BIM Intermobiliare SGR v. Grant Thornton LLP, No. 10-4028 (2d Cir. 2012)
Annotate this CaseThis opinion or order relates to an opinion or order originally issued on July 19, 2012.
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10-4028-cv(L) BIM Intermobiliare SGR v. Grant Thornton LLP 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 UNITED STATES COURT OF APPEALS FOR THE SECOND CIRCUIT August Term, 2011 Argued: November 2, 2011 Decided: July 19, 2012 Amended: August 29, 2012 Docket Nos. 10-4028-cv(L), 10-4280-cv(CON) - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -X SANFORD GOULD, Individually, and on behalf of all others similarly situated, YAN SUN, BULLDOG CAPITAL MANAGEMENT LP, KEVIN SHERMAN, MAX C. MICHAELS, ROBIN KWALBRUN, ELEANORE REZNICK, FRANK ZAPPARIELLO, THEODORE S. GUTOWICZ, DAVID RICH, RICHARD SULENTIC, ANDRES RIOS, Plaintiffs, and BIM INTERMOBILIARE SGR, a wholly-owned subsidiary of BANCA INTERMOBILIARE DI INVESTIMENTI E GESTIONI SPA, ROBERT AHEARN, DRYE CUSTOM PALLETS, JEFFERSON INSURANCE COMPANY OF NEW YORK, ALLIANZ LIFE INSURANCE COMPANY OF NEW YORK, INTERNATIONAL REINSURANCE COMPANY, S.A., LIFE USA, AGF AMà RIQUE, AGF HOSPITALIERS, AGF ASSET MANAGEMENT, FIREMAN S FUND INSURANCE COMPANY, THE NORTHERN TRUST COMPANY as trustee of the FIREMAN S FUND INSURANCE COMPANY MASTER RETIREMENT TRUST and as trustee of the FIREMAN S FUND 1 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 INSURANCE COMPANY MASTER RETIREMENT SAVINGS TRUST, ALLIANZ INSURANCE COPMANY, ALLIANZ LIFE INSURANCE COMPANY OF NORTH AMERICA, ALLIANZ ASSET MANAGEMENT NORTH AMERICAN EQUITY, US ALLIANZ DIVERSIFIED ANNUITY, US ALLIANZ GROWTH ANNUITY, US ALLIANZ VARIABLE INSURANCE PRODUCTS TRUST, AZOA GROWTH FUND, AZOA DIVERSIFIED ASSETS FUND, ALLIANZ OF AMERICA, INC., ALLIANZ CORNHILL INSURANCE PLC, CORNHILL PENSION NORTH AMERICAN EQUITY FUND, CORNHILL LIFE INSURANCE, MERCHANT INVESTORS ASSURANCE COMPANY LIMITED, and CORNHILL LIFE NORTH AMERICAN EQUITY FUND, Plaintiffs-Appellants, v. WINSTAR COMMUNICATIONS, INC., WILLIAM J. ROUHANA, JR., RICHARD J. UHL, NATHAN KANTOR, ROBERT K. MCGUIRE, Defendants, and GRANT THORNTON LLP, Defendant-Appellee.* -------------------------------X * The Clerk of the Court is respectfully directed to amend the official caption as set forth above. 2 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 Before: SACK, HALL, and LOHIER, Circuit Judges. Plaintiffs-Appellants appeal from a judgment of the United States District Court for the Southern District of New York (Daniels, J.) granting the motion for summary judgment of Defendant-Appellee Grant Thornton LLP ( GT ) and dismissing the Plaintiffs claims under Sections 10(b) and 18 of the Securities Exchange Act of 1934. Those claims related to GT s auditing of the financial statements of Winstar Communications, Inc. ( Winstar ). Because triable questions of fact exist as to (1) whether GT acted with scienter in making alleged misrepresentations in its audit opinion letter, (2) whether the Plaintiffs purchased Winstar s stock in actual reliance on those representations, and (3) whether the Plaintiffs suffered losses as a result, we VACATE the judgment of the District Court and REMAND for further proceedings. JONATHAN K. LEVINE, Girard Gibbs LLP, New York, NY (Daniel C. Girard, Girard Gibbs LLP, San Francisco, CA, on the brief), for PlaintiffsAppellants Jefferson Insurance Company of New York, Allianz Life Insurance Company of New York, International Reinsurance Company, S.A., Life USA, AGF Amérique, AGF Hospitaliers, Fireman s Fund Insurance Company, The Northern Trust Company as trustee of the Fireman s Fund Insurance Company Master Retirement Trust and as trustee of the Fireman s Fund Insurance Company Master Retirement Savings Trust, Allianz Insurance Company, Allianz Life Insurance Company of North America, Allianz Asset Management North American Equity, US Allianz Diversified Annuity, US Allianz Growth Annuity, US Allianz Variable Insurance Products Trust, AZOA Growth Fund, AZOA Diversified Assets Fund, Allianz of America, Inc., AGF Asset Management, Allianz Cornhill Insurance PLC, Cornhill Pension North American Equity Fund, Cornhill Life Insurance, Merchant Investors Assurance Company Ltd., and Cornhill Life North American Equity Fund. PATRICK L. ROCCO (Lee S. Shalov, Susan Marlene Davies, on the brief), Shalov Stone Bonner & Rocco LLP, New York, NY, for PlaintiffsAppellants BIM Intermobiliare SGR, a whollyowned subsidiary of Banca Intermobiliare di Investimenti E Gestioni SpA, Robert Ahearn, and DRYE Custom Pallets. 3 1 2 3 4 5 6 7 8 JAMES L. BERNARD, Stroock & Stroock & Lavan LLP, New York, NY (Larry K. Elliot, Cohen & Grigsby P.C., Pittsburgh, PA, on the brief), for Defendant-Appellee Grant Thornton LLP. LOHIER, Circuit Judge: Plaintiffs-Appellants appeal from a September 2010 judgment of the United States 9 District Court for the Southern District of New York (Daniels, J.) granting the summary 10 judgment motion of Defendant-Appellee Grant Thornton LLP ( GT ) and dismissing the 11 Plaintiffs claims arising from GT s audit of the financial statements of its client, Winstar 12 Communications, Inc. ( Winstar ). The Plaintiffs claimed that GT committed securities fraud in 13 violation of Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b) (the Act 14 or the Exchange Act ), and 17 C.F.R. § 240.10b-5, and made false and misleading statements in 15 an audit opinion letter in violation of Section 18 of the Act, 15 U.S.C. § 78r. We conclude that 16 genuine issues of material fact exist as to each of these claims. We therefore VACATE the 17 District Court s grant of summary judgment and REMAND for further proceedings. 