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Congress passed the Private Securities Litigation Reform Act over the veto of President Bill Clinton five years ago. Designed to rein in the meritless and abusive securities litigation that had become increasingly common practice the 1980s and early 1990s, the act gave defendants important new weapons for combating the abusive tactics of the plaintiffs’ class action bar. One of the major beneficiaries of the Reform Act is the accounting profession, which had been a major supporter of this legislation. Historically, accountants have been frequent targets of securities fraud lawsuits where they have audited a company and allegations of fraudulent financial information are involved. Often named in conjunction with the company for which the audit was performed — along with the company’s key officers and directors — accounting firms were viewed by the class action bar as “deep pockets” that would provide some assurance of recovery even if the audited company was or became insolvent during the litigation. Additionally, securities plaintiffs found it relatively easy to premise securities fraud claims against the auditors of a company based upon allegations that the defendants used allegedly defective audits to perpetrate a fraud. While the scienter requirement under the primary anti-fraud provision of the federal securities laws — Sec. 10(b) of the Securities Exchange Act of 1934 — may be satisfied by proof of knowing or intentional misconduct, courts have held that “reckless” conduct can in certain instances satisfy the scienter element. (However, the U.S. Supreme Court has never resolved the issue.) Thus, plaintiffs stood a fair chance of establishing some role for the accountants in allegedly fraudulent schemes by alleging that the auditors either knew of the fraud or were at the very least “reckless” in their certification of the company’s financial statements or their failure to detect the fraud. Not only did accountants face the threat of being dragged into securities litigations simply by virtue of their status as the auditor of the defendant corporation, but the potential exposure faced by accounting firms in such suits was magnified by the ability of securities plaintiffs to hold the auditor jointly and severally liable for the conduct of other defendants. Thus, even if the auditor was ultimately found to have only 1 percent liability for the alleged improper conduct, it could nevertheless be held 100 percent responsible to the plaintiffs. Therefore, in cases where recovery was unavailable against the company (because of insolvency) or against the named officers and directors (because, for instance, of a lack of directors and officers liability insurance), the accounting firm that performed the audit could find itself responsible for an enormous sum. Not surprisingly, under the old regime, accountants often felt pressured to settle before trial to avoid such disproportionate risk. It is against this backdrop that Congress passed the Reform Act. Indeed, in explaining the legislation’s goals, the Congressional managers specifically noted that the Congressional committees heard “evidence that abusive practices committed in private securities litigation include . . . the targeting of deep pocket defendants, including accountants [and others], without regard to their actual culpability.” While the Reform Act contains numerous measures designed to eliminate these abusive practices, among those most important to the accounting profession are the heightened pleading requirements (together with a stay of discovery during the pendency of a motion to dismiss), and the replacement of joint and several liability in most cases with proportionate liability. THE HEIGHTENED PLEADING STANDARD Under 15 U.S.C. Sec. 78u – 4(b)(2), the pleading standard for a Sec. 10(b) complaint “shall, with respect to each act or omission alleged to violate this chapter, state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.” The provision’s failure to define what the “required state of mind” is has led federal courts to take varying approaches. The Second and Third U.S. Circuit Courts of Appeals have held that the plaintiff must allege either: (1) facts to show that the defendant had both motive and opportunity to commit fraud; or (2) facts that constitute strong circumstantial evidence of conscious misbehavior or recklessness. See Shields v. Citytrust Bancorp., 25 F.3d 1124, 1128 (2d Cir. 1994); In re Advanta Corp. Securities Litigation,180 F.3d 525 (3d Cir. 1999). The heightened pleading standard has in certain cases given accounting firms an effective weapon against abusive securities litigation, especially where the substance of the allegations are that the firm violated generally accepted accounting principles (GAAP) and generally accepted auditing standards (GAAS) in the process of conducting an audit. Thus, for example, in Kennilworth Partners v. Cendant Corp.,HFS, Inc., 59 F. Supp. 