Opinion ID: 75504
Heading Depth: 3
Heading Rank: 2

Heading: Going Concern Qualifications

Text: With respect to Plaintiffs’ allegations regarding C&L’s failure to include 8 We hold alternatively that Plaintiffs’ allegations regarding C&L’s advice not to consolidate Conston’s financial statements with those of Cascade fail to satisfy the pleading requirements of Fed. R. Civ. P. 9(b). Far from supporting Plaintiffs’ allegation that C&L’s advice was fraudulent, FAS No. 94 instead supports C&L’s advice to Cascade that consolidated returns were not necessary. Conston was in bankruptcy at the time that the advice was given, and FAS No. 94 states: A majority-owned subsidiary shall not be consolidated if control is likely to be temporary [or] if it does not rest with the majority owner (as, for instance, if the subsidiary is in legal reorganization or in bankruptcy or operates under federal exchange restriction, controls, or other governmentally imposed uncertainties so severe that they cast significant doubt on the parent’s ability to control the subsidiary). FAS No. 94 (as quoted in ¶ 145 of Amended Complaint). 26 “going concern” qualifications in its audit reports of Conston and Fran’s Fashions,9 we can assume arguendo, but we expressly do not decide, that there are some circumstances in which a shareholder of a parent company can prove a § 10(b) violation when a misstatement about a subsidiary is made. Nevertheless, Plaintiffs’ allegations fail to state a claim because they do not satisfy the pleading requirements of Fed. R. Civ. P. 9(b). According to the amended complaint, C&L audited Fran’s Fashions for the fiscal year ended June 29, 1991, and issued an unqualified audit opinion stating that its audit had been conducted in accordance with GAAS. C&L also audited Conston for the fiscal year ended March 2, 1991, and the period ended June 1, 1991, and issued an unqualified audit report on August 1, 1991, which was included in Conston’s 10-K filed with the SEC on August 30, 1991. This audit report also stated that the audit had been conducted in accordance with GAAS. Plaintiffs allege that C&L’s audit reports of Fran’s Fashions and Conston were materially misleading because C&L violated auditing standards adopted by the AICPA and because C&L “knowingly or recklessly” omitted “going concern” qualifications for these Cascade subsidiaries. Plaintiffs allege that C&L knew that 9 According to AU Section 341 of the AICPA Statements on Auditing Standards, a “going concern” qualification is used when there is “substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time, not to exceed one year beyond the date of the financial statements being audited . . . .” 27 Fran’s Fashions and Conston were “in dire financial condition” and would need “significant, immediate funds” from Cascade in order to continue as going concerns during fiscal year 1992. Plaintiffs allege that, had C&L properly conducted its audits of Fran’s Fashions and Conston, it would have issued “going concern” opinions in connection with both of these subsidiaries’ financial statements, and the existence of such opinions would have required a similar opinion on Cascade’s financial statements. As part of Plaintiffs’ argument relating to C&L’s failure to include going concern qualifications, they allege that C&L violated numerous AICPA standards in auditing Fran’s Fashions. For example, Plaintiffs allege that C&L did not maintain an independence in mental attitude when conducting the audit; did not exercise due professional care in the performance of the examination and preparation of the report; did not obtain sufficient competent evidence to afford a reasonable basis for its audit opinion; and did not make reasonably adequate informative disclosures. “The Financial Accounting Standards of GAAP and the antifraud rules promulgated under § 10(b) of the 1934 Act serve similar purposes, and courts have often treated violations of the former as indicative that the latter were also violated.” Malone v. Microdyne Corp., 26 F.3d 471, 478 (4th Cir. 1994). 