18 BACKGROUND 19 1. Facts 20 Reviewing the District Court s grant of summary judgment in favor of GT, we construe 21 the evidence in the light most favorable to the [Plaintiffs], drawing all reasonable inferences and 22 resolving all ambiguities in [their] favor. 1 In re Omnicom Grp., Inc. Sec. Litig., 597 F.3d 501, 23 504 (2d Cir. 2010) (quotation marks omitted). 1 The Plaintiffs fall into two groups. BIM Intermobiliare SGR and other plaintiffs (collectively, the Lead Plaintiffs ) assert claims under Section 10(b) in a putative class action on behalf of investors who purchased Winstar common stock and bonds between March 10, 2000 and April 2, 2001. Jefferson Insurance Company of New York and twenty-four related entities (collectively, the Jefferson Plaintiffs ) purchased Winstar common stock from December 1998 to at least February 2001 and bring claims under both Sections 10(b) and 18. 4 1 Winstar was a broadband communications company whose core business was to provide 2 wireless Internet connectivity to various businesses. GT served as Winstar s independent auditor 3 from 1994 until Winstar filed for bankruptcy in April 2001, and GT regarded Winstar as one of 4 [its] largest and most important clients. 2 5 In 1999, however, the relationship deteriorated. Winstar warned GT that it would likely 6 terminate the relationship if GT s performance on unrelated international tax planning and other 7 accounting matters proved unsatisfactory. In March 1999 at least one member of Winstar s 8 board of directors openly urged during a board meeting that the GT partner overseeing the audit 9 of Winstar be removed from the Winstar account. GT eventually re-staffed the Winstar account 10 so that the 1999 audit was managed by a partner, Gary Goldman, and a senior manager, Patricia 11 Cummings, neither of whom had previously reviewed or audited the financial records of a 12 telecommunications company. 13 As relevant to this appeal, GT s audit for 1999 included several large account 14 transactions that Winstar consummated in an attempt to conceal a decrease in revenue associated 15 with Winstar s core business. Most of the large account transactions involved Lucent 16 Technologies, Inc. ( Lucent ), Winstar s strategic partner, and all of them were consummated at 17 the end of Winstar s fiscal quarters in 1999. Together, the transactions accounted for $114.5 18 million in revenue, or approximately 26 percent of Winstar s reported 1999 operating revenues 19 and 32 percent of its core revenues that year. At the time, GT considered these transactions to 2 Most of the revenue that GT derived from Winstar was from consulting rather than auditing. In 1999, for example, GT earned $275,000 for its auditing work for Winstar, compared with over $2 million in consulting fees. 5 1 be red flags, warranting the accounting firm s heightened scrutiny. 3 However, GT 2 ultimately approved Winstar s recognition of revenue in connection with each of these 3 transactions. 4 We discuss the evidence relating to each category of transaction in turn. 5 6 A. Questionable Sales The first category of questionable transactions involved a series of six end-of-quarter and 7 end-of-year transactions, primarily reported as equipment sales, for which there was little 8 evidence that any goods or services were ordered and delivered. For example, for the third 9 quarter of 1999 Winstar recognized $15 million in revenue for the sale of Lucent equipment to 10 Anixter Brothers, Inc. ( Anixter ), a wire and cable distributor. There were several unusual 11 aspects of this sale. First, Anixter ordinarily purchased equipment directly from Lucent, not 12 Winstar. Second, equipment sales were not part of Winstar s core business of creating and 13 operating wireless networks. Third, during GT s audit Cummings noted that the Anixter 14 transaction was apparently completed on September 30, 1999, the last day of Winstar s fiscal 15 quarter, but GT s work papers included no documents reflecting the sale s completion beyond a 16 purchase order from Winstar to Lucent and an invoice from Lucent to Winstar. Moreover, 17 neither the purchase order nor the invoice included an itemized list of the goods sold or indicated 18 the shipping terms, even though the items were to be shipped on September 30, 1999, and 3 The Public Company Accounting Oversight Board has recognized that one risk factor indicating potential fraud would be [s]ignificant, unusual, or highly complex transactions, especially those close to year end, that pose difficult substance over form questions. Joint App. at 3619 (quoting Am. Inst. of Certified Pub. Accountants, Statement on Accounting Standards ( AU ) § 316.17 (alterations in original)). Similarly, GT acknowledged that large, end-of-quarter transactions would warrant heightened scrutiny during the audit process. 6 1 delivered on October 4, 1999.4 Absent too was any document evidencing Anixter s agreement to 2 purchase the items. Lastly, not a single employee of Lucent, Winstar, or Anixter who was asked 3 about the equipment sale could recall it. 4 Five other transactions that were not part of Winstar s core business were consummated 5 at the end of one of Winstar s fiscal quarters and were barely documented. Winstar nevertheless 6 recognized a total of $49.7 million in revenue associated with these five transactions. First, 7 Winstar recognized $5 million in revenue in the first quarter of 1999 for a feasibility study that 8 Winstar was scheduled to conduct for Lucent, but which had not been delivered by at least 2000. 9 Second, Winstar recognized $21.1 million in revenue in the first and second quarters of 1999 in 10 connection with the sale of Lucent equipment to Williams Communications, Inc. ( Williams ). 11 The equipment was shipped by Lucent, not Winstar, on the last business day of the first and 12 second quarters (March 31, 1999 and June 30, 1999, respectively), with no written agreement. 