Does recklessness satisfy the scienter requirement? (criminal intent requirement) (Accountants' Liability)by Yodowitz, Edward J.
It should cause little worry to the accounting profession that an accountant is liable for violating the federal securities laws if, with actual knowledge of a client's securities fraud, the accountant substantially assists the client in perpetuating that fraud. Upon learning of such fraud, an accountant can generally avoid liability by: 1) refraining from any action that could be interpreted as assisting the fraud; and 2) refusing to provide any further services to the client. Of greater concern is the question of whether liability for aiding and abetting securities fraud attaches when the accountant is unaware of the fraud and unwittingly provides services that substantially assist the client in committing, continuing, or covering up that fraud. As recent cases indicate, those circumstances may result in such liability if the accountant's services are performed in a reckless manner and it is reasonably foreseeable that the auditor's opinion will be relied upon by third parties. As demonstrated below, although these cases are not well reasoned, accountants must nevertheless be cognizant of their strictures.
Usually an Aider and Abettor
While accountants of course can be and are the subject of claims alleging primary violations of Sec. 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder (collectively Rule 10b-5), generally they are changed with liability as aiders and abettors of another's Rule 10b-5 violation, often as a result of audits or opinions provided to a client. To prove a primary violation of Rule 10b-5 it must be established that the plaintiff (1) suffered damage (2) caused by reasonable reliance on the defendant's misrepresentation or omission (3) of material facts (4) made with scienter (i.e., an intent to deceive, manipulate, or defraud) (5) in connection with the purchase or sale of securities and (6) furthered by the defendant's use of the mails or any facility of a national securities exchange.
The widely accepted elements of an aiding and abetting claim are: 1) violation of Rule 10b-5 by the primary wrongdoer; 2) scienter, i.e., knowledge of the violation by the person sought to be charged; and 3) proof that that person substantially assisted in the achievement of the primary violation.
Since scienter must be proven, negligence cannot be the basis for Rule 10b-5 liability. However, courts have held that scienter does encompass recklessness in primary claims and, under certain circumstances, in aiding-and-abetting claims. The U.S. Court of Appeals for the Second Circuit has held that recklessness is sufficient to establish scienter if the alleged aider and abettor owes a fiduciary duty to the defrauded party. In Armstrong v. McAlpin, the Second Circuit clarified that if such a duty does not exist, "the scienter requirement scales upward-- i.e., the assistance rendered must be knowing and substantial." Moreover, inaction by the alleged aider and abettor will ordinarily not be treated as substantial assistance unless "it was designed intentionally to aid the primary fraud or it was in conscious and reckless violation of a duty to act."
Armstrong thus appears to require the presence of a fiduciary duty to trigger application of the recklessness standard in Rule 10b-5 aiding- and-abetting claims. However, in a case subsequently decided by a district court within the Second Circuit, Mishkin v. Peat, Marwick, Mitchell & Co., application of the recklessness standard was upheld in an aiding-and-abetting claim against the accounting firm, though concededly no fiduciary relationship existed between the firm and the alleged victims of the fraud.
In Mishkin, the accounting firm had audited and opined with respect to the year-end financials of a registered broker-dealer that subsequently went into bankruptcy. The plaintiff was the trustee for liquidation of the company and brought the action on behalf of customers. As subrogee, the trustee alleged that the defendant accounting firm had conducted its audit recklessly, thereby aiding and abetting the president of the company in covering-up his violations of Rule 10b-5. The president allegedly had engaged in a fraudulent scheme to conceal losses incurred by his firm through various fraudulent transactions, including the sale of fictitious securities.
Essentially, the accountants were charged with the failure to discover that the company was insolvent by "millions of dollars." The trustee claimed that, had the accounting firm conducted an adequate audit, it would have uncovered this fact. In denying the accounting firm's motion to dismiss the plaintiff's complaint for failure to state a claim for aiding and abetting, the court ruled that "recklessness is sufficient to establish scienter where the plaintiffs are third parties whose reliance upon the accountant's audit or opinion letter is reasonably foreseeable." The court did cite the language in Armstrong that a higher degree of scienter than recklessness is required where no fiduciary duty is owed to the defrauded party, and acknowledged that generally no fiduciary relationship exists between accountants and their clients or the clients' customers. Nevertheless, it found "some support" for this "foreseeable reliance" test in the language of the court of appeals decision that accountants "have a duty to take reasonable steps to correct misstatements they have discovered in previous financial statements on which they know the public is relying." The adoption of the foreseeable-reliance test in Mishkin thus apparently was propelled by the court's belief that an accountant--at least in performing subsequent work--"charged with the specific responsibility of a competent professional audit cannot relieve himself of liability by shutting his eyes to what was plainly to be seen."
