud in detail. A complaint alleging accounting irregularities fails to raise a strong inference of scienter if it allege[s] no facts to show that Defendants knew or could have known of the errors, or that their regular procedures should have alerted them to the errors sooner than they actually did. PR Diamonds, Inc., 364 F.3d at 684 (internal quotations omitted). General allegations regarding an auditor's access to information do not raise an inference of fraud. See id. at 695-96; cf. Kennilworth Partners L.P. v. Cendant Corp., 59 F.Supp.2d 417, 429 (D.N.J.1999) ([S]tatement[s that] could be made in relation to the auditor of every corporation are not sufficient to raise the inference of scienter, because [i]f [they] were sufficient ..., it might make every auditor liable in cases of securities fraud.). We have also held that a failure to follow Generally Accepted Accounting Principles is, by itself, insufficient to establish scienter for a securities fraud claim. Comshare, 183 F.3d at 553 (citations omitted). Improper accounting alone does not establish scienter whereby mere allegations that statements in one report should have been made in earlier reports do not make out a claim of securities fraud. Id. (citation omitted). The crux of plaintiffs' complaint against the accounting firm is that Ernst & Young failed to follow the professional standards that govern the auditor's testing of management's accounting estimates, such as the allowance for doubtful accounts. Plaintiffs claim that Ernst & Young's testing of the allowance attributable to the Gentiva Division receivables was deficient because Ernst & Young used old and stale data ... to test the reasonableness of the allowance. The old and stale data to which the plaintiffs refer is the model for determining the allowance as of June 30, 2002. Plaintiffs cite a note written on an April 2003 fax from an Ernst & Young partner to another outside auditor as circumstantial evidence of scienter. The fax includes two worksheets Ernst & Young used to determine the Gentiva Division's accounts receivable reserve requirement. Plaintiffs point to a handwritten note on the first worksheet stating that the worksheet was in a file with the previous schedule. This was labeled as `Q4,' which we assume was 12/00. I do not believe it was ever used even though the [percentages] are much higher. This amount more in line with reality. The previous schedule to which the worksheet is referring is the actual worksheet that Ernst & Young used to determine the reserve requirement. It is the second worksheet included in the fax. On the second worksheet, a note states the amount appears low. The district court noted that the first schedule bears a date after the events at issue and surmised that it had been misfiled. However, plaintiffs note that the two schedules were in the same file. They attach another copy of the second work-sheet bearing a print date of 11/02/2000, which shows that Ernst & Young possessed the worksheet during the events at issue. Given our standard of review, we must assume that the first and second worksheets were created in 2000 and that the copies attached to the fax bear a later date because that is the date they were reprinted. Nonetheless, even if we make this inference and plaintiffs can show that the second schedule existed in 2000, they still have not met the high threshold for scienter by establishing only that Ernst & Young had the data in hand. See PR Diamonds, Inc. 364 F.3d at 695-96 (stating that general allegations regarding an auditor's access to information do not raise an inference of fraud). Moreover, because mere allegations that statements in one report should have been made in earlier reports do not make out a claim of securities fraud, Comshare, 183 F.3d at 553 (quotation and citation omitted), it follows that even if Ernst & Young should have included the appropriate data in its audit, its failure to do so does not create an inference that it acted with the requisite scienter. See Ley, 543 F.3d at 817.