13 Third, Winstar recognized $9.1 million in revenue in the second quarter of 1999 in connection 14 with the sale of Lucent equipment to VoCall Communications Corporation ( VoCall ) on June 15 30, 1999. Although the sale was referenced in a series of non-numbered purchase orders, it was 16 not referenced in any executed, final agreement or shipping document. Fourth, Winstar 17 recognized $4.5 million in revenue in the third quarter of 1999 in connection with the sale of 18 unspecified WinStar Equipment to Cignal Global Communications ( Cignal ), which was 4 As stated by the Securities and Exchange Commission ( SEC ), delivery generally is not considered to have occurred unless the customer has taken title and assumed the risks and rewards of ownership of the products specified in the customer s purchase order or sales agreement. Typically this occurs when a product is delivered to the customer s delivery site (if the terms of the sale are FOB destination ) or when a product is shipped to the customer (if the terms are FOB shipping point ). SEC Staff Accounting Bulletin No. 101: Revenue Recognition in Financial Statements, 17 C.F.R. Part 211, at 6 (Dec. 3, 1999) ( SAB 101 ), available at http://www.sec.gov/interps/account/sab101.htm (last visited June 28, 2012). 7 1 contracted for on September 30, 1999, the last day of that quarter. However, GT was unable to 2 produce a document evidencing that the equipment had been shipped to Cignal during that 3 quarter. Fifth, Winstar recognized $10 million in revenue in the fourth quarter of 1999 in 4 connection with the sale of wireless radio equipment ( radios ) to Lucent under an agreement 5 dated December 30, 1999. GT endorsed the recognition of revenue even though its work papers 6 included shipping documents with conflicting dates, no document specified the goods purchased, 7 and Lucent, not Winstar, was in the business of manufacturing and selling radios. The same 8 agreement also involved a $2 million promotional credit purchased by Lucent for services that 9 had not yet been rendered by Winstar. Although GT specifically advised Winstar that 10 recognizing and recording the amount of the credit as revenue was improper and in violation of 11 generally accepted accounting principles ( GAAP ),5 Winstar nevertheless recognized the full 12 $2 million in revenue. 13 Each of these transactions appears to have violated the provisions of Staff Accounting 14 Bulletin No. 101 ( SAB 101 ), issued by the Securities and Exchange Commission ( SEC ), 15 which states that four conditions must be satisfied before revenue can be recognized: (1) 16 Persuasive evidence of an arrangement [for the sale of goods or services] exists, (2) Delivery 5 GAAP [are] those principles recognized by the accounting profession as the conventions, rules, and procedures necessary to define accepted accounting practice at a particular time. [They are] established by the American Institute of Certified Public Accountants . . . . In re Global Crossing, Ltd. Sec. Litig., 322 F. Supp. 2d 319, 325 n.5 (S.D.N.Y. 2004) (quotation marks and citations omitted). [The] single unified purpose [of GAAP] . . . [is] to increase investor confidence by ensuring transparency and accuracy in financial reporting. Id. at 339. 8 1 has occurred or services have been rendered, (3) The seller s price to the buyer is fixed or 2 determinable, and (4) Collectibility is reasonably assured. SAB 101 at 3.6 3 GT requested that Winstar s counterparties provide additional documentary evidence of 4 the relevant sales underlying each questionable transaction. By doing so, consistent with SAB 5 101, GT sought to obtain independent support for Winstar s recognition of revenue for each 6 transaction in other words, support from documents that were not generated by Winstar itself. 7 As of February 10, 2000, GT still had not received responsive documents from four of these 8 customers. Nonetheless, it issued an audit opinion letter opining that Winstar s 1999 financial 9 statements accurately reflected its financial condition and complied with GAAP. 6 The SEC has elaborated upon the delivery requirement as follows: [D]elivery generally is not considered to have occurred unless the product has been delivered to the customer s place of business or another site specified by the customer. . . . ... A seller should substantially complete or fulfill the terms specified in the arrangement in order for delivery or performance to have occurred. When applying the substantially complete notion, the staff believes that only inconsequential or perfunctory actions may remain incomplete such that the failure to complete the actions would not result in the customer receiving a refund or rejecting the delivered products or services performed to date. SAB 101 at 6 (footnotes omitted). In addition, revenue may be recognized in the absence of delivery only if a transaction meets seven requirements, including (1) that [t]he risks of ownership . . . passed to the buyer ; (2) that the buyer, not the seller . . . request . . . that the transaction be on a bill and hold basis, based on a substantial business purpose of the buyer; and (3) that the seller not retain any specific performance obligations such that the earning process is not complete. Id. (footnotes omitted). In its Form 10-K, Winstar stated, Revenues from equipment sales are recognized when the equipment is delivered to the customer. Professional services revenues are recognized under the percentage of completion method. Joint App. at 538. 