by T. GormanPosted on Posted in SECActions

The Senate Judiciary Committee heard testimony regarding proposed legislation to amend the honest services fraud statute in the wake of the Supreme Court’s decision last term in Skilling v. U.S., 130 S. Ct. 2896 (2010)(here). There, the Court limited the concept of honest services fraud under Section 1346 to bribes and kickbacks as defined in earlier case law. The Court rejected the government’s suggestion that the Section should also include undisclosed conflicts of interest. Honest services fraud is a charge frequently included in criminal securities fraud cases.

Witnesses appearing before the Committee agreed that the government needs new tools in the aftermath of Skilling. They also agreed that drafting legislation which would address some private conduct reached prior to Skilling presents a difficult problem. The government, however, urged the Committee to enact legislation which addresses certain public official conduct centered on undisclosed conflicts. Other testimony counseled caution and more study to avoid past difficulties.

Assistant Attorney General Lanny Breuer urged the Committee to move forward with a legislative fix to Skilling. Mr. Breuer began by telling the Committee that for decades the federal mail and wire fraud statutes were used to reach not just crimes aimed at depriving victims of money or property, but also honest services of public and private officials who owed a fiduciary duty of loyalty. The “core examples” of honest services fraud have been public officials and corporate officers “(1) accepting bribes or kickbacks, or (2) engaging in undisclosed self-dealing” according to Mr. Breuer.

After recounting the history of honest services fraud, Mr. Breuer told the Committee that Skilling is having a significant impact on the Department’s law enforcement efforts. Accordingly, he urged that new legislation be enacted to bridge the gap. Specifically, he requested that the Committee move forward with legislation which would cover a situation where a “public official who conceals his financial interests an then takes official action to advance those interest . . .” The need for this legislation is “urgent” Mr. Breuer noted.

In drafting new legislation, the Committee should be cognizant of four points in the wake of Skilling: 1) the need to provide adequate notice of what is prohibited; 2) the new statute should be tied to the wire and mail fraud statutes; 3) to ensure specificity, the section should draw content from the “well-established federal conflict of interest statute, 18 U.S.C. § 208, which currently applies to the federal Executive Branch;” and 4) the statute should specify that “no public official can be prosecuted unless he or she knowingly conceals, covers up, or fails to disclose material information that he or she is already required by law or regulation to disclose.” While the Department is also interested in addressing corruption in the private sector, it is not at this point prepared to offer proposed legislation in that area, Mr. Breuer noted.

Former Deputy Attorney General George Terwilliger III offered the Committee a different prospective. Mr. Terwilliger agreed that federal prosecutors need the proper tools to address corruption. At the same time, he told the Committee that passing ambiguous statutes presents significant interpretative problems that may require substantial judicial and other resources to resolve. The need for clarity is essential. Yet to date, Congress, in drawing the line between lawful and unlawful conduct, has written statutes with a broad and generalized brush in some instances.

In addressing the issues presented by Skilling, two key points should be considered. First, “part of the fundamental difficulty with adding deprivation of intangible rights to the fraud statute . . . is that it is somewhat inconsistent with the established element of fraud as grounded in an economic loss by a victim.” Second, since there are two different sets of interest as stake as to self-dealing by federal as opposed to state and local officials, “separating them in the criminal code may be well-advised.” In view of these difficulties, it would be prudent for the Committee to defer legislation now pending further study and consideration Mr. Terwilliger noted.

Program: Webcast Wednesday at noon: “The Supreme Court And Securities Litigation: A Review of Last Year A Look At The Coming Term” by Tom Gorman.
Presented by Celesque Legal Education in conjunction with ThomsonReuters.

by T. GormanPosted on Posted in SECActions

The Sixth Circuit addressed the liability of an outside auditor named as a primary violator in a securities fraud action in Louisiana School Employees’ Retirement System v. Ernst & Young, LLP, No. 08-6194 (6th Cir. Decided Sept. 22, 2010). There, the Circuit Court held that a plaintiff “may survive a motion to dismiss only by pleading with particularity facts that give rise to a strong inference that the defendant acted with knowledge or conscious disregard of the fraud being committed . . .” as to a defendant. However, “[t]he standard of recklessness is more stringent when the defendant is an outside auditor.” Slip op. at 9.

