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One of the more common and vexing questions arising under the Private Securities Litigation Reform Act of 1995 is whether scienter may properly be inferred from the facts alleged in a complaint. The U.S. Court of Appeals for the Sixth Circuit’s December decision in Fidel v. Farley is the latest instance in which a court of appeals has attempted to construct an analytical framework for making this determination. 1 ‘Fidel v. Farley’ In Fidel, the Ernst & Young (E&Y) accounting firm had performed the 1998 audit of clothing manufacturer, Fruit of the Loom, which experienced financial difficulties in the mid-1990s and filed for bankruptcy in December 1999. In 1995, the company had undertaken a major restructuring effort that involved outsourcing its sewing and manufacturing operations to plants in the Caribbean and South America, and, with E&Y’s assistance, upgrading its management information, inventory and production control systems. Despite these changes, the company suffered losses in 1996 and 1997. Although the company’s financial position began to improve in 1998, it announced that it would reorganize as a Cayman Islands corporation, which would require the accelerated redemption of $250 million in senior notes. The company’s share price fell in late 1998, apparently reflecting concern that Fruit of the Loom was accumulating excess inventories that would hurt future profits. The company announced that it would slow production for a few days and predicted significant revenue and earnings growth during 1999. Fruit of the Loom’s share price rose in early 1999 and the company completed a private placement of $250 million of new notes, to facilitate the Cayman Islands reorganization. Fruit of the Loom continued to suffer losses, however, and filed for bankruptcy in December. E&Y audited the company’s 1998 financial statements, on which the firm issued an unqualified audit report, which had been included in the registration statement for the private placement. In March 2000, investors sued Fruit of the Loom’s officers and E&Y. On the defendants’ motions to dismiss, the district court denied the officers’ motions, but granted E&Y’s motion on the ground that the complaint failed to comply with the Reform Act’s pleading requirements. The plaintiffs amended their complaint against E&Y, and after the district court again granted E&Y’s motion to dismiss, the plaintiffs appealed. Addressing the Reform Act’s heightened pleading standards, which require plaintiffs to “state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind,” the Sixth Circuit explained that this requirement “creates a situation in which plaintiffs are entitled only to the most plausible of competing inferences,” but that it does not mandate that the inference be “irrefutable.” Requisite Scienter The court focused on the central issue on appeal: whether plaintiffs had adequately alleged that E&Y acted with the requisite scienter, that is, recklessness. Under Sixth Circuit precedent, recklessness is “‘highly unreasonable conduct which is an extreme departure from the standards of ordinary care. While the danger need not be known, it must at least be so obvious that any reasonable man would have known of it.’ . . . It is ‘a mental state apart from negligence and akin to conscious disregard.’” 2 For claims against an outside auditor, the standard is “especially stringent,” and the Sixth Circuit follows the long-standing interpretation announced by the U.S. Court of Appeals for the Second Circuit in Decker v. Massey-Ferguson Ltd., that is, a mental state so culpable that it “‘approximate[s] an actual intent to aid in the fraud being perpetrated by the audited company.’” 3 The Sixth Circuit parsed each of the plaintiff-investors’ four arguments for inferring scienter against E&Y: (1) that numerous “red flags” should have placed E&Y on notice of the company’s financial improprieties; (2) that the magnitude of the company’s fraud created an inference that E&Y acted knowingly or recklessly in ignoring the company’s financial misstatements; (3) that the close temporal proximity between E&Y’s audit report and the company’s collapse, E&Y’s audit and consulting fees, and the proliferation of lawsuits against E&Y in connection with the firm’s audits of other companies found to have engaged in financial fraud were circumstances that supported an inference of scienter; and (4) that these allegations, even if individually insufficient, collectively demonstrated E&Y’s scienter. The court discounted each of these theories in turn. The court first addressed the eight alleged “red flags” that plaintiffs argued should have alerted E&Y to “likely improprieties” and to the need to perform a more exacting audit: (1) E&Y’s work as a consultant on the company’s internal systems, which gave the firm a regular presence at company offices and access to its documents and employees; (2) a securities fraud lawsuit filed against Fruit of the Loom before E&Y completed the 1998 audit; (3) E&Y’s knowledge, arising from the 1996 audit, that the company had a “demonstrated propensity to skirt financial rules”; (4) E&Y’s receipt of an anonymous letter detailing financial misstatements in the denim unit; (5) statements in E&Y’s 1996 audit work papers that the company had “demonstrated a trend of significant book to physical losses” in prior years and had understated its reserve for close-out inventory; (6) $60 million in write-offs in 1999 discovered by another accounting firm in the first few days of a special audit; (7) E&Y’s knowledge that Fruit of the Loom granted customers unlimited rights of return and extended payment terms; and (8) risk factors demonstrated by management, such as excessive interest in increasing the company’s stock price through aggressive accounting practices, domination of management by a small group, and high dependence on debt. The court held that none of these “red flags” raised