-
Tenth Circuit Holds That Auditor’s Negligence In Auditing Finances And Internal Controls Does Not Satisfy Heightened Securities Fraud Pleading Requirements
07/25/2016On July 19, 2016, the U.S. Court of Appeals for the Tenth Circuit upheld the dismissal of a proposed shareholder class action against Deloitte & Touch LLP. Sanchez et al. v. Crocs, Inc. et al., No. 11-1116 (10th Cir. July 19, 2016). The Court held that plaintiffs had not “established a strong inference that Deloitte acted recklessly, and consequently, their . . . claim fail[ed].” Plaintiffs had alleged that Crocs, Inc. hid increasingly unsellable inventory totals in 2006 and 2007 before announcing a $70 million inventory write-down in 2008, and that Deloitte knew about or recklessly disregarded “red flags” that should have alerted the auditing firm to the company’s impending financial troubles.
Plaintiffs alleged that Crocs and Deloitte had violated section 10(b) of the Securities Exchange Act (“Exchange Act”) because they valued the inventory at cost in the 2006 and 2007 reports while allegedly knowing, before the 2008 write-down, that the majority of Crocs’ inventory consisted of shoes that could not be sold at cost. Plaintiffs argued that, as the company’s auditor, Deloitte’s personnel were “regularly present” at Crocs’ corporate facilities and thus knew about the inventory issues or recklessly disregarded the issues by failing to exercise professional skepticism. The U.S. District Court for the District of Colorado dismissed the Exchange Act claims in February 2011, holding that the complaint failed to adequately allege that Deloitte had “actual knowledge of the alleged false or omitted facts,” and thus the complaint pleaded, at most, negligence by Deloitte. Plaintiffs appealed to the Tenth Circuit. While the case was pending before the appellate court, Plaintiffs reached a settlement with the Crocs defendants; thus, leaving Deloitte as the only remaining defendant.
The Tenth Circuit upheld the District Court’s dismissal, finding that “the complaint founders on the heightened pleading standard for scienter”—which the Court stated “may be satisfied by allegations of either intent or recklessness”—“imposed by securities law.” The Court held that the sole alleged basis for Deloitte’s awareness of the red flags—the fact that Deloitte personnel were present at Crocs and had access to confidential internal corporate information—was insufficiently concrete to demonstrate that Deloitte knew of the inventory issues. Under the heightened pleading standards required for allegations of securities fraud, plaintiffs were required, and had failed, to “specifically identify the reports or statements” that Deloitte had access to that contained the purported warning signs. The Court also found that the red flags alleged by Plaintiffs were not “so patently indicative of fraud that Deloitte’s failure to perceive them as such constituted ‘an egregious refusal to see the obvious.’”
The Court concluded that the facts, as pled, were “conceivably indicative of negligence on Deloitte’s part,” but “f[e]ll short of establishing the kind of intentional or conscious misconduct necessary to make out a viable § 10(b) claim.” The Tenth Circuit decision serves as a reminder of the high bar plaintiffs must meet to plead an actionable fraud claim under the Exchange Act.
