On October 31, 2024, the United States Court of Appeals for the Second Circuit revived claims brought under Section 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”) and Rule 10b-5 against an outside auditor (the “Auditor”) that performed audit and assurance services for a property and casualty insurer (the “Company”), in which plaintiffs are investors. New England Carpenters Guaranteed Annuity & Pension Funds, et. al.v. AmTrust Fin. Servs. Inc., et. al., 20-1643 (Oct. 31, 2024). In an earlier opinion, dated August 23, 2023, which we previously covered here, the Second Circuit affirmed the district court’s conclusion that plaintiffs failed to plausibly allege that alleged misstatements in the Auditor’s 2013 audit opinion were sufficiently material to support a claim under the Exchange Act. However, the Second Circuit granted plaintiffs’ petition for reconsideration and held that it had erred in its materiality analysis. It, therefore, vacated and remanded the district court’s dismissal of plaintiffs’ Exchange Act claims against the Auditor.
In April 2017, the Company—one of the largest publicly traded property casualty insurers in the United States—restated five years of its financial results to correct what it acknowledged were significant errors in its annual and quarterly reports filed with the SEC. In particular, the Company’s restatement disclosed that it had: (1) improperly recognized most of the expected revenue from certain extended warranty contracts at the start of, rather than over the life of, the contracts; and (2) improperly accounted for certain discretionary employee bonuses by treating the bonuses as expenses in the year they were paid rather than the year in which they were earned by employees.
Also in April 2017, a news report disclosed the details of the Company’s alleged accounting errors, including that the Auditor, which it retained to conduct its audit in 2013, allegedly “failed to complete the necessary checks” before issuing the Company’s audit opinion (“2013 Audit Opinion”). The 2013 Audit Opinion contained a certification that stated that the Company’s financial statements for that year were “fairly presented” and represented that it was conducted “in accordance with the standards promulgated by the Public Company Accounting Oversight Board.” The article further reported that the Auditor allegedly “covered up” its incomplete work by finishing necessary audit work only after it submitted the 2013 Audit Opinion. The Company’s stock price dropped after the article published.
Plaintiffs brought suit against the Company, certain of its officers and directors, and its underwriters, as well as the Auditor, for allegedly misstating the Company’s financial conditions, in violation of Sections 11, 12, and 15 of the Securities Act of 1933 (“Securities Act”) and Section 10(b) and 20(a) of the Exchange Act and the corresponding Rule 10b-5. The district court dismissed plaintiffs’ Third Amended Complaint in its entirety; plaintiffs appealed. With respect to Exchange Act claims against the Auditor, specifically, the Second Circuit held that, although plaintiffs adequately alleged the statements in the 2013 Audit Opinion concerning the accuracy of the Company’s financial statements and the Auditor’s conformity with requisite standards were false, they had failed to raise a plausible inference that those alleged misstatements were material. The Court found it to be significant that the certification language in the 2013 Audit Opinion was “so general” that no reasonable investor would depend on them as a guarantee. The Court further found that plaintiffs failed to plead a causal nexus between the alleged misstatements in the 2013 Audit Opinion and the decline in the Company’s stock.
In February 2024, plaintiffs—supported by the Securities and Exchange Commission as an amicus curiae—petitioned for the Second Circuit to rehear and reconsider their Section 10(b) and Rule 10b-5 claims against the Auditor, which the Second Circuit granted. On October 31, 2024, the Court issued an amended version of its August 2023 opinion, this time holding that plaintiffs adequately alleged Exchange Act claims against the Auditor. The Court first addressed the materiality of the alleged misstatements in the 2013 Audit Opinion’s certification. It held that the mere fact the 2013 Audit Opinion’s certification reflects “standardized language” does not render it immaterial. Rather, the Auditor’s certification “succinctly conveyed to investors” that the Company’s financial statements were reliable and that, without the Auditor’s certification, investors would have been alerted to the alleged problems with the Company’s accounting practices. Accordingly, the Court concluded that the 2013 Audit Opinion would lead a reasonable investor to believe that the Auditor conducted some meaningful inquiry into the veracity of the Company’s financial statements, when it allegedly had not done so.
With respect to loss causation, the Court found that plaintiffs alleged a cogent nexus between the April 2017 news report and the decline in the Company’s stock. In so holding, the Second Circuit found that the district court had erred in finding that the three-year gap between the audit work and the disclosure broke the chain in the alleged loss causation because the April 2017 news article was the first instance in which problems with the 2013 Audit Opinion were publicly disclosed and the 2013 Audit Opinion remained uncorrected throughout that time.
Finally, because the district court did not address whether plaintiffs’ adequately alleged scienter as to the Auditor, the Second Circuit addressed that issue afresh. It concluded that the Complaint raised a strong inference of scienter based upon allegations that the Auditor had “acted recklessly in conducting the audit and issuing the [2013 Audit Opinion],” including that the Auditor’s senior partners allegedly knew that the 2013 Audit Opinion did not comply with requisite standards and consciously concealed their noncompliance.
Accordingly, the Second Circuit vacated the district court’s dismissal of plaintiffs’ claims under Section 10(b) and Rule 10b-5 against the Auditor.
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