Ninth Circuit Expounds on Standard for Pleading Scienter Against Auditors Under Section 10(B)

April 19, 2011

In New Mexico State Investment Council v. Ernst & Young LLP‚ Case No. 09-55632‚ 2011 U.S. App. LEXIS 7680 (9th Cir. April 14, 2011)‚ the United States Court of Appeals for the Ninth Circuit clarified the standard for pleading scienter against a company’s outside auditor under Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b). In reversing the District Court’s dismissal of the Section 10(b) claim against Ernst & Young, the Ninth Circuit confirmed that it is “difficult” to plead scienter against an auditor, but disagreed with the District Court’s view that there is a “heavier” burden for pleading scienter against auditors.

Factual and Procedural Background

The plaintiffs filed a class action complaint against Broadcom Corporation, certain Broadcom officers and directors, and Broadcom’s outside auditor Ernst & Young asserting various claims relating to an alleged $2.2 billion stock option backdating scheme involving options to purchase over 239 million shares of Broadcom stock between 1998 and 2005. Although backdating options is not improper under the law or accounting principles, generally accepted accounting principles require that to the extent backdated options are in the money at the time of the grant, that profit must be recorded as an expense and treated as compensation to the option recipient over the vesting period. Failure to record such expense overstates the company’s reported income for each of the years the options vest.

The complaint alleged that Broadcom engaged in an improper stock option backdating scheme that required the company to restate its financial statements for the years 1998 to 2005. The complaint further alleged that Ernst & Young, as the auditor issuing the unqualified 2005 audit opinion, knew of, or was deliberately reckless in not knowing, that its 2005 audit opinion was materially false and misleading due to Broadcom’s stock option backdating scheme.

Ernst & Young filed a motion to dismiss, and the District Court dismissed plaintiffs’ Section 10(b) claim for failing to plead scienter. The District Court stated: “I think the allegations are deficient on actual knowledge of the defendant . . . , and I think there’s a little bit of a heavier burden of allegations on accountants on the question of scienter.” New Mexico State Investment Council, 2011 U.S. App. LEXIS 7680, at *4.

Scienter Allegations Against Auditors are Not Subject to a Heavier Burden

The Ninth Circuit disagreed. In reversing the District Court’s order, the Court stated that it “has previously advised against developing ‘separate[] rules of thumb for each type of scienter allegation.’” Id. at *10 (quoting South Ferry LP, No. 2 v. Killinger, 542 F.3d 776, 784 (9th Cir. 2008)). However, the Court noted that “pleading sufficient facts to support a strong inference of scienter by an outside auditor is difficult because outside auditors have more limited information than, for example, the company executives who oversee the audit.” Id. at *18. The Court also noted that “an auditor exercises ‘complex and subjective professional judgments that courts are not ideally positioned to second guess.’” Id.

The Court further explained that under Tellabs and Ninth Circuit law, the Court conducts “a two-part inquiry for scienter: first, we determine whether any of the allegations, standing alone, are sufficient to create a strong inference of scienter; second, if no individual allegation is sufficient, we conduct a ‘holistic’ review of the same allegations to determine whether the insufficient allegations combine to create a strong inference of intentional conduct or deliberate recklessness.” Id. at *11. The Court stated that “[w]hile a violation of GAAP, standing alone, is not sufficient, allegations of recklessness have been sufficient where defendants ‘failed to review or check information that they had a duty to monitor, or ignored obvious signs of fraud.’” Id. at *20 (citation omitted). Furthermore, “[w]ith respect to allegations of GAAS violations and how an audit is conducted, ‘[a]lleging a poor audit is not equivalent to alleging an intent to deceive.’” Id. (citation omitted).

Scienter Sufficiently Alleged Regarding May 2000 Stock Option Grant

The Court held that plaintiffs’ allegations were sufficient to raise a strong inference of scienter. Plaintiffs alleged that Ernst & Young did not adequately investigate issues surrounding Broadcom’s May 26, 2000 stock option grant. The grant was the largest in Broadcom’s history, and the Court noted that Broadcom’s stock price on May 26, 2000 was at its lowest point since October 1999.

