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.