Second Circuit rules that auditors have duty to correct past opinions

A recent ruling against a small accounting firm by the Second Circuit Court of Appeals may have broad implications for the accounting industry. In Overton v. Todman & Co., investors in a privately-held company brought an action for securities fraud under Section 10b-5 against the company’s auditor. They alleged that the financial statements were wrong and the auditor’s opinion that the statements were correct was false when made. While New York Southern District dismissed the case, the Second Circuit appeals court reversed the decision, holding that the auditor may be held primarily liable for federal securities fraud.

Specifically, the Court held that an accountant has a “duty to correct” the opinions and statements that it issues and violates that duty and becomes primarily liable for securities fraud when it:

(1) makes a statement in its certified opinion that is false or misleading when made;
(2) subsequently learns or was reckless in not learning that the earlier statement was false or misleading;
(3) knows or should know that potential investors are relying on the opinion and
financial statements; yet
(4) fails to take reasonable steps to correct or withdraw its opinion
and/or the financial statements; and
(5) all the other requirements for liability [for securities fraud] are satisfied.

The court also noted that accountants can also be held primarily liable if they assume the role of an insider in the company. (“[I]f the accountant exchanges his or her role for a role as an insider who vends the company’s securities, then the accountant shares in an insider’s duty to disclose.”)

The Court attempted to limit the impact of this decision by holding that the duty to correct was not implying that theere was a duty to update its past opinions. (“The duty to correct requires only that the accountant correct statements that were false when made. In contrast, the duty to update requires an accountant to correct a statement made misleading by intervening events, even if the statement was true when made. “) Immediately following that statement, however, the Court cited a case for the proposition that “in limited circumstances, an issuer may have ‘a duty to update opinions and projections . . . if the original opinions or projections have become misleading as the result of intervening events'”).

While the allegations in this case are a bit extreme, this case may have wide-reaching potential to create a new level of hedging (and CYA memos and disclaimers) for the accounting industry. The court’s mere hinting that there could be situations where an auditor could be held liable where it knew or should have known about an issue that needed updating places both accountants and young companies they represent in a tough spot. The decision suggests that accountants are only liable if they make a statement (i.e. issue an audit opinion), which is a sine qua non for many companies in raising their first and following venture round. Accountants (like lawyers) also often play a significant role in the business of a young or small company, i.e. act as insiders, and this case suggests that liability awaits. I guess no good deed goes unpunished! If other courts follow, both accountants and lawyers may really need to limit their role as company business advisors for mitigate potential exposure to these types of claims.

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