In a case harking back to the late 1990s, a U.S. Appeals Court reversed a District Court’s decision to dismiss charges that Ernst & Young knew about the stock-option backdating fraud committed by Broadcom Corp., its client at the time.
Up until now, plaintiffs in securities lawsuits have not been able to clear the high legal bar of proving that an audit firm knew about a corporate client’s backdating fraud, experts say. In Thursday’s decision, however, the U.S. Court of Appeals for the Ninth Circuit reversed a district court ruling granting E&Y’s motion to dismiss and sent the case back to a lower court.
The claims against the audit firm stem from a securities class-action lawsuit triggered by a $2.2 billion stock-option backdating scheme. The lawsuit was filed by an investment fund and a number of union pension funds against Broadcom, some of its officers and directors, and E&Y. The suit alleged that as Broadcom’s auditor, E&Y “knew of, or recklessly disregarded, Broadcom’s fraudulent backdating actions yet issued unqualified audit opinions attesting to the validity of Broadcom’s financial statements.”
For its part, E&Y believes that “our audit work was conducted professionally and appropriately, and that this claim has no merit,” according to a statement by the firm. “We will continue to defend ourselves vigorously throughout this process.”
Others contend that the case will have ramifications for CFOs as well as auditors. As a result of the decision, “the CFO should expect more probing by the company’s auditor and less automatic reliance on standard management representations,” says Thomas A. Dubbs, a senior partner with law firm Labaton & Sucharow, which represents the New Mexico State Investment Council, the lead plaintiffs in the case.
For auditors, the case may add back some of the liability they seem to have shed in the 2008 decision in Stoneridge Investment Partners v. Scientific Atlanta, according to Kevin LaCroix, an executive vice president of OakBridge Insurance Services, who edits The D&O Diary, a prominent legal and insurance blog. The Stoneridge decision threw out the use of the notion of “scheme liability” in shareholder suits against so-called aiders and abettors, such as accountants.
In the wake of the E&Y decision, auditors may now be held liable in shareholder suits against companies charged with fraud because they are “speaking for the company” in rendering their audit opinions, according to LaCroix.
In previous litigation, Broadcom, a semiconductor company with revenues in excess of $2.5 billion in 2006, was found to have fraudulently overstated its net earnings and understated its compensation expense by more than $2.2 billion between 2000 and 2006 as a result of improper accounting of backdated stock options.
The original class-action complaint against Broadcom includes nearly 35 pages of allegations that E&Y, as Broadcom’s auditor, was complicit in the scheme involving options to buy more than 239 million shares of Broadcom stock between 1998 and 2005.