28 However, allegations of violations of GAAS or GAAP, standing alone, do not satisfy the particularity requirement of Rule 9(b). See, e.g., Chill v. Gen. Elec. Co., 101 F.3d 263, 270 (2d Cir. 1996) (Allegations of a violation of GAAP provisions or SEC regulations, without corresponding fraudulent intent, are not sufficient to state a securities fraud claim.); In re Software Toolworks Inc., 50 F.3d 615, 627 (9th Cir. 1994) ([T]he mere publication of inaccurate accounting figures, or a failure to follow GAAP, without more, does not establish scienter.) (quotation omitted); Melder v. Morris, 27 F.3d 1097, 1103 (5th Cir. 1994) (boilerplate averments that the accountants violated particular accounting standards are not, without more, sufficient to support inferences of fraud); Decker v. MasseyFerguson, Ltd., 681 F.2d 111,120 (2d Cir. 1982) (holding that allegations concerning violations of general accounting principles do not satisfy the requirements of Rule 9(b)). See also McDonald v. Alan Bush Brokerage Co., 863 F.2d 809, 814 (11th Cir. 1989) (“Severe 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 . . . .”) (internal quotation omitted). In order to plead fraud with sufficient particularity to satisfy Rule 9(b), plaintiffs must therefore allege more than mere violations of auditing standards. 29 Plaintiffs here attempt to allege more by pointing to red flags that C&L allegedly ignored when it issued its unqualified audit opinions on Fran's Fashions and Conston. Plaintiffs allege: 1. During the course of C&L's 1989 audit of Allison, another Cascade subsidiary, C&L questioned the paucity of workpapers that Levy provided it regarding an acquisition audit Levy had done. 2. C&L's 1989 workpapers contained a newspaper article that contained a photograph showing Levy as a member of the Cascade management team, which called into question Levy's independence. 3. C&L was asked to perform services that otherwise would have been the responsibility of Cascade's auditor, Levy. 4. A C&L employee sent Levy a checklist on procedures to follow in preparing a 10-Q, indicating that Levy needed assistance in preparing such a filing. 5. C&L was originally asked to audit Fran's Fashions for the fiscal year ended June 3, 1990, but this request was mysteriously retracted, raising the distinct possibility that the income statement was in fact never audited. 6. In the course of auditing Fran's Fashions and Conston in 1991, C&L saw no Jean Cosmetics counters, calling into question the truth of [Cascade’s] management's representations regarding Jean Cosmetics. 7. Levy was a sole practitioner rather than a large Big Six accounting firm. 8. Members of the Cascade Board had little or no retail clothing experience. 9. C&L knew Fran's Fashions had lost millions of dollars during the 30 fiscal years ended June 30, 1990, and June 29, 1991, and this made Cascade's reports of tremendous growth and profitability highly suspect since Fran's Fashions constituted a material part of Cascade's business. 10. C&L learned during its audit of Fran's Fashions that many of its accounts payable were long overdue. 11. C&L knew or recklessly disregarded that the person who signed Cascade's 1989 and 1990 10-Ks as CFO did not act in that capacity. Taking all of these allegations as true, Plaintiffs have failed to satisfy the pleading requirements of Rule 9(b). In certain circumstances, courts have held that allegations of violations of GAAP or GAAS, coupled with allegations of ignoring red flags, can be sufficient to state a claim of securities fraud. See, e.g., In re Sunbeam Sec. Litig., 89 F. Supp. 2d 1326, 1344-47 (S.D. Fla. 1999) (holding that plaintiffs pleaded fraud with sufficient particularity when they alleged that the accounting firm had been tipped off that Sunbeam had overstated its restructuring reserves and accounting firm ignored the information and issued its unqualified audit opinion); In re Ikon Office Solutions, Inc. Sec. Litig., 66 F. Supp. 2d 622, 629-30 (E.D. Pa. 1999) (concluding that allegations that accounting firm was informed at an Auditing Committee Meeting that Ikon's CFO was “cooking the books” and accounting firm’s failure to investigate this and other information about accounting problems supported a claim of reckless behavior by accounting firm); In re Health Management, Inc. Sec. Litig., 970 F. Supp. 192, 203 (E.D.N.Y. 31 1997) (holding that violations of auditing principles accompanied by ignorance of red flags, including an analyst's letter warning the accounting firm of artificially inflated accounts receivable, was sufficient to create a strong inference of recklessness). In this case, however, Plaintiffs