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Financial Reporting and the Law

A recent district court decision may affect audit committee members who do not act when faced with obvious reporting or other red flags. In In re Longwei Petroleum Investment Holding Ltd. Securities Litigation, the U.S. District Court for the Southern District of New York denied a motion to dismiss a case under sections 10(b) and 20(a) of the Securities Exchange Act of 1934 (Exchange Act) and Rule 10b-5 thereunder against, among others, two of the three members of an audit committee. In Longwei, the court found that the plaintiffs’ allegations that the two committee members failed to take any action in response to “acknowledged reporting failures” established scienter.

The two audit committee members had signed Longwei Petroleum’s 2011 annual report on Form 10-K, which disclosed that Longwei’s “disclosure controls were not effective” due to a “material weakness identified in [its] financial reporting.” Despite that disclosure, neither the board of directors nor the audit committee reported having had any meetings. The plaintiffs also alleged “that the auditors had a history of employment with other Chinese companies with accounting irregularities and failed to follow GAAP, yet the audit committee recommended their retention annually.”

In addition, the court noted the “enormous size of the alleged fraud, which circumstantially supports a finding of scienter,” as well as Longwei’s “remarkable success in comparison to its competitors, its history of inadequate reporting, and its sudden increase in revenues in 2010, just in time to satisfy the terms of an escrow agreement that risked the personal stock of Longwei’s founders.” The plaintiffs had alleged that these indicators, as well as others, were “red flags,” that “should have prompted further investigation.”

The court also denied the motions to dismiss filed by the auditors and the principal audit partner with respect to claims under section 10(b) of the Exchange Act, finding scienter based on “a combination of ‘red flags’ that should have raised the auditors’ suspicion, the enormous scale of the fraud, the auditors’ failure to follow generally accepted auditing standards . . ., and the fact that they had been rebuked for audit deficiencies in the past by the [PCAOB].” The court, however, granted the motion to dismiss filed by the principal audit partner with respect to a claim under section 20(a), finding that the allegations relating to the audit partner’s culpable participation were inadequate. Finally, the court denied the chief financial officer’s motion to dismiss claims under sections 10(b) and 20(a) of the Exchange Act, noting, among other things, that the signing of Form 10-K alone is sufficient evidence of control.