Friday, April 15, 2011
Court Revives Claim Auditor Abetted Broadcom Fraud
By a MetNews Staff Writer
Investors in Broadcom Corporation adequately pled their claim that the company’s outside auditor, Ernest & Young LLP, helped cover up a $2.2 billion options backdating scheme that led to civil and criminal charges against the company and several officers, the Ninth U.S. Circuit Court of Appeals ruled yesterday.
U.S. District Judge Jack Zouhary of the Northern District of Ohio, sitting by designation, said the class-action plaintiffs, including public and private pension funds, established a sufficient inference of wrongdoing to plead scienter under the heightened standards of the Private Securities Litigation Reform Act of 1995.
Broadcom has been under scrutiny for the past several years following disclosures that the Irvine-based semiconductor company fraudulently overstated its earnings, and understated its compensation expenses, by improperly accounting for backdated stock options over period of several years. The company agreed to pay $12 million in penalties to the Securities and Exchange Commission.
The investors sued Broadcom, Ernst & Young, and several individuals associated with the company. The claimed that Ernst & Young knew, or was deliberately reckless in not knowing, about the fraud.
The PSLRA requires a plaintiff to “state with particularity facts giving rise to a
strong inference that the defendant acted with the required state of mind.” Under prior Ninth Circuit decisions, the requirement may be satisfied by raising an inference of actual knowledge or deliberate recklessness that is stronger than any competing innocent inference.
The determination of whether that standard has been met, Zouhary said yesterday must be based on an analysis of the complaint as a whole. And U.S. District Judge Manuel Real of the Central District of California, whose dismissal of Ernst & Young was reversed by the appellate court, was in error in commenting that plaintiffs bear “a little bit of a heavier burden” in pleading scienter on the part of accountants and auditors, Zouhary said.
The plaintiffs in this case, the judge added, sufficiently pled three circumstances that each raised a sufficient inference of knowledge or recklessness—that Ernst & Young signed off on a large option grant in 2000 despite a lack of documentation; that it failed to question options granted in 2001 even though the compensation committee had no authority to grant options because one of its members had died and it lacked a quorum, and that it was directly involved with corrective reforms to the company’s option practices in 2003.
The judge acknowledged that a poor audit is not equivalent to an intent to defraud. But “the more likely an auditor would have discovered the truth if a reasonable audit had been conducted, the stronger the scienter inference,” he wrote.
The 2000 option grant, he elaborated, should have triggered the auditor’s attention because it was the largest in the company’s short history and had a potential $700 million impact on earnings, yet Ernst & Young took management’s word for its legitimacy and issued an unqualified opinion vouching for the accuracy of the company’s earnings statements.
“This failure to investigate such a large grant was not minor or technical in nature, and it is hard to imagine how a reasonable auditor, confronted with the same set of circumstances, would fail to obtain some documentation to verify Broadcom’s executive claim of a ‘Guideline Matrix program’ being put in place on that very day,” the judge said.
Also raising inferences of scienter, the judge said, were the granting of options by a compensation committee that was not legally constituted, and the auditors’ own involvement in correcting the option practices.
“Here, the allegations strongly suggest EY knew of and participated in the corrective reforms to address improper stock option grants, but made no communication and took no action until Broadcom announced its Restatement several years later,” Zouhary wrote. “This scenario survives a motion to dismiss.”
Judge Johnnie B. Rawlinson and Senior Judge Alfred T. Goodwin joined in the opinion.
The appeal was argued by New York lawyer Thomas A. Dubbs for the plaintiffs and Robert B. Hubbel of Gibson, Dunn & Crutcher LLP, for Ernst & Young.
The case is New Mexico State Investment Council v. Ernst and Young LLP, 09-55632.
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