9 1 2 B. Bifurcated Accounting In connection with at least three other transactions, Winstar employed a bifurcated 3 accounting scheme that GT ultimately approved prior to its audit of Winstar s financial 4 statements. Two of these transactions involved leasing or subleasing fiber optic network 5 capacity in units called indefeasible rights of use ( IRUs ). Winstar accounted for these IRUs 6 using a dubious bifurcated accounting method, pursuant to which it recognized as much as 94 7 percent of the revenue from the leases upon execution of the lease, reflecting the cost of optical 8 equipment ( optronics ) that transmitted data over fiber optic cable ( cable or fiber ). Winstar 9 then would recognize the balance of the revenue in later quarters, as payments were received 10 over the span of the lease, representing the customer s actual use of the network. In other words, 11 Winstar split the value of the leases so that the revenue associated with the optronics was 12 reported separately from revenue associated with the cable. By employing this accounting 13 method, Winstar was able to recognize $30.9 million in revenue up front in 1999. 14 During discovery, a forensic accountant retained by the Plaintiffs opined that the rules of 15 the Financial Accounting Standards Board and interpretive rules of the SEC prohibited the 16 division of leases for fiber optic networks because both the cable and the optronics were 17 essential to the network. Winstar conceded that the fiber and the optronics were not separable, 18 and that no other company previously had employed this bifurcated method in accounting for 19 IRUs. Indeed, Winstar specifically advised GT that the bifurcated approach had been criticized 20 by the accounting firm Deloitte & Touche LLP ( Deloitte ). 21 GT was in any event aware that revenue associated with an IRU contract could be 22 recognized only if the leased circuit was operational, or lit, in the language of the fiber optics 23 field. In the third and fourth quarters of 1999, however, Winstar had failed to light many of its 10 1 IRU circuits, a fact that should have precluded the company from recognizing revenue associated 2 with those IRUs. 3 In the midst of GT s audit, Winstar sent form letters dated December 30, 1999, and 4 December 31, 1999, to the counterparties to the two IRU transactions, Wam!Net, Inc. and 5 Cignal, respectively, to confirm that the IRU circuits had been deliver[ed] and accept[ed]. A 6 representative of Cignal signed a form letter confirming delivery and acceptance of the circuits. 7 By contrast, Wam!Net s Senior Vice President of Finance responded to a letter from Winstar as 8 follows: To our knowledge [the circuits] are not currently in place. A subsequent amended 9 letter from a different Wam!Net employee, which does not appear in the record but which 10 Cummings referenced in an email, purported to accept the circuits but did not address the 11 earlier letter response. After receiving the amended letter, GT did not further review whether the 12 circuits were installed and operational. Even though it appears not to have received the amended 13 letter until after February 11, 2000, GT approved Winstar s recognition of revenue for the 14 Wam!Net IRU circuit sale on February 10, 2000. 15 While GT appears to have neglected to verify that Wam!Net s IRU circuits were 16 operational, there was evidence that GT actually knew that the leased Cignal IRU circuits were 17 inoperative. GT nevertheless approved Winstar s recognition of revenue for the Cignal IRUs in 18 the third quarter of 1999. 19 Winstar employed a similar bifurcated accounting method in the fourth quarter of 1999 20 for its sale of radios to Lucent. The agreement between the two companies provided for Winstar 21 to install the radios, but Winstar recognized revenue for the transaction immediately, upon 11 1 delivering them to Lucent.7 GT expressed doubt that the radios and installation services were 2 separable,8 but it nevertheless approved of Winstar s recognition of $10 million in revenue in 3 connection with the transaction. C. Round-Trip Transactions 4 5 Several of the transactions discussed above involved round-trip transactions with 6 Cignal and Wam!Net at a time when the two customers were struggling financially. Round- 7 tripping typically refers to reciprocal agreements, involving the same products or services, that 8 lack economic substance but permit [both] parties to book revenue and improve their financial 9 statements. Teachers Ret. Sys. of LA v. Hunter, 477 F.3d 162, 169 (7th Cir. 2007). The two 10 principal round-trip transactions that were the focus of discovery involved a scheme pursuant to 11 which Winstar overpaid both companies for purportedly unrelated goods and services in 12 exchange for their purchase of IRUs, equipment, and services from Winstar by the end of 13 Winstar s third fiscal quarter of 1999 (Cignal), and the end of the fourth quarter of 1999 14 (Wam!Net). 15 Both round-trip transactions were material to Winstar s financial performance in 1999. 16 In the larger of the two transactions, Winstar recognized approximately $39 million in revenue in 17 the third and fourth quarters of 1999 in connection with sales to Cignal while it paid Cignal 18 $29.5 million under a separate agreement during the same time period and an additional $4.8 19 million in the first quarter of 2000. Similarly, Winstar recognized $19.6 million in revenue in 20 connection with sales to Wam!Net in the fourth quarter of 1999, even as it paid Wam!Net $25 7 Winstar also employed a bifurcated accounting method when it recognized $16.5 million in revenue in connection with a sale of radios to Wam!Net in the fourth quarter of 1999. As with the IRU accounting, it did so contrary to Deloitte s advice but with GT s approval. 8 GT also expressed serious doubts about whether Lucent had assumed the risks and rewards of ownership of the radios, given the generous terms of a warranty Winstar extended to Lucent. 