The court then held that the defrauded parties' reliance on the audit was foreseeable for two reasons. First, the plaintiff's claim arose out of alleged repurchase transactions, "a type of transaction in which the solvency of the issuer is directly relevant to a customer's decision to engage in the transaction." Second, under the rules of the SEC governing broker-dealers, the accountants had a duty "to deliver to the SEC an opinion certifying the issuer's annual financial statements" and to report "subsequently discovered deficiencies" to the SEC. The court found that this duty of disclosure, in the context of such a heavily regulated industry, gives rise to a public duty to render accurate audits." The company's "customers foreseeably and reasonably relied on the accounting firm's performance of that duty in deciding" to buy securities through the company.
As previously indicated, the foreseeable-reliance test adopted in Mishkin is subject to criticism for circumventing the apparent requirement in Armstrong that scienter greater than recklessness is necessary to establish aiding-and-abetting liability if the alleged aider-abettor owes no fiduciary duty to the victim of the fraud. In effect, Mishkin appears to create a special exception to this requirement for accountants involved in audits of highly regulated entities, thus adding to the possible circumstances in which they may be held liable for reckless aiding and abetting of Rule 10b-5 violations. Indeed, recent cases indicate that the foreseeable-reliance test for accountants is being stretched to even more tenuous lengths. In a case decided recently, Bernstein v. Crazy Eddie, Inc., the court was called on to consider, among other things, a motion to dismiss claims that an accounting firm had primary and aiding-and-abetting liability for violations of Rule 10b-5 and Sec. 12(2) based upon its audit of allegedly false and misleading financial statements contained in certain public documents filed by its corporate client with the SEC, including registration statements issued in connection with public offerings of the client's stock. The complaint in Bernstein alleged that, in order to paint a false picture of a company with a strong financial position, certain of the company's officers and directors "inflated the corporate client's net income, inventory, figures, and per store sales figures through a series of improper reporting practices." To advance this fraud, they purportedly "altered and destroyed documents, including invoices, inventory count sheets, debit memos, sales-incentives-related materials, and accounting records." The accounting firm allegedly violated "several generally accepted auditing standards and accounting principles . . . in in failing to look behind its client's irregular books and fabricated records and the client's patently false explanation for the 'loss' of destroyed records." Holding that the complaint had adequately pleaded aider-and-abettor liability under Rule 10b-5 and Sec. 12(2), the court in Bernstein cited approvingly to Mishkin and stated that recklessness is sufficient to establish scienter when the defendant owes a duty to the victim of the fraud, as do the individual defendants former corporate officers and directors, or where the defendant is an accountant . . . upon whose audit or opinion letter plaintiffs reasonably and foreseeably relied."
In Stevens v. Equidyne Extractive Indus., 1980, the court, without citing Mishkin, accepted the foreseeable-reliance test for accountants, but dismissed a claim that an accounting firm knowingly or recklessly aided and abetted a Rule 10b-5 violation by its client in an offering of limited partnership interests. The plaintiff had purchased a participating interest in the limited partnership, which was described in an allegedly false and misleading offering memorandum. The complaint did not allege that the accounting firm "had direct involvement" with the offering memorandum or that it had "issued an opinion letter," but only claimed that the firm had set forth misleading information in pro forma projections prepared by the firm and appended to the offering memorandum. Because the projections were entirely speculative, reliance thereon was unreasonable and it could "hardly be said" that they substantially assisted the client in the perpetration of a fraud. The aiding-and-abetting claim against the accounting firm was thus dismissed.
Lessons for the Accountant
Whetehr a third party's reliance on an audit or opinion is reasonably foreseeable in a specific case will likely depend on the particular facts involved. There do appear, however, to be certain generalizations accounting firms should note in their efforts to reduce the possibility of liability for aiding and abetting federal securities fraud violations. First, Mishkin clearly demonstrates that foreseeable reliance may arguably be found where the accounting firm has made some representation or rendered some opinion in cases involving an audit of a highly regulated financial client, such as an opinion on a broker- dealer's financial statements. Second, irrespective of the amount of regulation to which the client is subject, foreseeable reliance may be found where the accountant has made some representation, such as an opinion, on a company's financial statements, which will be contained in a document that will be publicly filed or disseminated.
Moreover, even if the recklessness standard is applied in a Rule 10b-5 aiding-and-abetting claim, the defendant accounting firm should take some comfort in the fact that proving recklessness is not an easy chore. To establish recklessness, the plaintiff must demonstrate conduct that is "highly unreasonable, representing an extreme departure from the standards of ordinary care . . . . It must, in fact, approximate an actual intent to aid in the fraud being perpetrated by the audited company." The plaintiff, in the absence of direct evidence of the account's state of mind, would probably have to produce evidence showing that the accounting practices amounted "at best to a pretended audit" or that the audit report was "so flimsy as to lead to the conclusion that there was no genuine belief back of it." By extension, in the absence of an accountants's rendering an opinion in a highly regulated industry, plaintiff may be difficulty establishing that the investing public "would foreseeably rely" on an accountant's audit or opinion. Thus, a conscientious attempt to adhere to GAAS in conducting an audit should protect an accounting firm that is unaware of its client's fraud from aider-abettor liability under Rule 10b-5.
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