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On Feb. 26, the 2d U.S. Circuit Court of Appeals reversed a decision of the Southern District of New York and held a corporation’s auditor primarily liable under � 10(b) of the Securities Exchange Act of 1934 and Securities and Exchange Commission Rule 10b-5. Specifically, in Overton v. Todman & Co., CPAs, P.C., No. 06-2496-cv, 2007 WL 574623 (2d Cir. Feb. 26, 2007), the 2d Circuit held that an auditor may incur primary liability under � 10(b) and Rule 10b-5 when the auditor makes a statement in its certified opinion that is false or misleading when made, subsequently learns or was reckless in not learning that the earlier statement was false or misleading, knows or should know that potential investors are relying on the opinion, and yet fails to take reasonable steps to correct or withdraw its opinion and/or the financial statements. Given the paramount role that audits play for nearly every business in this country, this decision could have broad consequences for all accountants and the businesses that they audit. Direct Brokerage Inc. (DBI) was a registered securities broker-dealer and a closely held corporation that, from 1999 to 2002, employed Todman & Co., CPAs as its independent auditor. Todman issued an unqualified audit report every year. In early 2003, the New York State Division of Taxation and the New York County District Attorney’s Office notified DBI that it owed more than $3 million in unpaid payroll taxes, interest and penalties. That summer, DBI hired a forensic accounting firm, which found that Todman’s audits had been “deficient” and had “deviated materially” from generally accepted auditing standards. Because it was hovering close to bankruptcy that year, DBI sought investors and capital. The most interested was David Overton, the plaintiff. To help Overton decide whether to invest, DBI gave him its 2002 audited financial statements, which Todman had issued in February 2003. According to the complaint, by summer or fall 2003, Todman knew that these statements were inaccurate, that DBI needed money and that it was actively seeking lenders and investors. Overton sued auditor over errors in 2002 statements In early 2004, Overton invested $500,000 in DBI and loaned the company an additional $1.5 million. Several months later, DBI defaulted on the loan and Overton lost his entire investment. He then sued Todman and its successor in interest, Trien, Rosenberg, Rosenberg, Weinberg, Ciullo & Fazzari LLP, alleging that the firm violated � 10(b) and Rule 10b-5 by remaining silent when it knew that the 2002 statements it certified had material errors. Overton argued that Todman knew that potential investors would rely on its professional opinion in making an investment decision. Todman moved to dismiss the complaint. The district court granted Todman’s motion to dismiss, holding that the auditor had no duty to notify Overton that the financial statements were inaccurate. The court said that Overton’s claims failed as a matter of law because he neglected to allege that Todman’s audits were fraudulent, that its statements were knowingly false when they were made or that Todman’s work was otherwise actionable under the federal securities laws. The court said that, in effect, Overton argued for a rule that would indefinitely require a closely held corporation’s outside auditor to notify an entire unknown class whenever a financial statement, neither fraudulently nor recklessly prepared, is no longer accurate. The court rejected that rule. Vacating the district court’s decision to dismiss, the 2d Circuit held that an accountant violates the “duty to correct” past statements and becomes primarily liable under � 10(b) and Rule 10b-5 “when it (1) makes a statement in its certified opinion that is false or misleading when made; (2) subsequently learns or was reckless in not learning that the earlier statement was false or misleading; (3) knows or should know that potential investors are relying on the opinion and financial statements; yet (4) fails to take reasonable steps to correct or withdraw its opinion and/or the financial statements; and (5) all the other requirements for liability are satisfied,” such as materiality, transaction causation, loss causation and damages. Id. at *8. The 2d Circuit’s opinion states that it comports with the U.S. Supreme Court’s decision in Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164 (1994), that � 10(b) does not authorize aiding and abetting liability, in two “crucial respects”: “First, we remain true to the prohibition on aiding and abetting liability because we require that an accountant make its own misleading omission by failing to correct its certified opinion.” 