Justices' BDO Denial May Allow for Increased Auditor Liability

On Oct. 6, the U.S. Supreme Court denied a petition for writ of certiorari filed by accounting firm BDO USA LLP.[1]

In denying the petition, the Supreme Court let stand BDO v. New England Carpenters Guaranteed Annuity and Pension Funds, an October 2024 U.S. Court of Appeals for the Second Circuit decision that held that an alleged false audit certification was material for purposes of pleading a claim under the anti-fraud provisions of the federal securities laws.

Although the Second Circuit stopped short of adopting a bright-line materiality standard, its decision meaningfully lowers the pleading burden for plaintiffs and makes the early dismissal of such claims more difficult, potentially exposing auditors to increased securities fraud litigation.

Factual and Procedural Background

On April 4, 2017, AmTrust Financial Services Inc. restated five years of its financial results to correct major accounting errors in its annual and quarterly reports filed with the U.S. Securities and Exchange Commission. The restatement addressed, among other issues, improper revenue recognition related to extended warranty contracts and improper accounting for certain discretionary employee bonuses.

The restatement prompted the filing of a putative securities class action against various AmTrust officers and board members, its external auditor BDO, and certain underwriters for allegedly misstating the company's financial statements in violation of Sections 11, 12 and 15 of the Securities Act, and Section 10(b) and 20(a) of the Securities Exchange Act and Rule 10b-5 thereunder.

The District Court Opinion

In April 2020, the U.S. District Court for the Southern District of New York dismissed the third amended complaint in its entirety under Rule 12(b)(6) of the Federal Rules of Civil Procedure.[2] The district court held that none of the alleged misstatements were actionable under the federal securities laws, including the Section 10(b) claim based on BDO's representation that it conducted its audit in accordance with Public Company Accounting Oversight Board standards.[3]

The plaintiffs' allegations centered on BDO's purported failure to complete all required audit procedures before issuing an audit opinion, as well as its alleged efforts to conceal that the audit work had not been timely completed.

Notwithstanding these allegations, the district court concluded that the plaintiffs failed to adequately plead materiality. Specifically, the plaintiffs did not allege facts demonstrating that BDO's alleged failures to timely complete its audit work would have been significant to a reasonable investor, or that those deficiencies had any effect on the 2013 audit opinion.[4]

The Second Circuit's Initial Decision

On Aug. 23, 2023, the Second Circuit largely vacated the district court's dismissal of the plaintiffs' Securities Act claims under Sections 11, 12(a)(2) and 15, but affirmed the dismissal of the fraud claim against BDO.[5] The challenged audit certification in the 2013 auditor opinion stated that BDO had conducted its audit in accordance with PCAOB standards — an assertion that the appellants alleged was false.

Nonetheless, the Second Circuit concluded that the appellants failed to plead materiality because the complaint did not allege facts demonstrating that the purported misstatement in the audit certification would have been significant to a reasonable investor. In particular, the appellants failed to allege any link between the alleged misstatements in the 2013 auditor opinion and the material errors contained in AmTrust's 2013 Form 10-K.[6]

Critically, however, the Second Circuit did not suggest that audit certifications are categorically immaterial or too generalized to support securities fraud claims. Rather, it emphasized that the appellants had not alleged facts explaining why the audit certification itself would have been significant to a reasonable investor.

SEC Argument That Audit Certifications Have Independent Significance

On Sept. 6, 2023, the appellants moved for rehearing on the dismissal of the fraud claim against BDO.[7] In connection with that motion, the SEC submitted an amicus curiae brief addressing the materiality of an audit certification.[8]

The SEC forcefully argued that audit certifications, standing alone, convey important information to the market. According to the SEC, investors' perception of financial statements as reliable depends on auditors fulfilling their gatekeeper role with professionalism, integrity and independence.

The commission further emphasized that investors rely on audit certifications when making investment decisions. Where financial statements have not been audited in accordance with PCAOB standards, investors must account for the heightened risk that the company's financial statements are inaccurate or misleading.