The case is based on the acquisition by Accredo Health, Inc., of a division of Gentiva Health Services, Inc. The deal closed in June 2002. E&Y issued an unqualified audit opinion on Accredo’s 2002 fiscal year financial results.

Prior to closing, E&Y participated in due diligence. According to the complaint, the audit firm learned that nearly $58.5 million of the receivables in one division were uncollectible. E&Y also recognized that the allowance for doubtful accounts was understated resulting in revenue being materially overstated.

In May 2003, Accredo issued a press release stating that it was writing off the $58.5 million of accounts receivable acquired from Gentiva. In its Form 10-Q for the third quarter of 2003, the company noted that if the collection rates had been evaluated based on data as of January 1, 2003, the charge would have been recorded as of that date. Plaintiffs claim this statement was made to avoid a restatement. The company terminated E&Y and filed a malpractice suit against the firm. The next year, a securities class action was filed against the company and two officers. It was settled.

Subsequently, this separate suit was brought against E&Y alleging violations of the antifraud provisions of the federal securities laws. The district court dismissed the complaint, finding that scienter had not been adequately pleaded as required by the PSLRA and the Supreme Court’s decision in Tellabs, Inc. v. Makor Issuers &Rights, Ltd., 551 U.S. 308 (2007).

The Sixth Circuit affirmed. The Court began by noting that the PSLRA requires a securities law plaintiff to state with particularity both the facts constituting the alleged violation of Section 10(b) and those establishing scienter. As Tellabs holds, the “strong inference” standard of the PSLRA was intended to “raise the bar” for pleading scienter. While reckless conduct will suffice, when the case is against an outside auditor, more is required. In that instance “the complaint must identify specific, highly suspicious facts and circumstances available to the auditor at the time of the audit and allege that these facts were ignored, either deliberately or recklessly.” Slip. op. at 9 (citations omitted). Those well pleaded facts must give rise to a strong inference of scienter. In addition, a comparative analysis must be done regarding possible competing inferences.

Here, plaintiffs failed to adequately plead scienter. Pleading accounting irregularities or a failure to comply with Generally Accepted Accounting Principles is, by itself, insufficient. Central to plaintiffs’ allegations is a claim that E&Y failed to adhere to proper professional standards. This keyed to a claim that its testing of the receivables was deficient because the firm used “old and stale” data. Even if true, this type of allegation does not constitute securities fraud, the Court noted.

Plaintiffs’ claim is not bolstered by its assertion that the audit firm missed “red flags.” To create a strong inference of scienter from such a claim, the factual allegations must demonstrate an “egregious refusal to see the obvious, or to investigate the doubtful.” Slip. op. at 14 (citations omitted). Typically, courts look for multiple, obvious red flags before drawing an inference of scienter. In this regard, plaintiff points only to a series of facts which support conflicting inferences or that are not supported by facts demonstrating that the audit firm was aware of it.

Likewise, the magnitude of the error does not support a finding of scienter, as plaintiffs claim. In this regard the court held “[w]e decline to follow the cases that hold that the magnitude of the financial fraud contributes to an inference of scienter on the part of the defendant . . . Allowing such an inference would eviscerate the principle that accounting errors alone cannot support a finding of scienter.” Slip. op. at 17 (citations omitted). Indeed, such a claim is little more that hindsight, speculation and conjecture the Court noted.

Finally, the allegations regarding motive do not save the complaint. Here, plaintiffs accuse E&Y of committing fraud because of a promise of future professional fees. It is beyond dispute that the firm earned substantial fees from the company. There is no allegation, however, that the fees from Accredo were more significant than those from other clients. There are no facts in the complaint demonstrating that E&Y’s motive to retain Accredo as a client was any different than its general desire to retain business. Overall, plaintiffs’ claims are little more that the classic fraud by hindsight case.