Second circuit expands auditors' liability for securities fraud.

In a ruling that has already sent tremors through the accounting industry, the Second Circuit has ruled that accountants can be held liable for securities fraud if they fail to correct faulty financial reports. In agreeing with the plaintiff's claim that an accounting firm violated the Securities Exchange Act and a Securities and Exchange Commission (SEC) rule by misrepresenting a company's financial position, the court acknowledged that it was striking new legal ground.

"[F] or many years," Justice Chester Straub wrote for the court, "we have recognized the existence of an accountant's duty to correct its certified opinions, but never squarely held that such a duty exists for the purposes of primary liability under [section] 10(b) of the 1934 act and [SEC] Rule 10b-5. Presented with an opportunity to do so, we now so hold." (Overton v. Todman, 478 F.3d 479 (2d Cir. 2007).)

"This decision extends and crystallizes the duty owed by accountants in their opinion letters," said Rick Wolf, founder and managing partner of Lexacos, a business advisory group, and of Wolf Associates, a law firm specializing in corporate litigation, both based in West Orange, New Jersey. "It creates a completely different obligation for accountants and for how they perceive their duties.

"Previously," Wolf said, "accountants saw themselves as having a duty to the company that hired them. This decision extends that duty to shareholders, to the investing public, to individuals who rely on their opinion--even though these individuals did not directly hire the accounting company. It is a dramatic departure."

From 1999 to 2002, Direct Brokerage, Inc. (DBI)--a securities broker listed on the New York Stock Exchange--employed Todman & Co. as its accounting firm. In the summer of 2003, after being alerted to problems with its payroll taxes, DBI hired another firm, Integrated Management Solutions, to conduct a forensic audit. That firm found that Todman's audits had been flawed in several respects and inconsistent with generally accepted auditing practices.

At the same time, DBI was actively courting investors. When David Overton expressed interest in the company, it gave him its 2002 financial statements, which had been prepared by Todman in early 2003. These reports did not include any of the problems that Integrated had found. Overton then invested $500,000 in DBI and lent the company $1.5 million.

A few months later, DBI went into bankruptcy and defaulted on the loan, and Overton lost his entire investment. He sued Todman and its successor auditing firm, Trien, Rosenberg, Weinberg, Ciullo & Fazzari, LLP. Overton claimed the auditors and DBI knew the financial reports were incorrect and knew or should have known that outside investors would rely on these reports, yet took no action to correct its reports or withdraw its opinion, especially in regard to the company's payroll tax liability. Overton alleged that despite serious concerns raised by Integrated, Todman never corrected its financial reports or revised its "clean opinion" of DBI's financial status.

A trial court dismissed the case, but the court of appeals found that Overton's claim matched the court's own reasoning.

"The precise issue on appeal," Straub wrote, "is whether an auditor may incur primary liability under [section] 10 (b) and Rule 10b-5 when the auditor provides a certified opinion that is false or misleading when issued, subsequently learns or was reckless in not learning that the earlier statement was false or misleading, knows or should know that potential investors are relying on the opinion, yet fails to take reasonable steps to correct or withdraw its opinion and/or the underlying financial statements. We hold that under such circumstances, an auditor becomes primarily liable for securities fraud, assuming all the other elements of a securities fraud claim are present."

And in this case, Straub wrote, "since the complaint pleads precisely this theory of liability, we vacate the district court's dismissal and remand for further proceedings consistent with this opinion."

Whether the decision will result in greater legal liability across the board, Wolf said, "will depend on whether the decision is narrowly read on its facts or [is viewed as providing] a broad-based principle that can apply in other fact patterns. That's typically how the law works, that's the typical debate, so this case should be no different."

Wolf said he expects the decision to attract intense scrutiny because it comes from a jurisdiction--the Southern District of New York, which the Second Circuit covers--where business-related decisions are highly visible. "And the Second Circuit has tended to be more business-friendly, so this decision, coming from that circuit, is very significant and noteworthy," he said.