Under accounting rules, the “measurement date” for stock options cannot be established until the exact number of recipients and their respective number of options are identified. Further, if options have an exercise price lower than the fair market value of the stock as of the measurement date, the company would have to recognize a compensation expense equal to the difference between fair market value as of the grant date and the exercise price over the vesting period of the options. Plaintiffs cited to specific email exchanges between Ernst & Young and Broadcom and alleged that Ernst & Young knew by July 2000 that Broadcom had not yet allocated the grants to its employees, but failed to investigate further. The Court found these allegations sufficient to plead scienter: “EY apparently accepted management at its word, never received requested documentation, and issued an unqualified Opinion on the accuracy of Broadcom’s financial statements. These circumstances are sufficient to support an inference that EY knew, or should have known, the May 2000 options were not legitimate.” Id. at *21.

The Court also rejected Ernst & Young’s “roving scienter” argument that plaintiffs did not adequately allege scienter where they did not allege a concrete connection between the auditors who performed the audit in 2000 and those who issued the allegedly misleading 2005 audit report: “EY cannot insulate itself from accountability for multiple years of approved financial statements with a ‘right hand, left hand’ defense . . . . EY could limit its Opinion to the years for which it is confident in the audit.” Id. at *24.

Scienter Sufficiently Alleged Regarding Option Grants Approved When Compensation Committee Was Not Legally Constituted

The Court also determined that plaintiffs plead sufficient facts to support a strong inference of scienter based on option grants allegedly awarded when Broadcom’s compensation committee was not legally constituted. The complaint alleged that Ernst & Young accepted in support of the awards unsigned draft committee minutes and unanimous written consents dated after the death of the compensation committee member, when the committee necessarily lacked a valid quorum. The Court further noted that Broadcom specifically consulted with Ernst & Young on the option grant. The Court concluded that such allegations provide an inference of scienter at least as compelling as any opposing innocent inference. Id. at *26.

Scienter Pled Regarding Ernst & Young’s Involvement in Broadcom’s 2003 Corrective Reforms

The Court further concluded that plaintiffs sufficiently alleged scienter based on allegations that Ernst & Young had direct knowledge of the irregularities in Broadcom’s option granting process due to its participation in “corrective” reforms undertaken in 2003 to ensure future grants were treated properly. The plaintiffs alleged that as a result of its involvement with the 2003 reforms, Ernst & Young had knowledge that prior option grants caused previously reported financials to be false, but, nevertheless, continued to issue unqualified audit opinions as to those prior financial statements.

Several Other Grounds Support a Finding of a Strong Inference of Scienter

The Court also held that plaintiffs alleged several other grounds that would support a finding of scienter against Ernst & Young, including claims that Ernst & Young knew there was insufficient documentation. The Court noted that, while the contemporaneous documentation is not explicitly required under GAAP and GAAS, the standards give strong guidance to auditors to dig deeper once there are questionable circumstances surrounding such material transactions. The Court concluded that “[c]onsidering the number, magnitude, and multi-year financial impacts of these grants, it is certainly reasonable to infer scienter just as strongly as an innocent inference.” Id. at *32. The Court further held that the red flags pled in the complaint “further support a strong inference of scienter.” Id. at *33.

A Holistic Review of Plaintiffs’ Allegations Present a Strong Inference of Scienter

The Court concluded by holding that a holistic review of the scienter allegations also supports a strong inference of scienter. The Court held that “[w]hile Broadcom’s bad acts certainly may have played a role in the overall fraud, this Court’s purpose at this stage, under Tellabs, is simply to test whether the Complaint provides a sufficient inference of scienter for the case to proceed against EY. It does.” Id. at *34.


Although the Ninth Circuit declined to adopt the District Court’s statement that there is a heightened burden for pleading scienter against an auditor, the Court’s opinion confirms that it is “difficult” to plead scienter against an auditor. The Court’s opinion demonstrates that the strong inference of scienter standard can be met at the pleading stage, however, when plaintiffs plead specific, detailed facts relating to alleged deficiencies in an audit.


For more information about the subject matter of this alert, please contact the lawyers listed below:

Dale Barnes, Co-chair, Securities and Financial Institutions Litigation, 415.393.2522

Jordan Hershman, Co-chair, Securities and Financial Institutions Litigation, 617.951.8455

Jeffrey Q. Smith, Co-chair, Securities and Financial Institutions Litigation, 212.705.7566

This article was originally published by Bingham McCutchen LLP.