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In a major victory for accounting firms, a federal judge has dismissed all claims against Ernst & Young in a class-action shareholders’ suit brought by investors of IKON Office Solutions Inc. who blamed the accountants for failing to detect the company’s inflation of its stock price. Effectively canceling a trial that was set to begin next month, Senior U.S. District Judge Marvin Katz found that the plaintiffs could never prove that E&Y’s conduct was the cause of their losses or that E&Y acted with the requisite “ scienter” necessary to establish securities fraud. The plaintiffs had previously settled with IKON and some of its top officers for $111 million. Katz approved that settlement and awarded the plaintiffs’ lawyers more than $32 million in fees. But with more than $1 billion in losses from the stock’s precipitous drop in August 1998, the investors were hoping to recoup much more on their claims against E&Y. According to the suit, IKON’s former officers set out to inflate the company’s stock price so that they could go on an aggressive campaign of acquiring smaller companies, building an office-service empire that spread from the United States to Canada and Europe. Between 1995 and 1998, IKON purchased close to 200 independent companies, which it then attempted to integrate into its own network. But the company experienced a variety of problems in its growth, the suit alleged, especially with respect to its internal auditing procedures. And it kept the problems a secret so that it could keep its stock price high, the suit said, since most of its acquisitions involved using IKON stock as currency. After a “special review procedure” in the summer of 1998, IKON announced on Aug. 14, 1998, that it would be taking a $110 million charge to earnings — $94 million in the third fiscal quarter and $16 million against previously reported second fiscal quarter earnings. Stock prices dropped sharply on the news, and lawyers later said shareholders lost at least $1 billion when the stock reached its proper selling price. At first, the shareholders sued IKON and its former officers, all of whom were at the helm during the period that all of the alleged misleading statements were made. AMENDED SUIT But just a few months after the suit was filed, the plaintiffs returned to court and asked permission to add Ernst & Young as defendants for violating Section 10(b) and Section 11 of the Securities Act. The amended suit alleged that the accountants, as both external and internal auditors, acted recklessly by issuing unqualified audit reports in October 1997 that vouched for the financial statements issued by IKON. The auditors said IKON’s statements conformed with generally accepted accounting principles and that E&Y’s audit itself complied with generally accepted auditing standards. But shareholders alleged that E&Y auditors were aware that their audit was flawed because it made no mention of allegations they had heard that one of IKON’s officers was “cooking the books” and that the company lacked internal controls, had doubtful accounts and overstated its subsidiary income. The suit said E&Y was aware of the problems from a very early date but nonetheless continued to issue unqualified statements regarding IKON’s finances. In the audit opinions, dated Oct. 15 and 27, 1997, E&Y stated: “We have audited the accompanying consolidated balance sheets of IKON Office Solutions, Inc. … and the related consolidated statements of income, changes in stockholders’ equity and cash flows for each of the three years in the period ended Sept. 30, 1997. “… We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.” E&Y’s lawyers, Edward M. Posner of Drinker Biddle & Reath and Marc Gary of Mayer Brown & Platt in Washington, moved to dismiss the claims, arguing that the shareholders failed to meet the requirements for pleading fraud with “particularity.” But in an opinion handed down in September 1999, Judge Katz refused to dismiss E&Y as a defendant, saying the plaintiffs had met the legal test for pleading “ scienter,” or knowledge on the part of the auditors. E&Y argued that the plaintiffs could not show scienter merely by arguing that E&Y knew that IKON’s chief financial officer, Kurt Dinkelacker, had been accused of doctoring accounts. Katz disagreed, saying the suit alleges that E&Y was informed at an auditing committee meeting that Dinkelacker was altering accounts and instructing others to do so. The suit also said E&Y was informed of Dinkelacker’s wrongful activities by at least April 1997 and that handwritten notes showed that auditors were told that “Kurt instructed everyone to cook the books.” If proven, said Katz, those claims would be sufficient to hold the auditors liable. SUMMARY JUDGMENT Now, however, Katz has granted summary judgment in E&Y’s favor in In Re IKON Office Solutions Inc. Securities Litigation, finding that the claims could never be proven if the case went to trial. The only remaining claim against E&Y was an allegation of fraud pertaining to its unqualified audit opinion on IKON’s consolidated, year-end financial statements for fiscal year 1997. The financial statements allegedly overstated pretax income by $54.9 million. Throughout IKON’s fiscal year ending in September 1997, E&Y performed certain internal audit functions for IKON. It also served as independent auditor of IKON’s consolidated year-end financial statements. In December 1997, E&Y publicly issued its unqualified, or “clean,” audit