The SEC also cited commission precedent recognizing that false audit certifications are material misstatements of independent significance, even absent any link to errors in the financial statements.[9]

The Second Circuit's Amended Opinion

On Oct. 31, 2024, the Second Circuit amended its opinion and vacated the dismissal of the fraud claim against BDO.[10]

The Second Circuit started its analysis by distinguishing audit certifications from financial statement certifications required under the Sarbanes-Oxley Act made by AmTrust's officers. Here, the Second Circuit affirmed the dismissal of the SOX-related claims because they were nonactionable statements of opinion under the Supreme Court's 2015 decision in Omnicare Inc. v. Laborers District Council Construction Industry Pension Fund, while at the same time acknowledged that the audit certification resembled the SOX certifications.[11]

Notwithstanding the similarities between the two certifications, the Second Circuit agreed with the district court that the complaint alleged — unlike in the instance of the SOX certifications — critical facts that rendered the audit certification actionable. Specifically, the Second Circuit agreed that the alleged facts made it plausible that the audit partner who signed the audit opinion "disbelieved the statement that the audit was conducted in accordance with the relevant PCAOB standards."[12]

The Second Circuit disagreed with the lower court's holding, however, that materiality had not been adequately pled. The crux of the appeals court's reasoning was that audit certifications fundamentally convey to investors that audited financial statements are reliable.[13]

It then concluded — essentially mirroring the SEC's position — that materiality did not rest on an allegation that there was any link between false certification and specific errors in the financial statements.[14]

Takeaways

The denial of certiorari by the Supreme Court allows for expanded liability for accounting firms, but does not necessarily foreshadow that every inaccurate audit certification will be actionable fraud. Like all determinations of materiality, the materiality of a misstatement in an audit certification will turn on the particular facts and circumstances of the case.

Like the SOX certifications discussed by the Second Circuit, allegations regarding audit certifications may still be regarded by a court — depending on the facts pled — to be nonactionable opinion statements. For example, a missing audit work paper or some other deviation from PCAOB audit standards does not inescapably result in an actionable fraud claim.

The Second Circuit preserved the Omnicare defense for auditors who sign flawed audit certifications, so long as they had a reasonable subjective belief that their audit conformed to PCAOB standards. Auditors will not face liability for statements genuinely believed to be true, even if they later turn out to be wrong. 

Notwithstanding the survival of bedrock principles of materiality, the Supreme Court's denial of BDO's petition undoubtedly ups the ante for auditors. The Second Circuit now explicitly recognizes the independent materiality of audit certifications separate and apart from any impact on the accuracy of the financial statements.

This precedent provides a road map for pleading falsity with respect to audit certifications, and it will arguably increase the number of actions filed by both private plaintiffs and the SEC. It's also of importance that the SEC, unlike plaintiffs in private securities litigation, is not saddled with the burden of proving reliance and loss causation, thereby making it easier for the SEC to prevail.

In addition to filing a Section 10(b) complaint in federal district court, the SEC also has the powerful option of filing an administrative action against an auditor under Rule 102(e) of the SEC's Rules of Practice to censure, suspend, or bar an auditor who appears or practices before it. Even with the recent slowdown in enforcement activity, the SEC has emphasized that holding gatekeepers accountable remains one of its key priorities, and this opinion will be a persuasive authority for it to cite in administrative proceedings.

In this elevated risk environment, accounting firms and auditors should exercise heightened caution to ensure that audits are conducted in accordance with PCAOB standards, and that the corresponding audit certifications fit comfortably within the opinion statement protections afforded under Omnicare.

Reprinted with permission from Law360.

[1] BDO USA, LLP v. New England Carpenters Guaranteed Annuity and Pension Funds, et al., No. 24-1151.

[2] In re AmTrust Fin. Servs., Inc. Sec. Litig., 2020 WL 2787117 (S.D.N.Y. Apr. 20, 2020).

[3] The Sarbanes-Oxley Act of 2002, as amended, directs the PCAOB to establish, by rule, auditing and related professional practice standards for registered public accounting firms to follow in the preparation of audit reports for public companies and other issuers, and broker-dealers.See Auditing Standards | PCAOB.

[4] Id. at *34.

[5] New England Carpenters Guaranteed Annuity & Pension Funds v. Decarlo(New England Carpenters I), 80 F.4th 158, 165 (2d Cir. 2023).

[6] Id.

[7] Appellants' Mot. for Reh'g, New England Carpenters Guaranteed Annuity & Pension Funds v. DeCarlo, No. 20-1643, ECF No. 176 (2d Cir. Sept. 6, 2023).

[8] Brief for the SEC as Amicus Curiae, New England Carpenters Guaranteed Annuity & Pension Funds v. Newmark, No. 20-1643, ECF No. 202 (2d Cir. Feb. 16, 2024).

[9] Id. at 10, 13.

[10] New England Carpenters Guaranteed Annuity & Pension Funds v. Decarlo(New England Carpenters II), 122 F.4th 28 (2d Cir. 2024).

[11] New England Carpenters II at 47-48.

[12] Id. at 52-53.

[13] Id. at 53.

[14] Id.