August 2, 2011

Lehman Decision: Fairness Opinion Providers Can Take Some Comfort

Kevin Miller of Alston & Bird provides this analysis:

While not involving the issuance of a fairness opinion, fairness opinion providers can take some comfort from portions of a recent decision – In re Lehman Brothers Secs. and ERISA Litig. (SDNY July 27, 2011) – of the Federal District Court for the Southern District Court of New York dismissing federal securities law claims against Ernst & Young, Lehman Brothers’ outside auditor.

My Takeaway: In order to state a cause of action against an opinion provider under Section 10 and Rule 10b-5 of the Exchange Act, a complaint must set forth facts sufficient to warrant a finding that the opinion provider did not actually hold the opinion it expressed or that it knew that it had no reasonable basis for holding the opinion. Opinions are not statements fact and so, for purposes of stating a claim under Section 10 and Rule 10b-5, it is insufficient to merely allege that the opinion was objectively wrong.

See also In re Global Crossing, Ltd. Secs. Litig., 313 F. Supp. 2d 189, 210 (S.D.N.Y. 2003) (relying on the US Supreme Court’s decision in Virginia Bankshares, the Court noted that in order for the fairness opinion provider to be liable for false statements regarding its opinion under Section 11, the opinion provider must misrepresent its true opinion – “Materially misleading statements of opinion and belief can be actionable under the securities laws, where the party offering the opinion misrepresents its true belief, that is, where the opinion or belief is not truly held.”)

Key Quotes from the Case: The Exchange Act claims against E&Y – “The [amended complaint (the “TAC”)] alleges that E&Y’s statements in (1) Lehman’s 2007 10-K concerning its audit and Lehman’s financial statements, and (2) Lehman’s quarterly reports on Form 10-Q for the second and third quarters of 2007 and the first two quarters of 2008 concerning its review of Lehman’s financials were materially false and misleading.”

The Plaintiffs: Plaintiffs mount parallel attacks on E&Y’s statements in the 10-K and the 10-Qs. They allege that the audit, or GAAS, opinion in the 10-K – i.e., the statement that E&Y “conducted [its] audits in accordance with the standards of the Public Company Accounting Oversight Board” – was false because E&Y did not conduct its audits in accordance with those standards. They contend also that the GAAP opinion in the 10-K – i.e., the statement that, in E&Y’s “opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Lehman Brothers Holdings Inc. at November 30, 2007 and 2006, and the consolidated results of its operations and its cash flows for each of the three years in the period ended November 30, 2007, in conformity with U.S. generally accepted accounting principles” – was false because that statement did not conform to GAAP. Similarly, they assert that the statements in the 10-Qs – first that E&Y conducted its “review in accordance with the standards of the “PCAOB and, second, that E&Y, “[b]ased on [its] review, [was] . . . not aware of any material modifications that should be made to the consolidated financial statements referred to above for them to be in conformity with U.S.” GAAP – were false for substantially the same reasons.

The Court: The Court is mindful of the fact that some courts have considered the sufficiency of securities claims against auditors based upon statements as to the compliance of financial statements with GAAP without regard to the significance of the fact that such statements have been couched as opinions and thus without regard to the importance of the fact-opinion distinction. But the distinction is important. E&Y’s statement regarding GAAS compliance inherently was one of opinion. In order for the TAC sufficiently to have alleged that it was false, it had to allege facts that, if true, would permit a conclusion that E&Y either did not in fact hold that opinion or knew that it had no reasonable basis for it.(emphasis added).

The scienter analysis with respect to this claim is substantially the same. As with other defendants, in order to state an Exchange Act claim against an auditor, a complaint must “state with particularity facts giving rise to a strong inference” of scienter. The standard for evaluating assertions of an auditor’s scienter, however, is “demanding.” The complaint must allege that the auditor’s conduct was “‘highly unreasonable,'” representing “‘an extreme departure from the standards of ordinary care'” and “‘approximat[ing] an actual intent to aid in the fraud being perpetrated by the audited company.'” The “accounting judgments which were made [must have been] such that no reasonable accountant would have made the same decisions if confronted with the same facts.” (emphasis added) Plaintiffs’ allegations respecting “red flags” therefore bear not only on whether E&Y violated the pertinent GAAS requirements, but also on whether it did so with the requisite state of mind. For the reasons discussed above, the true sale opinion and netting grid were not red flags, the disregard of which could be called highly reckless. And while E&Y’s alleged failure to follow up on the Lee interview arguably would have been a departure from GAAS, the only subsequent E&Y statement at issue is the report on the interim financials in the 2Q08, which contained no statement of a GAAS-compliant audit. Accordingly, the TAC fails to allege that E&Y made any false or misleading statements with respect to GAAS compliance either in the 2007 10-K
or in any of the subsequent 10-Q’s, much less that it did so with scienter.

The Plaintiffs: Plaintiffs argue also that E&Y’s opinions as to Lehman’s preparation of its financial statements in accordance with GAAP were statements of fact and that they were false because those financial statements in fact did not comply with GAAP.

The Court: “The representation in the auditor’s standard report regarding fair presentation, in all material respects, in conformity with [GAAP] indicates the auditor’s belief that the financial statements, taken as a whole, are not materially misstated.” Thus, allegations that a company violated GAAP in preparing its financial statements are not sufficient, in and of themselves, to state a claim that an auditor’s opinion of GAAP compliance is a factual misstatement. For reasons already discussed, the complaint must allege specific departures from GAAP and, in addition, set forth facts sufficient to warrant a finding that the auditor did not actually hold the opinion it expressed or that it knew that it had no reasonable basis for holding it. (emphasis added).