12 1 million in the same quarter for prepaid marketing and the lease of a data service center. In 2 February 2000 GT questioned the [a]rms length nature of the [round-trip] transactions. It later 3 acknowledged that the transactions raise[d] a concern within GT as to whether or not absent 4 Winstar s payment . . . collectability was reasonably assured. Nevertheless, GT approved 5 Winstar s recognition of the full amount of revenue for both transactions. 6 7 D. The Audit Opinion Letter By letter dated February 10, 2000, GT issued an unqualified audit opinion letter stating 8 that Winstar s annual Form 10-K report for fiscal year 1999 complied with GAAP and fairly 9 represented Winstar s financial condition at the end of that year: 10 11 We have audited the accompanying consolidated balance sheets of Winstar Communications, Inc. . . . 12 13 14 15 16 17 We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. . . . We believe that our audits provide a reasonable basis for our opinion. 18 19 20 21 22 23 24 In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Winstar Communications, Inc. and Subsidiaries as of December 31, 1999 . . . in conformity with accounting principles generally accepted in the United States. 25 Joint App. at 529. E. Investment by the Jefferson Plaintiffs 26 From December 1998 to February 2001, the Jefferson Plaintiffs purchased over $200 27 million worth of Winstar stock. The investment portfolios of most of the Jefferson Plaintiffs 28 were managed by Ronald Clark, the Chief Investment Officer for Allianz of America 29 ( Allianz ). The remaining entities deferred to Clark to select their investments in United States 30 securities. Although Clark enjoyed ultimate authority for these investment decisions, he relied 13 1 on recommendations from a team of analysts, including Livia Asher, who recommended that 2 Allianz purchase Winstar stock. Based on Asher s recommendation, Clark caused Allianz and 3 the other Jefferson Plaintiffs to invest in Winstar. 4 Clark, it appears, did not personally review Winstar s financial statements prior to 5 making the decision to invest in Winstar. Instead, he relied on Asher to review the statements as 6 part of her job. During discovery, however, Asher acknowledged that she was uncertain of the 7 date of, or reason for, her recommendation that Allianz purchase Winstar stock. Nor could she 8 specifically recall reading Winstar s 1999 Form 10-K report. However, Asher testified that she 9 probably flipped through every single page of the report, based on her practice. She explained, 10 I can t imagine any reason why I would not have looked at this, . . . given our position in the 11 stock and given what I would normally do. Asher added that she habitually read auditors 12 opinion letters included in Forms 10-K to make sure that auditors believed that an issuer s 13 reports were kosher, but she did not specifically recall reviewing GT s audit report. 14 15 F. Winstar s Decline Winstar s stock reached a price per share of over $60 in March 2000. In May 2000 16 Lucent provided Winstar with financing in the form of a renewed credit facility in the aggregate 17 amount of $2 billion. Almost a year later, however, in March 2001, Asensio & Company 18 ( Asensio ), an investment firm, issued a press release criticizing Winstar s ability to pay its 19 debts and explaining that certain measurements of Winstar s financial performance were 20 questionable due in part to Winstar s revenue recognition from non-core businesses and sales 21 of equipment and services to related parties. Joint App. at 2412. The same press release 22 warned that [a]ny adjustment to Winstar s aggressive revenue accounting and capitalization of 23 cash expenditures would negatively and materially impact Winstar s reported [earnings] and 14 1 analyst s [sic] opinions of its operations. Id. at 2413. On March 19, 2001, Asensio issued 2 another press release reporting on Winstar s debt collapse, again criticizing its revenue 3 accounting practices and noting, Winstar has recognized revenues that created a slew of 4 uncollected items . . . . Its revenues include sales to related parties and non-core items such as 5 equipment sales and installation services. Id. at 2414. 6 The Asensio press releases preceded a significant downgrade in Winstar s credit rating 7 on April 3, 2001. Moreover, on April 16, 2001, Winstar announced that Lucent was cancelling 8 Winstar s credit facility, that Winstar would delay filing its Form 10-K report for 2000, and that 9 Winstar was considering a reorganization under Chapter 11 of the Bankruptcy Code. 10 By the time of the Asensio press releases, Winstar s revenues and its stock price had 11 decreased significantly during a marketwide decline in the prices of technology stocks. 12 However, the press releases, coupled with the subsequent announcements of Winstar s financial 13 troubles, were followed almost immediately by an additional steep decline in Winstar s stock 14 price, from over $10 per share before March 2001 to $0.14 per share by mid-April 2001. On 15 April 18, 2001, Winstar filed for bankruptcy. 16 During discovery, an economist retained by the Plaintiffs as an expert witness attributed 17 the decline in Winstar s stock price to, among other causes, the partial disclosure of Winstar s 18 alleged fraud by Asensio. The economist calculated that members of the putative class who had 19 purchased Winstar common stock lost as much as $974 million, that class members who 20 purchased Winstar notes lost up to $197 million, and that the Jefferson Plaintiffs lost over $96 21 million by investing in Winstar stock. 