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Litigation- USA

 

Introduction

In February 2007 the US Court of Appeals for the Second Circuit affirmed the dismissal of securities fraud claims against the large auditing firm Deloitte in Lattanzio v Deloitte & Touche LLP.(1) In a unanimous opinion the court upheld the district court’s dismissal of the claims asserted against Deloitte because of failure to plead a primary violation under Central Bank of Denver v First Interstate Bank of Denver, NA(2) and failure to plead loss causation, among other grounds.

 

The court ruled that an external auditor must make an actionable misstatement in order to be liable under Section 10(b) of the Securities Exchange Act of 1934, which was not alleged by the plaintiffs in this case, and that assisting in the drafting of a filing is not sufficient to establish liability under the section. The court also ruled that the auditor’s ‘going concern’ warning, combined with the precipitous adverse changes in the company’s financial situation apparent in financial statements, made it unambiguously apparent that the company faced a risk of bankruptcy, even if the underlying financial information was inaccurate, and demonstrated that the auditor’s misstatements did not proximately cause the plaintiffs’ damages.

 

Procedural History

The plaintiffs filed suit on behalf of a putative class of purchasers of the stock of Warnaco Group Inc between August 15 2000 and June 8 2001. The plaintiffs initially brought claims against Warnaco and several of its officers and directors, but later amended their complaint to add Deloitte, which had served as Warnaco’s external accountant from November 1999 until the end of the class period. Deloitte moved to dismiss the claims against it under Sections 9(b) and 12(b)(6) of the Federal Rules of Civil Procedure. After the initial claims were dismissed without prejudice, the plaintiffs filed an amended complaint and Deloitte again moved to dismiss the claims. At oral argument on Deloitte’s motion to dismiss, the judge “instructed plaintiffs to file another amended complaint which clearly sets forth the allegations against Deloitte, and reserved decision on Deloitte’s motion”.(3) The plaintiffs then filed a 116-page second amended complaint.

 

The plaintiffs alleged that in the months leading up to Warnaco’s bankruptcy filing of June 11 2001, “Warnaco had defaulted on its credit agreements, had failed to obtain waivers from its creditors, and had seen its stock price plunge to ‘almost zero’”.(4) The plaintiffs alleged that Deloitte knowingly made a number of affirmative misstatements concerning Warnaco’s financial condition during the class period and failed to correct misstatements made before the class period, even after discovering that they were false. The plaintiffs asserted that as a result of Deloitte’s misstatements the risk of Warnaco’s financial collapse had been concealed, resulting in the loss of the value of their shares when Warnaco filed for bankruptcy.

 

The plaintiffs’ allegations focused on three sets of Warnaco financial documents:

  • the annual statement (Form 10-K) and amendments for 1999;
  • three quarterly statements (Form 10-Q) filed during the class period; and
  • the Form 10-K for 2000.

The plaintiffs alleged that the 1999 Form 10-K overstated total shareholder equity by $30 million, at $563 million instead of $533 million. Deloitte allegedly became aware of $26 million of the misstatement, which was attributable to improper chargebacks in February 2000, but did not correct Warnaco’s financial statements until March 2001. Deloitte allegedly also became aware of the balance of the misstatement in Autumn 2000, but did not correct the company’s financials until August 2001, after Warnaco had already filed for bankruptcy.

 

Warnaco filed Form 10-Qs in August 2000, November 2000 and May 2001. The plaintiffs alleged that these quarterly statements again overstated total shareholder equity, as well as containing other errors. While these quarterly statements were not audited by Deloitte or accompanied by an audit opinion, federal securities regulations required Deloitte to review the Form 10-Qs.(5) The plaintiffs alleged that Deloitte reviewed the statements and was aware of the misstatements, but again did nothing to correct them.

 

Finally, the plaintiffs alleged that the 2000 Form 10-K misrepresented Warnaco’s total shareholder equity by $50 million, at $77 million instead of $27 million. The 2000 Form 10-K contained Deloitte’s audit opinion, wherein Deloitte stated that it had audited Warnaco’s balance sheet “in accordance with auditing standards generally accepted”.(6) Deloitte’s audit opinion expressly warned that Warnaco:

 

“was not in compliance with certain covenants of its long-term debt agreements…and has a working capital deficiency… These matters raise substantial doubt about its ability to continue as a going concern.”(7)

 

Decision

The Second Circuit affirmed the district court’s judgment of dismissal on the basis of the lower court’s “thorough and well-reasoned opinion”, concluding that “Deloitte was not liable for Warnaco’s quarterly statements, which it did not audit” and that “Deloitte had no duty during the class period to correct statements or misstatements made by Deloitte prior to the class period”.(8) With respect to Deloitte’s alleged misstatements in the 1999 and 2000 Form 10-Ks, the court ruled that the plaintiffs had inadequately pleaded loss causation.

 

No primary violation

In Central Bank the Supreme Court ruled that there is no private right of action for aiding and abetting a Section 10(b) violation and emphasized that Section 10(b) reaches only ‘primary violators’ of the federal securities laws. The court went on to hold that Section 10(b) “prohibits only the making of a material misstatement (or omission) or the commission of a manipulative act”. Against this backdrop, the Second Circuit in Lattanzio held that:

 

“to state a Section 10(b) claim against an issuer’s accountant, a plaintiff must allege a misstatement that is attributed to the accountant ‘at the time of its dissemination,’ and cannot rely on the accountant’s alleged assistance in the drafting or compilation of a filing.”

