A very recent opinion by Judge Baer of the United States District Court for the Southern District of New York in Whalen v. Hibernia Foods PLC summarizes the current status of the key principles relating to what must be alleged to state a valid claim against an outside accounting firm under the Private Securities Law Reform Act of 1995 ("PSLRA").

First, the Court notes that although the mountain created by the PSLRA for securities class actions is high, a properly pleaded complaint will permit the case to proceed to discovery. Of course, it is one thing to properly allege wrongdoing, and it is quite another to prove it. Lately, a number of class actions have gone to trial, which is contrary to the long-time trend of the settlement of all of these cases prior to trial. 
 
Defense motions addressed to the sufficiency of a complaint have focused on the scienter (the intent to defraud) requirement of Section 10b-5. The PSLRA requires that any complaint alleging a violation of Section 10(b) must "specify each statement alleged to have been misleading, and, the reason or reasons why the statement is misleading, and must state with particularity facts giving rise to a strong inference that the defendant acted with the required stated of mind" (scienter). 15 U.S.C. § 78u-4(b)(1)(B) and (b)(2).

This can be done in one of two ways:

(i) by alleging facts to show that the defendants had both motive and opportunity to commit fraud, or

(ii) by alleging facts that constitute strong circumstantial evidence of conscious misbehavior.

Alleging that the outside accounting firm wanted to keep the corporation as its client is insufficient. Prior to Sarbanes-Oxley you could plead that the desire to keep the non-auditing work, which very often far exceeded the amount billed for the auditing work, was that type of motive and opportunity. That factor is no longer present because Sarbanes-Oxley eliminated that type of potential conflict of interest.
 
Plaintiffs' counsel and the courts have focused on the second way of pleading scienter -- strong circumstantial evidence of conscious misbehavior or recklessness. Generally, this would mean that the conduct is highly unreasonable, and represents an extreme departure from standards of ordinary care to the extent that the danger was either known to the financial professional, or so obvious that the financial professional must have been aware of it. In the context of an audit, it is sufficient that the accounting practices were so deficient that "the audit amounted to no audit at all or ‘an egregious refusal to see the obvious' or otherwise investigate the doubtful." (1)  

Allegations of GAAP and GAAS violations by themselves are insufficient to satisfy the conscious misbehavior or recklessness alternative. Also, an isolated one or two red flags are normally insufficient to satisfy the stringent pleading requirements of the PSLRA. However, as this case points out, when you have a number of red flags, then a court could conclude that a reasonable auditor was on notice and acted recklessly when it disregarded all the red flags. In Hibernia, the plaintiff set forth the following red flags: 

• Throughout the class period Hibernia could not pay its suppliers and several creditors refused to continue shipping because of non-payment, while others filed legal action.
  
  
• Hibernia had an on-going practice of classifying discounts and rebates as "operating expenses" instead of deductions from the sales price of the products.
  
  
• Recognition of revenue for orders that were never placed and/or never shipped, and, in at least one instance, there was no underlying purchase order.
  
  
• Being advised by a former Hibernia finance manager that the company's cash situation had become so severe that the managing director of the frozen desserts division was paying suppliers out of his personal bank account.
  
  
• Hibernia began to fall behind on payments due the accounting firm and the accounting firm delayed its audit until they were brought current.

Of course, each case is different, and the number, nature and magnitude of the red flags will vary from case to case. What makes this area so difficult is that there is no way for the financial professional to tell, absent the filing of a complaint and a motion to dismiss the complaint, whether a court will determine that sufficient "red flags" have been alleged.
 
Another common practice is to cite unnamed sources for certain damaging allegations in the complaint. However, the plaintiff must identify these sources with sufficient particularity to support the probability that a person in a position occupied by the source would possess the information alleged. Merely stating that the confidential witnesses are former corporate or executive employees, without any description of positions, work assignments, or any other information is insufficient. In the Hibernia complaint, the role and responsibilities of the confidential sources, without setting forth their names, were set forth and deemed sufficient.
 
In summary, the law concerning the liability of financial professionals under Section 10(b) of the Securities Exchange Act of 1934 is still evolving. Whelan v. Hibernia Foods PLC is a useful summary of the current status of what is required for a plaintiff to overcome the high pleading standards set by the PSLRA. However, what constitutes sufficient "red flags" is still a very gray area. From a practical point of view, this will always be a somewhat gray area, as the facts in each particular case will be different. Until Congress provides a "bright line" test for scienter, I do not see the situation improving.

CHARLES HECHT has been a principal of his own law firm specializing in securities law since 1971. He was previously on the staff of the Division of Corporate Finance of the Securities and Exchange Commission at its headquarters in Washington, DC. Contact him at 212.490.3232 or visit www.securitiescounselors.com

(1) SEC v. Price Waterhouse, 797 F.Supp. 1217, 1240 (S.D.N.Y. 1992).