2d 417 (D.N.J. 1999), the District Court relied on the Reform Act’s heightened pleading standard to dismiss a complaint against Ernst & Young based solely on the allegation that the accounting firm failed to follow GAAP and GAAS in its audits of CUC Corp. before that company merged with HFS to form Cendant. The court rejected the plaintiffs’ allegation that Ernst & Young inaccurately represented that its audit of CUC was properly conducted, and stated that such after-the-fact conclusory allegations did not give rise to a “strong inference” of scienter, as required by the Reform Act. The decision noted that alleged violations of GAAS and GAAP must be accompanied by factual allegations of fraudulent intent to survive a motion to dismiss. The court then concluded that the plaintiffs’ complaint neither alleged specific facts illustrating that Ernst & Young had both the motive and opportunity to commit fraud, nor contained strong circumstantial evidence of conscious misbehavior or recklessness by the auditor. The district court in In re Livent, Inc. Securities Litigation,1999 WL 138482 (S.D.N.Y. 1999), reached a similar result, granting Deloitte & Touche Canada’s motion to dismiss for failure to plead scienter and to plead fraud with particularity in connection with Deloitte’s auditing activities of a theatrical production company. As in Kennilworth, the Liventcourt concluded that the plaintiffs had failed to plead facts giving rise to a strong inference of scienter, as required by the Reform Act. Of course, the Reform Act’s heightened pleading standard does not mean that accounting firms will in all cases will be able to exit a securities fraud suit at the motion to dismiss stage. For instance, the district courts in both Kennilworth and Livent dismissed the complaints without prejudice, giving the plaintiffs another opportunity to allege facts sufficient to meet the Reform Act standards. Moreover, a complaint that contains specific facts giving rise to a strong inference of scienter will survive a motion to dismiss. Thus, in In re Sunbeam Securities Litigation,1999 WL 1223604, *18 (S.D. Fla. 1999), the plaintiffs brought suit against Sunbeam, several directors, and its auditor Arthur Andersen, alleging that the company overstated a restructuring charge which in turn created reserves that Sunbeam then improperly used to boost its 1997 financial results. Arthur Andersen did not deny that its audit of Sunbeam’s 1997 financials had violated GAAP and GAAS, but nevertheless argued on a motion to dismiss that plaintiffs’ allegations failed to meet the Reform Act’s pleading requirements for scienter. The District Court disagreed, finding that the complaint plead specific facts demonstrating that the accounting firm either knew, or was severely reckless in not knowing, about Sunbeam’s alleged accounting improprieties. PROPORTIONATE LIABILITY UNDER THE REFORM ACT Another Reform Act provision that has benefited the accounting profession is Congress’ restriction of joint and several liability in securities fraud cases. In an attempt to curb the plaintiff class-action bar’s ability to use the threat of joint and several liability to coerce settlements from secondary defendants, Congress replaced joint and several liability in most cases with proportionate liability in the Reform Act. Proportionate liability under the act requires that the jury in a securities fraud action apportion the degree of liability among the various defendants. Joint and several liability is available only where: (1) the defendant knowingly participated in the fraud; (2) plaintiffs are entitled to damages exceeding 10 percent of their net worth, where their net worth is less than $200,000; or (3) a defendant cannot pay its share of damages due to insolvency, in which case the other defendants must make additional payments of up to 50 percent of their own liability to cover for the insolvent defendant. The Reform Act’s replacement of joint and several liability with proportionate liability was expected to reduce the potential value of lawsuits against secondary defendants such as accounting firms and other corporate advisors, thereby acting as a disincentive to the naming of such defendants. Furthermore, it was thought that removing the threat of such disproportionate liability would motivate accountants and other secondary defendants that were sued for securities fraud to fight abusive securities litigations rather than settle. Although proportionate liability has not appeared to stem the tide of accounting fraud cases, the elimination of joint and several liability — combined with the other procedural and substantive safeguards of the Reform Act — apparently has motivated accounting firms to litigate suits brought against them. Indeed, last year accounting firm BDO Seidman defended and prevailed in the first post – Reform Act securities case taken to trial. Decided on Oct. 26, 1999, In re Health Management Inc. Securities Litigation (S.D.N.Y.), was