The case, Overton v. Todman & Co., __F.3d__2007 W.L. 574263 (Feb. 26, 2007), did not involve the typical public shareholder suit, but rather the audited financial statements of a broker-dealer, which was using those financial statements to seek additional financing. The suit was filed by one of the investors who allegedly relied on those financial statements in making a substantial equity and debt investment in the brokerage firm. Shortly after the investment was made the brokerage firm filed for bankruptcy.

The Second Circuit set forth five requirements to establish when an auditing firm is primarily liable under §10(b) and Rule 10b-5 for failing to correct its opinion and the underlying financial statements. Specifically, the court held:

an accountant violates the "duty to correct" and becomes primarily liable under §10(b) of the 1934 Act and Rule 10b-5 when it (1) makes a statement in its certified opinion that is false or misleading when made; (2) subsequently learns or was reckless in not learning that the earlier statement was false or misleading; (3) knows or should know that potential investors are relying on the opinion and financial statements; yet (4) fails to take reasonable steps to correct or withdraw its opinion and/or the financial statements; and (5) all the other requirements for liability are satisfied.

2007 WL 574623 at *8. The additional components are typical of all Rule 10b-5 claims; e.g. materiality, transaction causation, loss causation, justifiable reliance, and damages.

The Second Circuit imposed three important limits.

• An auditing firm only has a duty to correct its prior certified financial statements. This is not to be expanded to include a broader duty to update those financial statements. Thus, an accountant need only correct statements that were false when made, and not those that were made misleading by intervening events.
  
  
• The duty to correct is limited to those statements set forth in its opinion and certified financial statements. That is because the outside auditing firm is under no duty to divulge information collateral to the statements of accuracy and financial fact set forth in its opinion and the certified financial statements.
  
  
• The holding in that case was specifically limited to those circumstances where the accounting firm (1) makes a statement in its certified opinion that is false or misleading when made; (2) subsequently learns or is reckless in not learning that the earlier statements was false or misleading; (3) knows or should know that potential investors are relying on its opinion.

Under those circumstances, if the outside accounting firm fails to take reasonable steps to correct or withdraw its opinion or the underlying financial statement it becomes primarily liable for a misleading omission under §10b and Rule 10b-5, assuming all the other elements of liability under §10b and Rule 10b-5 are present.

This decision also clarifies what the duties are of an outside accounting firm when it becomes aware that its prior financial statements were inaccurate. Even more important, it requires the outside accounting firm to take steps if there are sufficient red flags to determine if its opinion and prior financial statements were materially inaccurate.

Another question will be what type of red flags will trigger a duty to investigate to determine whether you have a duty to correct. One of the unanswered questions will be whether the Overton decision will be utilized by shareholders of a public company after the public company is forced to restate its financial statements, alleging that prior to the restatement the outside auditing firm knew or should have known that its opinion and the related financial statements were no longer accurate. Could persons who purchased after the date the accountant knew or should have known of the problem and the date of the restatement have a potential claim for the failure to timely correct? Another question will be what type of red flags trigger the obligation to investigate whether you have a duty to correct.

In the Overton case, the Second Circuit held that the plaintiff had alleged that there were sufficient red flags alerting Todman & Co. that is should have investigated further to determine whether or not its prior opinion and financial statements were false and misleading. Of course, discovery had not yet occurred. And it is quite another thing for the plaintiff to prove the facts alleged in the complaint at trial. But, in theory, under these specific circumstances investors have a claim under §10(b) and Rule 10b-5 against an outside accounting firm for failing to correct a prior opinion and financial statements.

Return to SEC Central

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