22 23 15 1 2. Procedural History 2 On April 10, 2001, the Lead Plaintiffs filed a putative class action complaint in the 3 Southern District of New York against Winstar, GT, Lucent, and certain Winstar executives 4 alleging securities fraud under Section 10(b) of the Exchange Act, 15 U.S.C. § 78j(b). In 5 December 2001 the Jefferson Plaintiffs filed a separate complaint in the District Court against 6 GT, claiming violations of both Section 10(b) and Section 18 of the Exchange Act, 15 U.S.C. § 7 78r(a).9 As a result of various settlements among the parties, the claims against GT were all that 8 remained by 2008. After discovery, GT moved for summary judgment to dismiss the Plaintiffs 9 claims and also moved unsuccessfully to preclude the Plaintiffs expert loss causation analysis. 10 In September 2010 the District Court granted GT s motion for summary judgment, 11 concluding that (1) the Plaintiffs had failed to demonstrate that a genuine dispute of material fact 12 existed as to whether GT acted intentionally or recklessly, as required under Section 10(b) of the 13 Exchange Act, and (2) the Jefferson Plaintiffs had failed to demonstrate that such a dispute 14 existed as to whether they actually relied on GT s audit opinion letter, as required under Section 15 18 of the Exchange Act. In re Winstar Commc ns Sec. Litig., No. 01 CV 11522 (GBD), 2010 16 WL 3910322, at *5-6 (S.D.N.Y. Sept. 29, 2010). 17 This appeal followed. 18 19 DISCUSSION We review a district court s grant of summary judgment de novo, viewing the evidence in 20 the light most favorable to the non-moving party and drawing all reasonable inferences and 21 resolving all ambiguities in its favor. E.g., Grain Traders, Inc. v. Citibank, N.A., 160 F.3d 97, 22 100 (2d Cir. 1998). We will affirm the judgment only if there is no genuine dispute as to any 9 Although the Defendants filed motions to dismiss in June 2002, the District Court did not rule on them. Similarly, a motion for class certification was filed but never resolved by the District Court. 16 1 material fact and the movant is entitled to judgment as a matter of law. Fed. R. Civ. P. 56(a). 2 There is no genuine issue of material fact where the record taken as a whole could not lead a 3 rational trier of fact to find for the non-moving party. Durakovic v. Bldg. Servs. 32 BJ Pension 4 Fund, 609 F.3d 133, 137 (2d Cir. 2010) (quotation marks and brackets omitted). Put another 5 way, [a]n issue of fact is genuine if the evidence is such that a reasonable jury could return a 6 verdict for the nonmoving party. Omnicom, 597 F.3d at 509 (quotation marks omitted). 7 To sustain a claim under Section 10(b) of the Exchange Act and Rule 10b-5, the 8 Plaintiffs must show (i) a material misrepresentation or omission; (ii) scienter; (iii) a 9 connection with the purchase or sale of a security[;] (iv) reliance by the plaintiff(s); (v) 10 economic loss; and (vi) loss causation. Id. (alteration in original) (quoting Dura Pharms., Inc. 11 v. Broudo, 544 U.S. 336, 341-42 (2005)). 12 1. Scienter 13 Plaintiffs may satisfy the scienter requirement by producing evidence of conscious 14 misbehavior or recklessness. See ECA, Local 134 IBEW Joint Pension Trust of Chicago v. JP 15 Morgan Chase Co., 553 F.3d 187, 198 (2d Cir. 2009). Scienter based on conscious misbehavior, 16 in turn, requires a showing of deliberate illegal behavior, Novak v. Kasaks, 216 F.3d 300, 308 17 (2d Cir. 2000), a standard met when it is clear that a scheme, viewed broadly, is necessarily 18 going to injure, AUSA Life Ins. Co. v. Ernst & Young, 206 F.3d 202, 221 (2d Cir. 2000) 19 (alterations omitted). 20 In AUSA Life, we applied this standard to representations by the accounting firm Ernst 21 & Young ( E & Y ), which, as plaintiffs allege with respect to GT, consistently noticed, 22 protested, and then acquiesced in the financial misrepresentations of an audit client under 17 1 pressure from the client s management. Id. at 205. We held that by issuing an unqualified audit 2 report despite its knowledge of accounting improprieties by the client, E & Y intentionally 3 engaged in manipulative conduct, id. at 221 (quotation marks omitted), in violation of Section 4 10(b). We explained that 5 6 7 8 9 10 11 12 13 Id.; see also SEC v. KPMG LLP, 412 F. Supp. 2d 349, 379 (S.D.N.Y. 2006) (triable issue as to 14 conscious fraud existed when accountant was [a]ware of [the client s] earnings pressures but 15 allowed aggressive accounting policies without any serious study to determine that these 16 unusual, indeed unique, accounting treatments would result in financial statements that fairly 17 represented [the client s] financial condition ). 18 E & Y is not an accounting dilettante. It knows well that its opinions and certifications are afforded great weight, and it must have known that its financial certifications with regard to [its client] would be compelling to the investors. . . . [I]t is sufficient [for the purposes of showing scienter] for a plaintiff to allege and prove that a defendant could have foreseen the consequences of his actions but forged ahead nonetheless . . . . Scienter based on recklessness may be demonstrated where a defendant has engaged in 19 conduct that was highly unreasonable, representing an extreme departure from the standards of 20 ordinary care . . . to the extent that the danger was either known to the defendant or so obvious 21 that the defendant must have been aware of it. Rothman v. Gregor, 220 F.3d 81, 90 (2d Cir. 22 2000) (quotation marks omitted). Recklessness may be established where a defendant failed to 23 review or check information that [it] had a duty to monitor, or ignored obvious signs of fraud. 24 Novak, 216 F.3d at 308. 25 26 The District Court concluded that Winstar engaged in dubious accounting practices, that [m]uch of the supporting documentation that Winstar supplied to GT was a mere 18 1 contrivance meant to paper the transactions and create the appearance of legitimacy, and that 2 GT failed to uncover the accounting fraud being perpetuated by the Winstar defendants. 