Securities Fraud Class Action Claims Against Accountants Properly Dismissed for Failure to Plead Scienter Required by Private Securities Litigation Reform Act (PSLRA) because Evidence Showed Company Concealed Information from Accountants Fourth Circuit Holds
Plaintiffs filed a class action against various defendants alleging securities fraud violations; the class action complaint alleged that Royal Ahold, N.V., a Dutch corporation, and U.S. Foodservice, Inc. (USF), a Maryland-based Ahold subsidiary, engaged in improper accounting practices. Public Employees’ Retirement Ass’n of Colorado v. Deloitte & Touche LLP, 551 F.3d 305, 306 (4th Cir. 2009). The class action also alleged that Ahold’s accountants, Deloitte & Touche LLP (Deloitte U.S.) and Deloitte & Touche Accountants (Deloitte Netherlands) – which are two legally distinct entities, participated in Ahold’s alleged fraud, id. Defense attorneys for the Deloitte defendants moved to dismiss the class action on several grounds, including for failure to satisfy the heightened pleading requirements established by the Private Securities Litigation Reform Act (PSLRA). In pertinent part, the PSLRA requires that plaintiffs plead facts alleging a “strong inference” that the defendant in a securities fraud lawsuit acted with the requisite scienter. Id., at 306. The district court granted the defense motion and dismissed the class action complaint as to the Deloitte defendants without leave to amend, id., at 307-08. The Fourth Circuit affirmed, finding “the inference that the Deloitte defendants lacked the necessary scienter more compelling than any competing inference that they knowingly or recklessly perpetrated a fraud on Ahold’s investors” and that the proposed second amended class action complaint was futile. Id., at 306.
We do not here discuss in detail the nature of the improper accounting practices underlying the class action claims. See Deloitte, at 306-08. In brief, the two frauds Ahold alleged perpetrated involved (1) the improper consolidation of revenue from various joint ventures, in violation of GAAP, that resulted in substantial overstatement of earnings, and (2) the premature recognition of income from promotional allowances. Id., at 307. The actions led Ahold to restate earnings for fiscal years 2001 and 2002, and revealed that Ahold’s accounting practices had overstated earnings by more than $500 million. Id. The announcement led to a 60% drop in stock price, and to SEC civil enforcement actions against Ahold and various individual defendants. Id. Moreover, at least 21 private class action lawsuits were filed alleging securities fraud, and the Judicial Panel on Multidistrict Litigation centralized the class actions for pretrial purposes in the District of Maryland, id. The district court appointed Public Employees’ Retirement Association of Colorado and Generic Trading of Philadelphia, LLC as Lead Plaintiffs, and a Consolidated Amended Securities Class Action Complaint was filed against Ahold entities, the Deloitte defendants, and others. Id. Lead Plaintiffs settled the class action as to the non-Deloitte defendants, and then filed a motion to amend the class action complaint to assert new claims against the Deloitte defendants. Id., at 308. The district court denied the motion on the basis of futility, and the Fourth Circuit affirmed.
The Circuit Court began its analysis by reviewing in detail the frauds underlying the class action and the Deloitte defendants’ roles in them. See Deloitte, at 308-10. We do not summarize that discussion, nor do we summarize the Court’s discussion of the law governing securities fraud claims, including the PSLRA. See id., at 310-13. We believe the heart of the Fourth Circuit’s analysis may be found in its conclusions. Specifically, with respect to the joint venture fraud, the Court noted that Ahold “concealed” information from its accountants, which implies that the accountants were not involved in the fraud. Id., at 314. And while “perfect hindsight” might suggest that the Deloitte defendants “should have required stronger evidence of control from Ahold” in connection with consolidating revenue from the joint ventures, and while defendants may even have been negligent in failing to require such evidence, “the evidence as a whole leads to the strong inference that defendants were deceived by their clients into approving the consolidation.” Id. And with respect to the promotional allowances fraud, plaintiffs’ claim that Deloitte was complicit in the fraud because it ignored several “red flags” was unpersuasive. See id., at 314-15. Deloitte raised the relevant issues with Ahold “numerous times,” id., at 315.
In the end, the Fourth Circuit affirmed the district court order refusing leave to file the amended class action complaint. We quote at length the Circuit Court’s conclusion at page 316:
Seeing the forest as well as the trees is essential. With respect to both frauds, plaintiffs point to ways that defendants could have been more careful and perhaps discovered the frauds earlier. But plaintiffs cannot escape the fact that Ahold and USF went to considerable lengths to conceal the frauds from the accountants and that it was the defendants that ultimately uncovered the frauds. The strong inference to be drawn from this fact is that Deloitte U.S. and Deloitte Netherlands lacked the requisite scienter and instead were deceived by Ahold and USF. That inference is significantly more plausible than the competing inference that defendants somehow knew that Ahold and USF were defrauding their investors.
It is not an accountant’s fault if its client actively conspires with others in order to deprive the accountant of accurate information about the client’s finances. It would be wrong and counter to the purposes of the PSLRA to find an accountant liable in such an instance. Because we find no version of the facts creates a strong inference that the Deloitte defendants had the scienter required for a cause of action under § 10(b), the district court rightly denied the plaintiffs’ motion for leave to amend their complaint.