Plaintiffs also argue that Ernst & Young disregarded numerous red flags that should have triggered a higher degree of scrutiny and that collectively these red flags support a strong inference of scienter. As the district court discussed, and as mentioned above, for a red flag to create a strong inference of scienter in securities fraud claims against an outside auditor, it must consist of an egregious refusal to see the obvious, or to investigate the doubtful. PR Diamonds, Inc., 364 F.3d at 693 (citation omitted). Courts typically look for multiple, obvious red flags before drawing an inference that a defendant acted intentionally or recklessly. Id. at 686-87 (citations omitted). Mere allegations that an accountant negligently failed to closely review files or follow Generally Accepted Auditing Standards cannot raise a strong inference of scienter. See Ley, 543 F.3d at 817 (alleged red flags known to auditor, including Generally Accepted Auditing Standard violations and statement by an anonymous witness, did not give rise to scienter). The district court compared this case to the facts in Fidel v. Farley, 392 F.3d 220 (6th Cir.2004), overruled on other grounds, Tellabs, 551 U.S. 308, 127 S.Ct. 2499, 168 L.Ed.2d 179 (2007), where we found that alleged red flags did not create the inference that the auditor acted with scienter in preparing its audit report. Id. at 229. In Fidel, plaintiffs alleged that its outside auditor should have been placed on notice by red flags that included (i) having unfettered access to the documents and employees at all offices; (ii) knowing of a securities fraud lawsuit filed against the company before it completed its audit; (iii) knowing of the company's propensity to disobey financial rules; (iv) receiving an anonymous letter that detailed some of the company's financial misstatements; and (v) noting in its audit papers that the company demonstrated significant book to physical losses and was understating its reserve for close-out inventory. Id. at 228-29. The court in Fidel found no inference of scienter because the red flags occurred before or after the audit period or because there was no indication that the auditors knew or could have known that the red flags affected the financial results for the audit year. Id. at 229. In this case, plaintiffs' list of red flags is not as compelling as that found in Fidel. For example, plaintiffs claim that Ernst & Young ignored that Gentiva had reduced the reserve percentages by pointing to a memorandum. The memorandum appears to be an internal Accredo report, which stated: For the first item, [Ernst & Young] had used the percentages calculated for CY00 as the basis for the required reserve as of September 2001 as this was the latest information presented to them. [Gentiva] had tweaked the percentages down for September as a result of current collection trends; however, [Ernst & Young] has not seen the basis for doing so. This change in percentages used results in approximately $2,400,000 of the change. While the plaintiffs suggest that this memorandum shows that Ernst & Young discovered that Gentiva had been tweak[ing] the percentages down, the competing inference is that Ernst & Young required Gentiva to show why management did so. We conclude that the more compelling inference is that Ernst & Young was resisting a lower reserve. Plaintiffs also allege that investment banker Thomas Weisel Partners' alleged refusal to consummate the purchase of Gentiva's acute care business was another red flag that should have focused Ernst & Young on the accounts receivable. Plaintiffs do not plead facts to support their contention that Ernst & Young knew that this acquisition was a condition of Accredo's purchase of the Gentiva Division or that Thomas Weisel Partners backed out of it. Here, plaintiffs do not allege highly particularized facts demonstrating a connection between the failed acquisition and the accounts receivable. Plaintiffs also emphasize the Gentiva Division's history of serious accounts receivable problems as revealed in the 2000 Cap Gemini/Ernst & Young consulting engagement, which recommended that Gentiva write off millions in uncollectible receivables. However, no one disputes that a substantial portion of the Gentiva Division accounts receivable was indeed thought to be uncollectible. Plaintiffs seek to use this allegation to show that Ernst & Young was aware of the prior receivables collection problems in 2000, which, presumably, should have alerted them to similar problems in 2002. As the district court points out, however, [t]he timing of this awareness would not support a finding of scienter because the complaint does not allege facts suggesting that Ernst & Young was on notice that the accounts receivable problems were in excess of the substantial allowance recorded in 2002. Plaintiffs next claim that during its audits, Ernst & Young saw the days-sales-outstanding for the acute business approaching nearly 300 days, allegedly an indication that a material portion of the receivables were uncollectible and worthless. Again, Ernst & Young does not dispute that a portion of the Gentiva Division's accounts receivable were uncollectible. Moreover, plaintiffs do not plead facts that support their contention that Ernst & Young not only knew of the information before issuing its audit report, but also that knowing so would amount to no audit at all. See PR Diamonds, Inc., 364 F.3d at 693-94 (quotation marks and citations omitted); see also Konkol, 590 F.3d at 398 (stating that even monitoring the high day sales outstanding is a general allegation not sufficient to support scienter). Accordingly, because plaintiffs' red flags rest on conclusory allegations and are devoid of facts, we hold that they do not create an inference that Ernst & Young acted with scienter.
