A couple weeks back, Dena Aubin of the Reuters tax team had a very insightful story about the risks auditors face as more countries permit some form of mass shareholder litigation. With class actions or their like now permitted in more than 20 countries, Aubin said, auditors’ structural firewall – in which national operating units are legally isolated from each other and from the parent firm – isn’t as liability-proof as it once seemed. Aubin cited Ernst & Young’s recent $118 million settlement of a Canadian class action stemming from its audits of the collapsed Chinese forestry company Sino Forest as a possible preview of what’s in store for the Big 4 accounting shops, thanks to a surge in international litigation. Their potential exposure is so large, according to Aubin, that commercial insurers no longer offer affordable liability coverage to audit firms, which have shifted to a self-insured model.
That’s outside of the United States, though. In this country, Aubin found, shareholders rarely even bother to name audit firms as defendants in class actions: Only two securities class actions filed in 2012 made claims against top audit firms. And if you want to know why, read U.S. District Judge Shira Scheindlin’s 72-page opinion Monday dismissing allegations that the Chinese unit of Deloitte Touche failed investors in its audits of the Chinese financial software firm Longtop Financial Technologies, which admitted in 2011 to cooking its books and was subsequently sued by the Securities and Exchange Commission. Scheindlin concluded that Deloitte may have been lazy, at worst, but under U.S. laws and accounting standards, the audit firm should be considered a victim of Longtop’s fraud, not an abetter of it.
What’s unusual in this case, as Scheindlin explained, is that shareholder lawyers from Grant & Eisenhofer andKessler Topaz Meltzer & Check had more evidence than plaintiffs usually get in securities class actions. The judge had previously refused to dismiss claims against Longtop’s CFO, who then had to produce millions of pages of documents and emails to shareholders. They argued in an amended complaint that evidence obtained from the CFO showed that Deloitte had red-flag warnings of Longtop’s internal control problems, misreporting of revenue and underpayment of social welfare obligations. The audit firm, plaintiffs claimed, confronted Longtop officials about some of the issues but never disclosed problems to investors. In a brief opposing dismissal of their claims, the plaintiffs said Deloitte “chose the path of least resistance” and abdicated “its corporate watchdog responsibilities.”
Deloitte’s lawyers at Sidley Austin contended that the new discovery only bolstered their arguments that the audit firm performed dutifully but was duped by its client. The CFO’s documents showed that the firm asked the proper questions and demanded answers, Deloitte said, which it wouldn’t have done if it had the requisite fraudulent intent to mislead investors.
Scheindlin agreed. To meet the standard for scienter, she said, shareholders would have had to show Deloitte’s audits were so deficient that they fell outside any acceptable bounds. It’s easy in retrospect, she said, to say that an audit firm should have followed up on one concern or another, but U.S. laws require evidence that fraud is the most plausible explanation for an auditor’s failures. As long as the auditor can offer an equally reasonable explanation for its conduct, it’s off the hook.