an inference that E&Y acted with scienter. Rather, “as far as [E&Y] knew the 1998 financial results were not in question at the time it signed off on them.” The court dismissed some of the “red flags” because of timing: at least two of the alleged red flags occurred in 1996, not 1998, and another (the $60 million write-offs) occurred “well after” E&Y issued its audit report. As to the red flags that may have occurred in 1998, “there [was] no indication that [E&Y] knew or could have known that these red flags affected the 1998 financial statements.” Missing were particularized facts showing, for example, that E&Y failed to take into account that Fruit of the Loom granted certain customers unlimited rights of return or that such returns had increased from the prior year. Further, allegations concerning E&Y’s computer consulting engagement and the firm’s access to documents and management were “insufficiently concrete” to raise an inference of scienter, because plaintiffs alleged neither what E&Y should have learned from this access, nor that E&Y had any greater access to Fruit of the Loom’s confidential information than any other auditor or consultant. Finally, with regard to plaintiffs’ contention that these “red flags” should have caused E&Y to perform a more exacting audit and that the failure to do so was a “conscious decision” or “severe recklessness,” the court explained that, even assuming that E&Y “did not follow standard accounting practice in failing to perform a more rigorous audit,” the alleged red flags “were not so obvious that the strongest inference that can be drawn from them is that [E&Y] must have deliberately or recklessly ignored them in preparing its audit report.” In sum, the plaintiffs’ red flags rested solely on “conclusory allegations” of what E&Y must or should have known and therefore did not create a strong inference of scienter. Turning to the plaintiffs’ next theory, the Sixth Circuit declined to follow cases that had held that the magnitude of financial fraud contributed to an inference of scienter. 4 To permit such an inference, the court explained, “would eviscerate the principle that accounting errors alone cannot justify a finding of scienter,” and would, contrary to the Reform Act’s intent, permit the court to engage in speculation and hindsight. In addition, the occurrence of write-offs in 1999 “in no way implie[d] that [E&Y] acted with scienter while auditing the 1998 financial data.” Even if E&Y had restated the figures used in its audit, the court explained, such a subsequent revelation of the falsehood of previous statements would not imply scienter, because mere allegations that statements in one report should have been made in earlier reports do not make out a claim of securities fraud. Thus, “even if [E&Y] should have included the write-offs in its audit or that the audit report contained false statements because it did not include write-offs during that year,” the complaint failed to allege any “concrete facts” giving rise to a strong inference that the write-offs demonstrated E&Y’s scienter. The court also rejected plaintiffs’ third theory that various circumstances gave rise to an inference of E&Y’s scienter. The close temporal proximity between E&Y’s audit and the company’s bankruptcy filing was “conjecture [which] cannot support the inference of scienter under the PSLRA’s pleading requirements because there is no indication from the class members’ allegation that [E&Y] knew or recklessly disregarded information it had before it at the time it issued its audit report. Without more, inferring scienter from the temporal proximity between [E&Y's] report and Fruit of the Loom’s financial downturn is nothing more than speculation.” Allegations that E&Y wanted to keep Fruit of the Loom as a client were insufficient to establish recklessness. And the fact that E&Y had been sued and settled for significant amounts in unrelated litigations was irrelevant to E&Y’s scienter with respect to the Fruit of the Loom audit. No Inference of Scienter Finally, the court rejected the plaintiffs’ attempt to aggregate all of these deficient allegations to establish a strong inference of E&Y’s scienter. Reviewing the entirety of the complaint, the court concluded that the plaintiffs did not allege any facts that showed that E&Y knew or should have known that Fruit of the Loom’s 1998 financial statements were false at the time of E&Y’s audit report, but rather they relied on conclusory allegations and speculation to try to establish E&Y’s scienter, which did not create an inference, let alone the requisite strong inference, that E&Y acted with the required state of mind. The court also rejected plaintiffs’ attempt to hold E&Y liable for the unaudited financial information in Fruit of the Loom’s May 1999 offering documents. The court explained that, to hold E&Y liable for an “alleged implicit endorsement of the unaudited financial figures or for its failure to insist on a correction to these figures would effectively revive aider and abettor liability” eradicated by the Supreme Court’s holding in Central Bank of Denver NA v. First Interstate Bank of Denver NA. 5 Finally, the court affirmed the district court’s refusal to permit the plaintiffs again to amend, holding that the Reform Act restricts the scope of Rule 15(a) of the Federal Rules of Civil Procedure in the context of securities litigation “such that plaintiffs have a more limited ability to amend their complaints.” William R. Maguire is a member of Hughes Hubbard & Reed. Endnotes: 1. 392 F3d 220 (6th Cir. 2004). 2. Id. at 227 (quoting In re Comshare, Inc. Sec. Litig., 183 F3d 542, 550 (6th Cir. 1999)). 3. Id. (quoting Decker, 681 F2d 111, 121 (2d Cir. 1982)). 4. See, e.g., Carley Capital Group v. Deloitte & Touche LLP, 27 FSupp2d 1324, 1339 (N.D. Ga. 1998); In re Baan Co. Sec. Litig., 103 FSupp2d 1, 21 (D.D.C. 2000). 5. 511 US 164 (1994).

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