 

The court observed that it was dispositive that the “accountant’s assurances were never communicated to the public”. What was critical - and what was not alleged by the plaintiffs here - is that there was an actionable misstatement made by Deloitte. Under the standards articulated by the court, it was not sufficient to impose Section 10(b) liability on Deloitte because it worked on allegedly false filings for an issuer or even understood and appreciated the falsity of those filings. As the court expressly held, if the financial statements could not be attributed to Deloitte, then they could not form the basis for Section 10(b) liability.

 

No loss causation

The Supreme Court’s seminal 2005 loss causation ruling, Dura Pharmaceuticals, Inc v Broudo, “rejected the theory that artificial inflation of a security’s purchase price is, without more, sufficient to establish loss causation”.(9) The Dura court went on to observe that:

 

“it should not prove burdensome for a plaintiff who has suffered an economic loss to provide a defendant with some indication of the loss and the causal connection that the plaintiff has in mind.”(10)

 

However, the Supreme Court did not detail what allegations would be sufficient to plead loss causation.

 

In Lentell v Merrill Lynch & Co, decided by the Second Circuit shortly before the Supreme Court issued its decision in Dura, and authored by Judge Jacobs, who also authored Lattanzio - the court held that:

 

“a plaintiff could plead loss causation either by alleging that (i) the market reacted negatively to a corrective disclosure regarding the falsity of the defendant’s misstatements, or (ii) that the defendant misstated or omitted risks that did lead to the loss.”(11)

 

The Lentell court explained that “[l]oss causation is the causal link between the alleged misconduct and the economic harm ultimately suffered by the plaintiff”.(12) Loss causation is related to the concept of proximate cause, and a misstatement is “the ‘proximate cause’ of an investment loss if the risk that caused the loss was within the zone of risk concealed by the misrepresentations…alleged by a disappointed investor”.(13)

 

The Second Circuit in Lattanzio ruled that the plaintiffs failed to plead a sufficient connection between Deloitte’s misstatements and the losses suffered as a result of Warnaco’s bankruptcy. The court rejected the plaintiffs’ argument that the relevant risk concealed by the alleged misrepresentations was that Deloitte’s audits were not conducted in accordance with generally accepted accounting practices; the relevant risk was Warnaco’s bankruptcy. As a result, in order to state a claim, the plaintiffs were required to allege that Deloitte’s misstatements concealed the risk of Warnaco’s bankruptcy.

 

Upon analyzing the allegedly misstated financial statements the court found that the risk of Warnaco’s bankruptcy was not “altogether concealed”.(14) First, the court noted that the public financial statements disclosed that Warnaco’s reported total shareholder equity had decreased from $563 million in May 2000 to $35 million in May 2001, a 94% loss that indicated that “[c]learly, Warnaco could not continue for very long in this direction”.(15) Second, Deloitte had expressly warned in the 2000 Form 10-K that Warnaco was “not in compliance with certain covenants of its long-term debt agreements”, and that there was substantial doubt regarding Warnaco’s ability to continue as a going concern.(16) The court found that Deloitte’s going concern warning, which it characterized as an “ominous alarm”, when accompanied by the collapse in Warnaco’s total shareholder equity, made it unambiguously apparent that Warnaco faced a risk of bankruptcy.

 

The Second Circuit in Lentell held that where, as in this case, the allegedly fraudulent statement itself disclosed substantial indications of the risk of loss, a plaintiff could still plead loss causation by alleging:

 

“(i) facts sufficient to support an inference that it was defendant’s fraud - rather than other salient factors - that proximately caused plaintiff’s loss; or (ii) facts sufficient to apportion the losses between the disclosed and concealed portions of the risk that ultimately destroyed an investment.”(17)

Applying the Lentell framework, the court examined the misstatements attributed to Deloitte, and concluded that they were fewer, more sporadic and less egregious than Warnaco’s misstatements.(18) Accordingly, the court ruled that the plaintiffs failed to allege loss causation, as they failed to allege facts sufficient (i) to show that Deloitte’s misstatements - as opposed to Warnaco’s - were the proximate cause of the plaintiffs’ loss, and (ii) to assign “some rough proportion of the whole loss to Deloitte’s misstatements”.(19)

 

Comment

Although it has not received much attention, this ruling should substantially benefit defendants (especially in the Second Circuit) facing securities fraud claims. The Lattanzio court addresses two of the strongest defences available to defendants in securities fraud class actions - the primary violation and loss causation defences - and adopts a pro-defence stance with respect to each. The court reinforced that a defendant must make a misrepresentation, or that a misrepresentation must be attributable to a defendant, to support Section 10(b) liability. Likewise, the Second Circuit’s discussion of loss causation creates substantial obstacles for plaintiffs seeking to state a securities fraud claim. The court did not cite the Supreme Court’s 2005 seminal loss causation ruling in Dura; rather, it cited and analyzed the circuit’s earlier (and arguably more stringent) 2005 ruling in Lentell.

 

The Second Circuit in Lattanzio has provided district courts with substantial ammunition to dismiss at the pleading stage securities fraud class actions against secondary actors, even in the context of a bankrupt issuer. Whether district courts follow the circuit’s lead remains to be seen.

 

 International Law Office