opinion stating that the financial statements fairly presented IKON’s financial position in conformance with professional accounting standards. The integrity of this audit opinion was at the heart of the shareholders’ claims against E&Y. Investors complained that the 1997 financial statements overstated pretax income, and that E&Y knew or must have been aware of these overstatements when it issued its “clean” audit opinion. As a result, they said, E&Y violated Section 10(b) and Rule 10b-5 when it opined that IKON’s financial statements conformed with Generally Accepted Accounting Principles and that E&Y’s own audit of the financial statements complied with Generally Accepted Accounting Standards. But Katz found that the investors could never prove that E&Y’s conduct was the cause of their losses. EXPERTS DON’T SUPPORT CLAIM “Neither analysts’ reports nor plaintiffs’ expert analysis indicate that the stock decline was caused by anything other than business conditions and operational and management problems,” Katz wrote. Katz found that IKON’s announcement of its 1998 second quarter earnings shortfall — which set off the first “window” of decline in the stock price in April 1998 — blamed “issues related to the transformation [i.e., IKON's aggressive merger and acquisition initiative], competitive pressures, and costs associated with product rationalization.” During the second window of decline — which was triggered by an announcement of lower than expected third quarter earnings in June 1998 — Katz found that an analyst report blamed “the same factors that led to the 2Q earnings shortfall, namely weak equipment sales amid tough competition from bigger industry rivals … and problems associated with integrating and absorbing recent acquisitions.” Likewise, Katz said, the third window of loss began in July 1998 with an announcement that IKON was investigating the causes of the FY98 earnings shortfalls and its operating problems. The plaintiffs’ own expert, Katz said, summarized analysts’ reports as saying that “the problem is the consolidation. The problem is the mergers.” That finding, Katz said, was fatal to the plaintiffs’ claims against E&Y. “As described by plaintiffs’ expert, IKON’s announcements and analysts’ reports focused on factors such as the transformation initiative, touch competition, and weak sales, and not on the alleged accounting misstatements or income inflation,” Katz wrote. But plaintiffs’ attorneys Merrill G. Davidoff and Todd S. Collins of Berger & Montague argued that they need not point to any direct reference to the financial misstatements or inflated income, because the fact that income had been inflated was disclosed indirectly through the disclosures of business troubles and earnings shortfalls. The inflated income report, they said, led to unrealistically high earnings projections, and those earning projections were later exposed as too high when the market recognized the true state of IKON’s business and operating conditions in the spring of 1998, resulting in the loss. The announcements of earnings shortfalls and other operational and business problems, they said, exposed the grim reality of the company’s situation, and corrected the undue optimism caused by the 1997 income inflation. But Katz found that “it is not sufficient to show inflation caused by a misrepresentation and subsequent loss.” Instead, he said, “the determinative factor is that there is no evidence that the alleged misstatements loss caused the loss, as opposed to or in addition to other factors.” NO ‘SCIENTER’ Katz also found that the plaintiffs could never prove that E&Y acted with scienter, or “a mental state embracing intent to deceive, manipulate or defraud.” Although the 3rd Circuit has held that a showing of “recklessness” satisfies the scienter requirement, Katz found that the case law over the years calls for “a very strong form of recklessness, one that is relatively close to intentional conduct.” The plaintiffs argued that there were “red flags” that should have alerted E&Y that IKON might be concocting fraudulent numbers. E&Y, they said, failed to investigate the red flags, showing that it acted with either knowing or reckless disregard for the truth when it opined on the 1997 financial statements. But Katz found that the evidence could not support an inference that E&Y failed to properly investigate the allegations of fraud. “The evidence in this case indicates that E&Y did not fail to respond to the red flags it encountered, but that it received reasonable assurances that the top management at IKON was informed of all potential problems and that all allegations received due investigation by outside counsel,” Katz wrote. The plaintiffs also said E&Y knew that IKON’s internal accounting structure was in utter disarray, and that such knowledge supports the allegation that it acted recklessly in approving the financial statements. But Katz said, “A reasonable jury could not infer that recklessness based on the fact that E&Y knew of problems with IKON’s internal accounting structure.” Finally, the plaintiffs claimed that the “special procedures,” which applied charges to the 1998 financial statements but not to the 1997 financial statements, consisted merely of “sham procedures” and were performed with the express purpose of obscuring the alleged 1997 misstatements. But Katz found that the evidence presented “rebuts any inference that the special procedures were such a sham.”

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