1. What exactly is the difference between an auditor’s opinion and a statement of fact?

2. In her opinion, Judge Forrest wrote that: “Section 10 and 11 claims regarding opinion statements require the statement was both objectively false at the time that it was made and also subjectively false – that is, that defendants did not honestly believe the statements when they made them.” Do you believe subjective falsity is a proper standard of care? What if the auditors did honestly believe the statements when they made them but failed to uncover the evidence needed to objectively determine that a material misstatement existed in the financial statements or ICFR. Should they be able to escape legal liability under Section 10(b) or Section 11?

3. Do you believe the rulings in Omnicare and Puda Coal swing the pendulum too far in the direction of the auditors with respect to when they can be held legally liable for violations of Section 10b and Section 11? Explain.

Background

On May 23, 2016, the U.S. Court of Appeals for the Second Circuit affirmed the dismissal of federal securities claims, under Section 10(b) and Section 11 of the Securities Acts, against Moore Stephens, an accounting firm that performed audits of Puda Coal’s 2009 and 2010 consolidated financial statements and of Puda’s ICFR as of December 2009 and 2010. For each of these years, Moore Stephens issued Independent Auditors’ Reports, in which it opined that Puda’s consolidated financial statements conformed to GAAP and that Puda maintained effective ICFR. The court held a summary order that plaintiff-shareholders in the lawsuit failed to establish scienter under Section 10(b) and failed to establish subjective falsity under Section 11.¹ Significantly, the court held that auditors’ reports are “statements of opinion subject to the … standard” established by the Supreme Court for Section 11 claims in Omnicare, Inc. v. Laborers District Council.

Case Summary

The case is In re Puda Coal Securities Litigation. Puda Coal was a China-based coal supplier that went public in the United States through a reverse merger in 2005 and began trading on the NYSE in 2009. In 2011, investors learned that the company’s chairman, Ming Zhao, and his brother, Yao Zhao, had secretly transferred Puda Coal’s only revenue-generating asset, a coal mining subsidiary named Shanxi Puda Coal Group Co. Ltd., to themselves and then pledged a 49 percent interest in Shanxi to a Chinese private equity group. In a securities class action, the plaintiffs alleged that Moore Stephens had violated Sections 10(b) and 11 of the Securities Act of 1933 when it gave Puda Coal clean opinions. The charge was that Moore Stephens had misrepresented material facts, concealed adverse material facts, and “fraudulently certified” Puda Coal’s financial statements, the plaintiffs said in their complaint. In addition, plaintiffs argued Moore Stephens violated Section 11 when it claimed to have conducted its audits in accordance with PCAOB standards. The audits had not complied with those standards, the plaintiffs said.

Plaintiffs brought claims in the Southern District of New York alleging that Moore Stephens should have uncovered fraud at Puda Coal involving the transfer of its main operating subsidiary to a company executive thereby leaving Puda Coal a shell company. The District Court ruled there was no material fact on Section 10(b) scienter and that there was no evidence of and no triable issue on Section 11 subjective falsity.

On appeal, the Second Circuit affirmed the lower court’s ruling on both claims. First, the court affirmed summary judgment on plaintiff’s Section 10(b) claim because there was no triable fact as to whether Moore Stephens’ audit was reckless or auditors acted with intent to deceive, manipulate, or defraud. There was “no factual basis for alleging that the…audits were ‘extreme departure[s’] from PCAOB standards ‘amounting to no audit at all.’” Further, summary judgment was granted because plaintiff’s alleged “red flags” were “not obvious signs of fraud,” holding that plaintiffs alleged, at most, “fraud by hindsight,” which is not sufficient to meet the heightened scienter standard for auditors.