Plaintiffs next argue that the magnitude of the fraud supports the inference that Ernst & Young acted with scienter. Plaintiffs state that they are aware of this Court's holding in Fidel v. Farley, 392 F.3d 220 (6th Cir.2004), that the magnitude of an accounting fraud cannot be used to bolster a scienter inference. Plaintiffs suggest, however, that the prominent nature of the [Gentiva Divisions'] accounts receivable allowance and the error's $58.5 million magnitude, in combination with the other facts alleged, provides an additional, scienter-bolstering inference. We have addressed similar allegations of scienter based on the magnitude of fraud with respect to an outside auditor. We decline to follow the cases that hold that the magnitude of the financial fraud contributes to an inference of scienter on the part of the defendant. Fidel, 392 F.3d at 231. Allowing such an inference would eviscerate the principle that accounting errors alone cannot support a finding of scienter. Id.; Stambaugh v. Corrpro Cos., 116 Fed.Appx. 592, 597 (6th Cir.2004) (declining to find a strong inference of scienter where, among other things, the plaintiff referenced the magnitude of the fraud and the fact that the fraud involved a material component of the defendant's business). Furthermore, as reasoned by the court in Reiger v. Price Waterhouse Coopers LLP, to infer scienter solely from the magnitude of the fraud would require hindsight, speculation, and conjecture. 117 F.Supp.2d 1003, 1013 (S.D.Cal.2000). We are bound by our holding in Fidel, and we thus reject plaintiffs argument that the magnitude of the alleged error was indicative of Ernst & Young's scienter.
Plaintiffs accuse Ernst & Young of being motivated to commit fraud by the promise of future professional fees. Indeed, Ernst & Young's Memphis Office earned $1.1 million in auditing fees from Accredo during fiscal year 2002. Plaintiffs' motive and opportunity allegations, however, do not raise an inference of scienter. [A]llegations that the auditor earned and wished to continue earning fees from a client do not raise an inference that the auditor acted with the requisite scienter. Fidel, 392 F.3d at 232. Even a specific account that was one of the auditor's most lucrative would not imply scienter on the part of the auditor. See In re Cardinal Health Inc. Sec. Litig., 426 F.Supp.2d 688, 778 (S.D.Ohio 2006). The complaint contains no allegations that Ernst & Young's fees from Accredo were more significant than its fees from other clients or that Accredo's business represented a significant portion of Ernst & Young's revenue. See Fidel, 392 F.3d at 232-33. Plaintiffs allege no facts to support an allegation that Ernst & Young's motive to retain Accredo as a client was any different than its general desire to retain business. Plaintiffs also point to post-Class Period events to help bolster a strong scienter inference, such as post-Class Period statements and charges leveled in Accredo's lawsuit against Ernst & Young. Specifically, plaintiffs look to an April 2003 statement, which is after the Class Period. William Drummond, an Ernst & Young partner and the lead audit partner for Accredo during the Class Period, admitted to Joel Kimbrough, Accredo's Senior Vice President and CFO, that there was a problem. Moreover, the facts alleged in the May 5, 2003 professional negligence complaint that Accredo filed against Ernst & Young may support a contention that, at least in Accredo's opinion at the time, the allowance was understated as of June 30, 2002 when Accredo acquired the Gentiva Division. Finding scienter based on such allegations would be equivalent to the classic fraud by hindsight case where a plaintiff alleges that the fact that something turned out badly must mean defendant knew earlier that it would turn out badly. Konkol, 590 F.3d at 403 (citation omitted). A statement such as there was a problem does not tell us whether Ernst & Young fraudulently refused to see the obvious with regard to the allowance at the time of its audit of the 2002 financial statements. In addition, Accredo's malpractice complaint against Ernst & Young does not support an inference that Ernst & Young engaged in fraud. Without specific allegations showing that Ernst & Young either knew or recklessly disregarded the falsity of its own statements at the time the statements were made, the fact that the statements later turned out to be false is irrelevant to a cause of action under PSLRA. Id.
Finally, plaintiffs argue that the allegations contained in the complaint combine to create a strong inference of scienter. In their brief, they argue that the district court was [e]rroneous ... [in its] rejection of myriad facts that, considered collectively and holistically ... raise a strong inference of defendants' scienter. It is true that this court employs a totality of the circumstances analysis whereby the facts argued collectively must give rise to a strong inference of at least recklessness. PR Diamonds, Inc., 364 F.3d at 683 (citation omitted). However, even taken as a whole, the complaint does not establish that plaintiffs met the PSLRA's requirement of pleading 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). Taking plaintiff's allegations as true, as we must, Ernst & Young's alleged failures were not so grievous as to suggest that their work was no audit at all. See PR Diamonds, Inc., 364 F.3d at 693. In the end, plaintiffs' allegations do not raise a strong inference that Ernst & Young acted with scienter in affirming Accredo's allegedly fraudulent accounting. Conclusory allegations about what Ernst & Young must or should have known while auditing Accredo do not amount to specific allegations that show material misstatements or omissions committed with recklessness. Plaintiffs thus fail to adequately allege all of the elements of their Section 10(b) and Rule 10b-5 claim.