Grant Thornton (GT) audited Winstar, a broadband communications company that provided businesses with wireless internet connectivity. Winstar was one of GT’s largest and most important clients, but only 12 percent of the company’s fees came from auditing, the rest were for consulting projects. Winstar asked that the partner in charge of its audit be replaced and also threatened to fire GT. In response, Winstar assigned two auditors who had no experience with telecommunications companies. 

When Winstar’s real revenues fell,it began to report fake ones. For example, at the end of the fiscal year, it reported that a large percentage of its revenue was from equipment sales to Lucent Technologies, a strategic partner. Equipment sales were not part of Winstar’s core business and there was little documentation that these sales had taken place. Winstar also reported revenue for a feasibility study for Lucent, which had not yet been performed and promotional credits purchased by Lucent for services not yet rendered. Rather than spreading out the revenue over the life of various leases, it reported most revenue when the document was signed. It also engaged in round-trip transactions in which it overpaid other companies for goods and services and, in return, those companies bought unneeded equipment from Winstar. These transactions were material to Winstar’s results.

These practices violated GAAP and SEC rules. At first, GT warned that the transactions were red flags and warranted further examination. But GT ultimately allowed the revenues and issued an unqualified audit opinion. A year later, Winstar filed for bankruptcy protection.

Companies that had purchased stock in Winstar after GT issued its clean opinion filed suit against the accounting firm alleging securities fraud under §10(b). GT filed a motion for summary judgment, which the trial court granted on the grounds that the firm had not acted with scienter. Plaintiffs appealed.

Questions:

1. Did GT violate §10(b)? Did it act with scienter?

2. What was the key issue in this case?

3. How would you define scienter? 

4. Why did the court find scienter in this case?

5. Why do you think they did this?