have not alleged any facts suggesting actual awareness by C&L of any fraud. Plaintiffs have pointed to no tips, letters, or conversations raising inferences that C&L knew of any fraud. Furthermore, Plaintiffs have pointed to no facts suggesting that C&L was severely reckless in not knowing about any fraud. Plaintiffs' purported red flags consist of C&L's alleged possession of documents and other information which Plaintiffs allege should have revealed the need for going concern qualifications in C&L's audit opinions of Fran's Fashions and Conston. At most, these allegations raise an inference of gross negligence, but not fraud. In order for Plaintiffs to survive a motion to dismiss on their claim regarding C&L’s failure to include going concern qualifications in its audit reports of the two Cascade subsidiaries, we would have to infer several conclusions: (1) that Fran’s Fashions and Conston had a need for capital infusion; (2) that the capital infusion had to come from Cascade; (3) that C&L therefore had a duty to investigate 32 Cascade; and (4) that such investigation would have disclosed all of the ugly facts later revealed about Cascade. On the basis of the allegations here, this series of inferences is too tenuous to amount to one of “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.” McDonald, 863 F.2d at 814 (quotation omitted). Although Plaintiffs generally allege a duty on the part of C&L to investigate Cascade, they point to no accounting principle which clearly sets out such a duty. Plaintiffs argue that AU Section 341 (relating to an auditor’s consideration of an entity’s ability to continue as a going concern) establishes such a duty. Section 341 provides generally that an auditor has a responsibility to evaluate whether there is substantial doubt about an entity’s ability to continue as a going concern for a reasonable period of time. However, a careful reading of that section reveals that it sets forth no bright-line duties, and it certainly does not even mention any duty of an auditor of a subsidiary to audit or investigate the parent. The language of the general duty to evaluate whether there is “substantial doubt” indicates that there are no bright lines and that discretion is necessarily involved. We doubt that the sparse allegations here rise to the level of stating with particularity a violation of AU Section 341. But we need hold only that Plaintiffs have failed to allege a 33 highly unreasonable misrepresentation or omission which constitutes an extreme departure from standards of ordinary care. Especially in light of the disclosures actually made, see infra, we readily so hold. In addition to the lack of particularity of Plaintiffs’ allegations, especially as to the circumstances which allegedly gave rise to an omitted duty and the manner in which the alleged statements or omissions were misleading, we believe that the disclosures actually made by C&L significantly undermine any hint of fraud. With respect to the challenged financial statements for Fran’s Fashions for the fiscal year ended June 29, 1991, which were audited by C&L, these statements disclosed a negative net worth and significant losses. With respect to the challenged March 2, 1991, and June 1, 1991 financial statements for Conston, which were audited by C&L, these statements disclosed that Conston had experienced operating losses in prior years and was in bankruptcy until April 18, 1991, and that Conston’s “continued existence [was] dependent upon its ability to substantially achieve its plan of reorganization.” With respect to Plaintiffs’ alleged “red flags” relating to C&L’s knowledge of losses and overdue accounts payable of subsidiaries, we thus conclude that C&L did in fact disclose the substance of the alleged “red flags.” With respect to the alleged “red flags” relating to Levy, we readily conclude that they suggest negligence at most. Plaintiffs’ few remaining allegations of “red 34 flags” similarly can support nothing more than negligence. Therefore, assuming arguendo that there are some circumstances in which a shareholder of a parent company can prove a § 10(b) violation when a false or misleading statement about a subsidiary is made, Plaintiffs’ allegations related to C&L’s audit reports of Fran’s Fashions and Conston nevertheless fail to satisfy the pleading requirements of Rule 9(b).