2007 WL 574623, at *8. “Second, we require, as a component of the underlying duty to correct, what Central Bank labeled a ‘critical’ element under � 10(b) and Rule 10b-5: reliance by potential investors on the accountant’s omission.” Id. By bolting its opinion to Central Bank, the 2d Circuit declared that the auditor’s conduct was just as culpable as the company that fabricated its financial statements. Thus now in the 2d Circuit, an auditor that does not correct known misstatements � or misstatements it should have known � is just as liable as the company that made the error. This casts a wide net of liability. Though the holding appears to contort the definition of primary liability beyond judicial precedent, the opinion stresses that it follows decisions that the 2d Circuit would have reached if it had the opportunity. In IIT v. Cornfeld, 619 F.2d 909 (2d Cir. 1980), the court examined whether a plaintiff could hold an auditor � Arthur Andersen & Co. � liable for aiding and abetting securities fraud by failing to disclose the existence of a raiding conspiracy between a mutual fund and a complex of companies. The plaintiffs sued on the theory that the auditor, having certified financial statements, was under a duty to disclose such information as it became known, and that the violation of that duty rendered the accountant liable as an aider and abettor to securities fraud. The Overton court explained that the Cornfeld panel “recognized that ‘[a]ccountants do have a duty to take reasonable steps to correct misstatements they have discovered in previous [certified] financial statements on which they know the public is relying.’ ” 2007 WL 574623, at *9. However, because the plaintiff pleaded only aiding and abetting liability, “ we had no opportunity . . . to consider whether primary liability could arise from a violation of the duty to correct, and did not reach that issue.” Id. Overton noted that the 2d Circuit also addressed the issue � though, again, only obliquely � several times in the 1990s. In Shapiro v. Cantor, 123 F.3d 717 (2d Cir. 1997), for example, the court examined an accountant’s duty to correct a certified statement, but this time the claim was for primary liability. The investor plaintiffs alleged that an accountant committed securities fraud by failing to inform them that one principal in partnerships was a convicted felon and that his 12-year-old son was sole officer, director and shareholder of a corporation that served as a general partner. The court held that the complaint failed to state a claim for relief because a duty to disclose arises only “when one party has information that the other party is entitled to know because of a fiduciary or other similar relation of trust and confidence between them.” Id. at 721. A year later, in Wright v. Ernst & Young LLP, 152 F.3d 169 (2d Cir. 1998), cert. denied, 525 U.S. 1104 (1999), a plaintiff alleged on appeal � raising the issue for the first time � that the accountant could be primarily liable because it had “discovered facts tending to undermine the accuracy” of its earlier audit report, knew that the market was relying on the report, and failed to correct it. The Overton court noted that the Wright panel “agreed in principle with this theory of liability.” 2007 WL 574623, at *7. Nevertheless, the court held that the plaintiff failed to plead this theory in the amended complaint and waived her chance to file a second amended complaint. Accountant has duty to correct, but not update What effect will the decision have? The Overton court noted that, “[i]mportantly, we hold only that an accountant has a duty to correct its prior certified statements, as opposed to a broader duty to update those statements.” Id. at *9. This distinction is vital because “[t]he duty to correct requires only that the accountant correct statements that were false when made. In contrast, the duty to update requires an accountant to correct a statement made misleading by intervening events, even if the statement was true when made.” Id. Accounting firms should seek guidance on how to comply with the holding. The court’s opinion requires firms “to take reasonable steps to correct or withdraw its opinion and/or the financial statements.” This requirement is at best ambiguous for several reasons. First, what are “reasonable steps”? Does the firm have to threaten to withdraw from future engagements if the company refuses? Must the audit partner notify the Securities and Exchange Commission? Second, how should a firm correct or withdraw its opinion? Do the accountants make a “noisy withdrawal” and publish their decision in a newspaper? That seems draconian, but logical if the goal is to notify investors, such as Overton. Barring congressional intervention, these answers will arrive via case law. Marc D. Powers is a partner in the New York office of Baker Hostetler. He leads the firm’s national securities litigation and regulatory enforcement practice. James E. Pfeffer is an associate in that office.

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