the first of over 700 cases filed since the passage of the act to be considered by a jury. Shareholders claimed that auditors from BDO Seidman had either knowingly participated in an accounting fraud that had been perpetrated by officers of the company, or had been reckless in failing to discover Health Management’s fraudulent records. In response, BDO Seidman argued that the accounting firm itself had been defrauded by the company, and thus played no role in the fraud. The jury concluded that BDO Seidman was neither reckless in its failure to discover the fraud nor a knowing participant in the fraud. Undoubtedly cognizant of the Reform Act’s restriction of joint and several liability to knowing securities violations, the plaintiffs in In re Health Managementsought to prove that BDO Seidman knowingly participated in the company’s accounting fraud. The plaintiffs also prepared for the possibility of proportionate liability by offering the testimony of Health Management’s chief executive officer in an attempt to shift a substantial share of the blame to the auditors. Other accounting firms that take securities fraud cases to trial should anticipate similar tactics by plaintiffs’ counsel. Nevertheless, the Reform Act’s restriction joint and several liability certainly reduced the potential exposure of BDO Seidman, and may well have played a role in the firm’s decision to take the case to trial rather than settle. OUTLOOK FOR THE FUTURE Surprisingly, while the Reform Act has given the accounting profession new weapons for combating abusive securities lawsuits, the number of accounting securities cases has in fact risen dramatically since the passage of the law. According to a February 2000 report from the National Economic Research Associates (NERA), 146 suits alleging accounting fraud were filed in 1998, up from 68 cases in 1996, the first full year that the Reform Act was in effect. NERA also reported that based upon the first five months of data, 1999 looked to be a record year for such cases. The reason for this increase in accounting fraud cases is unclear, although the rising but volatile stock markets may be playing some role. For instance, steep price drops of individual stocks — especially high-tech stocks — give the class action bar more opportunities to file securities fraud suits against public companies and their auditors when stock prices drop following disappointing earnings news. Furthermore, it is important to note that the Reform Act has no impact on the ability of individual securities plaintiffs to sue accounting firms for common-law securities fraud in the state courts. Although Congress enacted legislation in 1998 that pre-empts such claims where they are brought as class actions, the New Jersey Appellate Division’s recent decision in Kaufman v. i-STAT,324 N.J. Super. 344(App Div. 1999), cert. granted, 162 N.J. 489, may give groups of individuals and institutional investors the incentive to pursue accounting fraud cases in state court. (The 1998 legislation permits actions involving 50 plaintiffs or less.) In Kaufman, the Appellate Division ruled that the fraud-on-the-market theory, a judicially created presumption that permits a securities plaintiff to satisfy the reliance element in a federal securities claim under Sec. 10(b) by demonstrating reliance on the integrity of the market price of a security, could be used by the plaintiff to satisfy the actual reliance element in a common law claim of fraud. This decision gives the plaintiffs’ bar the opportunity to argue that common-law securities fraud claims, including claims against auditors, should be permitted to proceed even where plaintiffs cannot demonstrate actual reliance upon an alleged misstatement. While the New Jersey Legislature in 1995 passed legislation restricting the ability of third parties not in privity with an accountant to sue for negligence arising out of the accountant’s professional services (see N.J.S.A. 2A:53A-25), that statute does not address claims for fraud. In November 1999, the New Jersey Supreme Court granted certification to review the Kaufmandecision, and it remains to be seen whether this expansion of the common law will stand. However, until the issue is resolved, accounting firms doing business in New Jersey need to be cognizant of this potentially expansive liability for fraud, regardless of the added protections afforded in federal securities cases governed by the Reform Act. Edward T. Dartley is of counsel in the litigation department of Roseland’s Lowenstein Sandlerand is a member of the firm’s securities litigation and enforcement group. K. Leigh Smith is an associate in the securities litigation group. Lowenstein Sandler represents the defendants in Kaufman v. i-STAT and represents Ernst & Young in the Cendant securities litigation of which the Kennilworth Partners v. Cendant Corp., HFS, Inc. case is a part. Both cases are discussed in this article.

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