Ninth Circuit Confirms Securities Act of 1933 Does Not Impose Strict Liability on Auditors

The US Court of Appeals for the Ninth Circuit recently affirmed dismissal of a securities claim against an auditor, holding it was not strictly liable for alleged misstatements in its client’s initial public offering.

The case, Hunt v. PricewaterhouseCoopers LLP, was the Ninth Circuit’s first occasion to consider application of the US Supreme Court’s Omnicare decision to claims against an auditor under Section 11 of the Securities Act of 1933. The Ninth Circuit held that Omnicare squarely applies to audit opinions and reaffirmed the delineation of duties between an auditor and its client and, relatedly, the distinction in the Securities Act between those who “prepare” financial statements and those who “certify” financial statements. The decision provides a clear and helpful precedent for auditors defending claims arising out their clients’ public stock offerings.

After Bloom Energy issued revisions to its 2016 and 2017 financial statements and a restatement of its 2018 and 2019 financial statements, Bloom stockholders amended an existing securities class action to add claims under Section 11 against the accounting firm that audited Bloom’s 2016 and 2017 financial statements. Bloom is a renewable energy company that sells fuel-cell servers that convert natural gas or biogas into electricity.

The case centers on the accounting for Managed Services Agreements (MSA) that Bloom used in connection with sale-leaseback arrangements of these energy servers. Under these MSAs, Bloom first sold the energy server to a bank, then leased it back from the bank, and then subleased the energy server to a customer. At the time of the lease to the customer, Bloom also entered into another contract with the customer to service the energy server.

Under the relevant accounting standards, Bloom could account for these sale-leaseback arrangements as either operating leases or capital leases. The proper accounting depended on Bloom’s judgment about the useful economic life of the energy servers, as compared to the lease term. In its fiscal year 2016 and 2017 financial statements, Bloom accounted for MSAs as operating leases.

The distinction between operating leases and capital leases affected Bloom’s recognition relating to the MSAs. Under an operating lease, an energy server would not be recognized as an asset. Instead, lease payments to the bank would be recorded as an expense, and payments from the customer would be recorded as revenue. In contrast, a capital lease would be recorded on Bloom’s balance sheet by recognizing the energy server as an asset with a corresponding liability to the bank.

The accounting firm was engaged by Bloom to audit its 2016 and 2017 financial statements and express an opinion as to whether those financial statements presented fairly, in all material respects, Bloom’s financial position.

After conducting its audits, the accounting firm did not object to Bloom classifying the MSAs as operating leases under Generally Accepted Accounting Principles (GAAP), and stated, “[i]n our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of [Bloom] as of December 31, 2017 and December 31, 2016….” When Bloom prepared its registration statement in connection with its 2018 initial public offering (IPO), it included the accounting firm’s audit opinion.

After Bloom completed its IPO, however, it reevaluated its MSAs and determined they should be treated as capital leases (loans from the bank rather than sales) and not operating leases. To reflect these classifications, Bloom revised its 2016 and 2017 financial statements and restated its 2018 and 2019 financial statements. Bloom’s stock price fell the day after it announced the revisions and restatements.

DECISION

In their complaint, plaintiffs alleged the accounting firm was liable under Section 11 for purportedly actionable statements and omissions in Bloom’s registration statement regarding its accounting for MSAs because the audit opinion did not identify that Bloom should have classified the MSAs as capital leases instead of operating leases. [1] The accounting firm moved to dismiss, and the District Court granted the motion. Rather than amend their complaint, plaintiffs appealed to the Ninth Circuit.

On appeal, plaintiffs did not challenge the District Court’s dismissal of their claim that the audit opinion itself was false or misleading apart from its certification of the financial statements. Put differently, plaintiffs did not deny that Bloom prepared its own financial statements or that the accounting firm neither prepared the statements nor repeated those statements in its opinion. Rather, plaintiffs argued that the accounting firm should be strictly liable under Section 11(a)(4) of the Securities Act for the misstatements in Bloom’s financial statements. [2]