3 Winstar, 2010 WL 3910322, at *3, *5. GT does not seriously dispute these conclusions, which 4 are in any event supported by the record before us. The District Court concluded, however, that 5 the evidence demonstrated only that GT was performing its role as [Winstar s] independent 6 auditor and fell short of demonstrating scienter in the form of either conscious misbehavior or 7 recklessness. Id. at *3. We disagree. 8 9 Some evidence supports the Plaintiffs contention that GT consciously ignored Winstar s fraud when it approved Winstar s recognition of revenue for the suspicious 1999 transactions. 10 This evidence goes beyond a mere failure to uncover the accounting fraud and, in general, relates 11 to (1) Winstar s recognition of revenue for the sale of equipment or services without sufficient 12 indicia of delivery, (2) its recognition of all revenue associated with the incomplete sale of 13 telecommunications systems, and (3) its recognition of revenue for sales of IRUs, equipment, 14 and services to financially unstable companies to whom Winstar paid back large sums under 15 separate contractual obligations. 16 There is also evidence that GT failed to confirm Winstar s representations regarding 17 these transactions or to retain and review documents evidencing each transaction. Indeed, an 18 expert forensic accountant retained by the Plaintiffs testified that GT s failure to exercise due 19 professional care, gather reliable documents, and issue an adverse opinion in this regard 20 represented a violation of Generally Accepted Auditing Standards ( GAAS )10 with regard to all 10 Under GAAS, a central objective of the independent auditor s engagement is to obtain sufficient competent evidential matter to provide him with a reasonable basis for forming an opinion. Joint App. at 3604 (quoting AU § 9326). Gathering and objectively evaluating audit evidence requires the auditor to consider the competency and sufficiency of the evidence. . 19 1 of the challenged transactions. Furthermore, the record evidence supports a conclusion that GT 2 knew, even under the terms of Winstar s bifurcated accounting method a method that had been 3 criticized by Deloitte but reviewed and approved, with skepticism, by GT that revenue could 4 not be properly recognized for IRUs unless the leased circuits were operational. During 5 discovery, Cummings acknowledged that GT knew the circuits for the Cignal IRUs were not 6 operational. Under these circumstances, GT s approval of Winstar s recognition of revenue for 7 the nonfunctional circuits presents a genuine issue of material fact as to whether GT acted with 8 the requisite scienter under Section 10(b). 9 We point to the IRU transactions only as one example of a transaction that suggests that 10 GT acted with scienter. Triable issues regarding GT s scienter exist for the other questionable 11 transactions as well. Broadly speaking, there was admissible evidence that in the course of its 12 audit GT learned of and advised against the use of indisputably deceptive accounting schemes, 13 but eventually acquiesced in the schemes by issuing an unqualified audit opinion. See AUSA 14 Life, 206 F.3d at 221. Based on this record, we cannot conclude that this and the other evidence 15 adduced by the Plaintiffs was insufficient to raise a genuine issue of material fact about whether, 16 in issuing an unqualified audit opinion letter, GT agreed to [Winstar s] accounting abuses, 17 knowing . . . that [investors] and others would be receiving and relying upon the manipulated 18 financial reports. Id. At this stage, the Plaintiffs have proffered enough facts constituting 19 evidence of conscious misbehavior or recklessness to survive summary judgment. 20 We note that in granting summary judgment in GT s favor, the District Court placed 21 particular emphasis on the magnitude of GT s audit work, both in time spent and documents . . [P]rofessional skepticism should be exercised throughout the audit process, and requires the employment of a questioning mind in the gathering and objective evaluation of evidence, including with regard to representations by management. Id. at 3589-90 (quoting AU §§ 230.0708). 20 1 reviewed. For example, it noted that GT spent 1,928 hours of professional time, assembled 2 working papers spanning 3,000 pages, and reviewed copies of contracts, Winstar business 3 plan[s], press releases, board minutes, and memos prepared by Winstar and GT addressing 4 accounting issues. Winstar, 2010 WL 3910322, at *2. The number of hours spent on an audit 5 cannot, standing alone, immunize an accountant from charges that it has violated the securities 6 laws. Here, the Plaintiffs adduced evidence that, notwithstanding the magnitude of its audit, GT 7 repeatedly failed to scrutinize serious signs of fraud by an important client, including: (1) 8 significant end-of-quarter transactions;11 (2) the absence of documents confirming the goods or 9 services ordered by Winstar customers, the fact of delivery, or the existence of an underlying 10 agreement; (3) the repeated failure of Winstar or its clients timely to provide supporting 11 documentation requested by GT; (4) Winstar s transactions outside its core business; and (5) 12 round-trip transactions in which revenues were subsequently offset by Winstar s payments to 13 financially unstable customers under unrelated contractual obligations. 