U.S. Court of Appeals says accountants can be liable under securities law.

In what best can be termed an inconsistent ruling regarding accountants' liability under securities law, the U.S. Court of Appeals, Ninth Circuit, ruled that an accounting firm could be held liable, under section 11 of the Securities Act of 1933, even when the alleged misrepresentations by the auditors had not become public prior to the bankruptcy of an audited corporation.

This case began when investors in Worlds of Wonder, Inc. (WOW) lost their entire $80 million investment in WOW junk bonds after the corporation filed for bankruptcy on December 21, 1987. The investors sued the officers, directors, underwriters and shareholders, as well as Deloitte & Touche, WOW's auditors.

WOW was formed in 1985 to manufacture and distribute The World of Teddy Ruxpin, and in 1986, the company launched a second product, Lazer Tag. Both products were top-10 selling toys for the 1986 Christmas season. On the basis of this performance, WOW posted net revenue of $327 million for the fiscal year ended March 31, 1987.

In an effort to fund further expansion, WOW sold $80 million of junk bonds on June 4, 1987. On July 27, 1987, the corporation reported losses of $10 million for the first fiscal quarter, and, on November 9 of that year, WOW reported net second-quarter losses of $43 million. On December 21, 1987, the company filed for bankruptcy.

The investors filed a class-action suit alleging securities fraud. The district court granted summary judgment in favor of all the defendants, holding the junk bond prospectus fully disclosed the risks of investing in WOW; even if the 1987 financial statements were false or misleading, all the defendants had established affirmative defences to section 11 liability. The court summarized its ruling by stating: "When a company fails, it does not automatically mean that a violation of the securities laws has occurred. There are a number of risks involved whenever one invests in any company.... The securities laws do not insulate investors against stock downturns which are caused by events not foreseeable to the company's management, nor do they provide insurance against risks that were disclosed to investors at the time they purchased the securities."

On appeal, the appellate court concurred with the district court's grant of summary judgment, except as that grant applied to Deloitte & Touche. The court noted every defendant other than Deloitte could escape section 11 liability for the statements by establishing that they "had no reasonable ground to believe and did not believe the statements were untrue or misleading." Under section 11, in order to sustain summary judgment in its favor, Deloitte needed to prove that the depreciation in value of the junk bonds resulted from factors other than the alleged misstatements in the 1987 financial statements. The appellate court ruled that the district court's ruling that WOW never disclosed to the market the fact that the 1987 financial statements contained material errors was far too narrow a reading of Deloitte's liability under section 11. Specifically, the decline in value of WOW's securities was directly related to transactions for which Deloitte allegedly made erroneous accounting determinations and, consequently, Deloitte's alleged errors were related to the decline in value of WOW's securities. (Worlds of Wonder Securities Litigation, 94 Daily Journal, D.A.R. 13038)