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Auditor's liability for securities violations.

The U.S. Court of Appeals for the Ninth Circuit ruled that an audit firm preparing a fraudulent audit report that it knew would be included in its client's annual 10-K filing with the Securities and Exchange Commission may be held liable as a primary violator of the Securities Exchange Act of 1934. This case began in November 1990 when Ernst & Young prepared and issued an allegedly false and misleading audit opinion for its audit of Community Psychiatric Centers (CPC), a publicly traded corporation. The shareholders alleged the firm had failed to disclose that the corporation had a major accounts receivable problem. They further alleged the firm knew the audit opinion would be included in the 10-K. Shareholders sued the firm after the corporation's stock plummeted in September 1991 with the announcement of a major drop in earnings attributed to $37 million in uncollectible debt.

The plaintiffs' class action alleged the firm had produced a fraudulent audit report with the knowledge that the client would disseminate the report to the securities market. As a consequence of these actions, the firm allegedly committed fraudulent acts in connection with the trading of securities and thus violated section 10(b) of the 1934 act. The plaintiffs further claimed the firm was both a primary violator of section 10(b) and a secondary violator as a conspirator and alder and abettor to CPC. The district court granted the firm's motion for summary judgment on all counts. The court held an independent accounting firm does not act "in connection with" securities trading when it produces a fraudulent audit report that it knows its client will include in a 10-K. The plaintiffs appealed.

On appeal, the Ninth Circuit reversed and remanded the district court's grant of summary judgment. The court rejected the firm's argument that section 10(b) limits liability to only those who actually trade securities. In analyzing the 1934 act, the court noted the act was designed to protect investors from manipulation of stock prices. The "traders-only" rule proposed by the firm is inconsistent with the act's goals. It would exempt from section 10(b) a broad range of misinformation and market manipulation, as long as the perpetrators did not buy or sell securities in connection with their activities. A party that introduces fraudulent information into the securities market does no less damage to the public because it does not trade stocks. Therefore, the act's goals are better served by giving section 10(b) its natural meaning and imposing liability on all whose false assertions are reasonably calculated to influence the investing public. (McGann et. al. v. Ernst & Young, 96 C.D.O.S. 6719)
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Title Annotation:McGann v. Ernst & Young
Author:Baliga, Wayne
Publication:Journal of Accountancy
Article Type:Brief Article
Date:May 1, 1997
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