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IKON Office Solutions Inc. paid $111 million to settle a shareholders’ suit that accused the company of overstating its income, but a federal appeals court has now ruled that the same investors don’t deserve a penny from the accounting firm of Ernst & Young because they simply have no evidence that its audit was performed recklessly. “There is no reasonable basis in the record to doubt that [E&Y] harbored an honest and well-founded belief in the accuracy of its audit, and, without further substantiating evidence, a jury may not premise a finding of willful or knowing conduct to defraud or recklessness merely by judging between competing but nevertheless sound accounting methodologies,” 3rd U.S. Circuit Court of Appeals Judge Morton I. Greenberg wrote. The ruling affirms a February 2001 decision by Senior U.S. District Judge Marvin Katz of the Eastern District of Pennsylvania, who 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. Katz had already approved Valley Forge, Pa.-based IKON’s $111 million settlement and awarded the plaintiffs’ lawyers $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. 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 § 10(b) and §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 they 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. The plaintiffs cleared the first hurdle when Katz refused to dismiss the case. But 17 months later, on the eve of trial, Katz granted summary judgment in E&Y’s favor, saying the plaintiffs didn’t have the evidence to prove their claims. At the time, 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 had performed internal audit functions and 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 that audit opinion was at the heart of the shareholders’ claims against E&Y. Katz found that the investors could never prove that E&Y’s conduct was the cause of their losses because “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.” On appeal, the plaintiffs’ team of lawyers — Todd S. Collins, Merrill G. Davidoff, Jacob A. Goldberg and Douglas M. Risen of Philadelphia-based Berger & Montague; Stuart H. Savett of Philadelphia-based Savett Frutkin Podell & Ryan; Jared Specthrie and Justin C. Frankel of Milberg Weiss Bershad Hynes & Lerach in New York; and Lynn Lincoln Sarko and Britt L. Tinglum of Keller Rohrback in Seattle — argued that E&Y’s audit was recklessly performed because it ignored conspicuous “red flags” that should have alerted it to IKON’s fraud. They also argued that E&Y impermissibly relied on IKON’s internal controls in preparing its audit calculations. The Court of Appeals was unimpressed. Writing for a unanimous three-judge panel, Greenberg found that the plaintiffs’ evidence, even when viewed in hindsight, was not enough to show that E&Y recklessly or knowingly issued a materially false and misleading audit opinion after reviewing IKON’s 1997 year-end financial statements. The plaintiffs argued that E&Y ignored allegations that IKON CFO Kurt Dinkelacker had been “cooking the books” and supplying fraudulent numbers during the 1997 audit. Greenberg disagreed, saying the evidence proved that E&Y “took appropriate steps to determine whether the allegations had any merit.” The alleged accuser, IKON official Peter Shoemaker, denied under oath that he ever made the remark, Greenberg noted, and IKON’s top management hired two senior partners at Philadelphia-based Ballard Spahr Andrews & Ingersoll to investigate the allegation. The lawyers ultimately found there was “nothing to the cooking-the-books allegation,” he noted. The plaintiffs also pointed to an E&Y “checklist” that cited numerous “risk factors” at IKON, including the company’s “unduly aggressive earnings targets,” and “excessive interest in maintaining or increasing stock price or earnings trend,” as well as its commitment to achieving “what appear to be unduly aggressive or unrealistic forecasts.” But Greenberg found that 98 of the queries on the 20-page checklist were marked “no,” and that it was irrelevant to E&Y’s potential liability in the case because it was prepared prior to the audit. “The simple fact that [E&Y] identified IKON management’s strong preference for favorable earnings, standing alone, does not raise an inference of scienter sufficient to survive a summary judgment motion predicated on the absence of scienter,” Greenberg wrote. Instead, Greenberg said, the checklist “tends to corroborate [E&Y's] diligence in conducting the 1997 audit, identifying potential risks at an early stage in accordance with professional standards.” The plaintiffs argued that numerous errors in the audit that, taken together, showed that E&Y’s work was reckless. But Greenberg found that “the discovery of discrete errors after subjecting an audit to piercing scrutiny post-hoc does not, standing alone, support a finding of intentional deceit or of recklessness.” An audit, Greenberg said, “does not guarantee that a client’s accounts and financial statements are correct any more than a sanguine medical diagnosis guarantees well-being; indeed, even an audit conducted in strict accordance with professional standards countenances some degree of calibration for tolerable error which, on occasion, may result in a failure to detect a material omission or misstatement.” To hold E&Y liable for fraud under § 10(b), Greenberg said, the plaintiffs needed more than “mere second-guessing of calculations.” In fact, he said, they would have to prove that E&Y ‘s judgment — at the moment it was exercised — was “sufficiently egregious such that a reasonable accountant reviewing the facts and figures should have concluded that IKON’s financial statements were misstated and that as a result the public was likely to be misled.” In his closing paragraph, Greenberg colorfully restated his conclusion that the plaintiffs had fallen far short of making their case: “In short, appellants’ citations to the record, like misshapen jigsaw pieces that collectively fail to reveal the picture embedded within the puzzle, simply raise no inference that Ernst opined on IKON’s consolidated financial statements with knowing or reckless disregard for the truth,” he wrote. Greenberg was joined in the opinion by Chief Circuit Judge Edward R. Becker and Judge Anthony J. Scirica. E&Y was represented by attorneys Lawrence S. Robbins, Gary A. Orseck and Kathryn S. Zecca of Robbins Russell Englert Orseck & Untereiner in Washington, D.C.; Edward M. Posner and William M. Connolly of Drinker Biddle & Reath in Philadelphia; and Jonathan C. Medow and Brian J. Massengill of Mayer Brown & Platt in Chicago.

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