The Ninth Circuit resoundingly rejected plaintiffs’ argument. The Ninth Circuit reiterated that Section 11 includes a due diligence defense, which requires that “accountants … exercise due diligence in investigating the materials provided to them using the accepted practices of their profession.” [3] Accordingly, Section 11 imposes a negligence standard for an accountant’s liability, [4] and in order for plaintiffs to prevail on a Section 11 claim, they must establish that an accounting firm did not have a “reasonable ground to believe” and did not believe, “at the time such part of the registration statement became effective, that the statements therein were true.” [5] The Ninth Circuit added that, in enacting the Securities Act, there is nothing to indicate that Congress intended for accountants to be subject to strict liability. [6]

The Ninth Circuit next addressed applicability of the Supreme Court’s 2015 decision in Omnicare Inc. v. Laborers Dist. Council Const. Indus. Pension Fund, 575 US 175, in which the Supreme Court excluded statements of opinion from liability under Section 11. [7] Specifically, Omnicare held that a statement of opinion may give rise to liability under Section 11 as a misrepresentation of fact only if (1) the speaker does not actually hold the opinion, (2) the opinion contains an embedded misrepresentation of fact, or (3) an omission makes the opinion statement at issue misleading. [8] Hunt was the first time the Ninth Circuit had occasion to consider applicability of Omnicare to auditors.

Without hesitation, the Ninth Circuit “extend[ed]” the holding in Omnicare to accountants and noted that doing so is consistent with Section 11’s due diligence defense. [9] The Ninth Circuit held: “accountants may be liable for statements of fact if they did not act with due diligence; however, accountants will not be liable for statements of opinion, even if they reflect a subjective belief that admits there is a possibility of error, as long as the statement of opinion was sincerely held.” [10]

After reiterating that an auditor can only be liable for misstatements or omissions in financial statements that it prepares or certifies, the Ninth Circuit concluded that the accounting firm was not a preparer of the financial statements at issue (nor could it be under applicable accounting rules). [11] Finally, the Ninth Circuit clarified that an “accountant’s certification of financial statements is nothing more than an opinion,” and held that, in this case, the accounting firm could not be liable for its audit opinion because that opinion “did not make any material misstatements of fact or omissions but rather was merely a statement of opinion based…upon the subjective judgment of the MSA classification.” [12] The Ninth Circuit ultimately affirmed the District Court’s ruling dismissing the complaint against the accounting firm.

TAKEAWAYS

The Ninth Circuit’s decision in Hunt provides clarity regarding the legal standard for claims against auditors in connection with a company’s IPO. The decision in Hunt confirms that in the Ninth Circuit audit opinions are statements of opinion for purposes of Omnicare. This is consistent with the US Court of Appeals for the Second Circuit, which has likewise so held. [13]

No other circuits appear to have reviewed this precise question, although before the Supreme Court’s decision in Omnicare, the US Court of Appeals for the Tenth Circuit recognized that “[t]he opinion paragraph, as the term suggests, is stated as an opinion of [the auditor] rather than a statement of absolute fact or a guarantee.” [14] Further, following the Supreme Court’s decision in Omnicare, some authors predicted that audit opinions would be treated as opinions under its holding. [15]

The decision in Hunt recognizes the distinctive roles of a company’s outside auditor and makes clear that auditors do not act as guarantors of the accuracy of a company’s financial statements.

The Ninth Circuit quoted extensively from the accounting standards relevant to the role of management and the role of an auditor. The Ninth Circuit further noted that “the division of responsibility is based on practical realities,” and the “limits placed on accountants to assess a company's financial statements preclude its ability to ensure that there are no misstatements….” [16] As a result, Section 11 does not “make accountants guarantors of every statement made by the issuer; to make such a holding would turn the whole accounting world upside down” and make audits prohibitively expensive. [17]

The Ninth Circuit also held there was an alternative basis for its application of Omnicare in the fact that the financial statement line items at issue were based on Bloom’s “subjective judgments (not statements of fact) concerning the actual useful life of the Energy Server.” [18] Bloom’s determination of whether the accounting standards mandated that Bloom treat the MSAs as capital leases or operating leases involved significant accounting judgments, which rendered those determinations opinions, not facts. [19] According to the Ninth Circuit, “numbers can sometimes be facts and other times be opinions[.]” [20] Accordingly, in this instance, Omnicare doubly applied because the accounting firm’s audit report was an opinion on top of company management’s opinion.