14 In short, regardless of the hours GT spent or the number of documents it reviewed in the 15 course of its 1999 audit of Winstar, a jury reasonably could determine that the audit was so 16 deficient as to be highly unreasonable, representing an extreme departure from the standards of 11 Here, only GT s February 10, 2000 audit opinion letter regarding Winstar s Form 10-K for fiscal year 1999 forms the basis for its liability under Section 10(b). Winstar s quarterly financial reports for 1999, no matter how involved GT was in their formulation, cannot serve as independent grounds for Section 10(b) liability for GT because, unlike with the Form 10-K, GT never made any public statements vouching for their accuracy. See McAdams v. McCord, 584 F.3d 1111, 1114 & n.2 (8th Cir. 2009). That GT was involved in their formulation at best would give rise to aiding and abetting liability under Section 10(b), as to which there is no private cause of action. See Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164, 177 (1994). The end-of-quarter transactions are nevertheless relevant to the issue of GT s scienter because they should have raised red flags for GT as to whether they were genuine and could be reported on Winstar s end-of-year filing for fiscal year 1999. Indeed, evidence in the record, including email communications between GT employees, suggests that GT remained troubled by many of these transactions around the time it filed its audit opinion letter. 21 1 ordinary care . . . to the extent that the danger was either known to [GT] or so obvious that [GT] 2 must have been aware of it. Rothman, 220 F.3d at 90 (quotation marks omitted). 3 2. Reliance 4 Section 18 of the Exchange Act, 15 U.S.C. § 78r(a), requires actual rather than 5 constructive reliance upon a materially false or misleading statement by one who has purchased 6 or sold a security. Heit v. Weitzen, 402 F.2d 909, 916 (2d Cir. 1968). The District Court 7 concluded that the Jefferson Plaintiffs failed to show reliance because they could not 8 demonstrate that they or their representatives actually saw Winstar s 1999 Form 10-K filing, 9 much less read the included independent accountant report of GT. Winstar, 2010 WL 3910322, 10 at *6. Even assuming that such eyeball reliance is the sort of actual reliance required by our 11 precedents, the District Court s conclusion somewhat understates the record evidence on this 12 score. Ronald Clark and Livia Asher worked on behalf of the Jefferson Plaintiffs. Although 13 Asher was unable to recall specifically that she reviewed GT s audit opinion letter, there was 14 evidence that she actively reviewed such letters as a matter of practice in deciding whether to 15 recommend certain stocks. At this stage of the proceedings, Asher s testimony is enough; from 16 that evidence, a jury reasonably could infer that she actually reviewed and relied on the relevant 17 statements in the documents. See, e.g., Fed. R. Evid. 406. Accordingly, we conclude that the 18 District Court erred in granting summary judgment in GT s favor on the Jefferson Plaintiffs 19 Section 18 claims. 20 3. Causation 21 GT argues in the alternative that the District Court s grant of summary judgment should 22 be affirmed because the Plaintiffs failed to show loss causation. We have described loss 23 causation as the causal link between the alleged misconduct and the economic harm ultimately 22 1 suffered by the plaintiff. Emergent Capital Inv. Mgmt., LLC v. Stonepath Grp., Inc., 343 F.3d 2 189, 197 (2d Cir. 2003). Among other things, the misconduct must be a substantial factor in the 3 sequence of responsible causation. AUSA Life, 206 F.3d at 215 (quotation marks omitted). 4 With these principles in mind, however, we have also warned that if the loss was caused by an 5 intervening event, like a general fall in the price of Internet stocks, the chain of causation will 6 not have been established[, b]ut such is a matter of proof at trial. Emergent Capital, 343 F.3d at 7 197; see also AUSA Life, 206 F.3d at 214-15 ( [W]hen the plaintiff s loss coincides with a 8 marketwide phenomenon causing comparable losses to other investors, the prospect that the 9 plaintiff s loss was caused by the fraud decreases. ). 10 Relying largely on the deposition testimony of an expert witness economist, the Plaintiffs 11 argue that they have adduced proof of loss causation in the form of the press releases from 12 Asensio and Winstar s April 2001 announcements, which publicly exposed Winstar s substantial 13 financial weaknesses and together suggested for the first time that Winstar had engaged in 14 improper revenue recognition practices for a period of time that included 1999. Although a 15 much closer call, a jury could reasonably infer based on the expert testimony and other evidence 16 that the precipitous decline in Winstar s stock price in 2001 was attributable in part to the 17 alleged fraud. 18 GT counters that any decline in Winstar s stock price that was not caused by broader 19 market trends resulted not from the alleged fraud but from Lucent s cancellation of its credit 20 facility. This may be true for a portion of the collapse in Winstar s stock price. There is support 21 as well for the argument that the downgrade in Winstar s credit rating resulted in a substantial 22 decline in the stock price. But these facts, if established, hardly foreclose the reasonable 23 inference that some part of the decline was substantially caused by the disclosures about the 23 1 fraud itself. We therefore conclude that a jury reasonably could find the requisite causal link 2 between [Winstar s] alleged misconduct and the economic harm ultimately suffered by the 3 Plaintiffs. See Emergent Capital, 343 F.3d at 197. 4 5 CONCLUSION We have considered GT s other arguments, and we conclude that they are without merit. 6 For the foregoing reasons, we VACATE the District Court s grant of summary judgment, and we 7 REMAND for further proceedings. 24
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