LOHIER, Circuit Judge:
Plaintiffs-Appellants appeal from a September 2010 judgment of the United States District Court for the Southern District of New York (Daniels, J.) granting the summary judgment motion of Defendant-Appellee Grant Thornton LLP ("GT") and dismissing the Plaintiffs' claims arising from GT's audit of the financial statements of its client, Winstar Communications, Inc. ("Winstar"). The Plaintiffs claimed that GT committed securities fraud in violation of Section 10(b) of the
Reviewing the District Court's grant of summary judgment in favor of GT, "we construe the evidence in the light most favorable to the [Plaintiffs], drawing all reasonable inferences and resolving all ambiguities in [their] favor."
Winstar was a broadband communications company whose core business was to provide wireless Internet connectivity to various businesses. GT served as Winstar's independent auditor from 1994 until Winstar filed for bankruptcy in April 2001, and GT regarded Winstar as "one of [its] largest and most important clients."
In 1999, however, the relationship deteriorated. Winstar warned GT that it would likely terminate the relationship if GT's performance on unrelated international tax planning and other accounting matters proved unsatisfactory. In March 1999 at least one member of Winstar's board of directors openly urged during a board meeting that the GT partner overseeing the audit of Winstar be removed from the Winstar account. GT eventually re-staffed the Winstar account so that the 1999 audit was managed by a partner, Gary Goldman, and a senior manager, Patricia Cummings, neither of whom had previously reviewed or audited the financial records of a telecommunications company.
As relevant to this appeal, GT's audit for 1999 included several "large account" transactions that Winstar consummated in an attempt to conceal a decrease in revenue associated with Winstar's core business. Most of the large account transactions involved Lucent Technologies, Inc. ("Lucent"), Winstar's strategic partner, and all of them were consummated at the end of Winstar's fiscal quarters in 1999. Together, the transactions accounted for $114.5 million in revenue, or approximately 26 percent of Winstar's reported 1999 operating revenues and 32 percent of its "core" revenues that year. At the time, GT considered these transactions to be "red flags," warranting the accounting firm's "heightened scrutiny."
We discuss the evidence relating to each category of transaction in turn.
The first category of questionable transactions involved a series of six end-of-quarter and end-of-year transactions, primarily reported as equipment sales, for which there was little evidence that any goods or services were ordered and delivered. For example, for the third quarter of 1999 Winstar recognized $15 million in revenue for the sale of Lucent equipment to Anixter Brothers, Inc. ("Anixter"), a wire and cable distributor. There were several unusual aspects of this sale. First, Anixter ordinarily purchased equipment directly from Lucent, not Winstar. Second, equipment sales were not part of Winstar's core business of creating and operating wireless networks. Third, during GT's audit Cummings noted that the Anixter transaction was "apparently" completed on September 30, 1999, the last day of Winstar's fiscal quarter, but GT's work papers included no documents reflecting the sale's completion beyond a purchase order from Winstar to Lucent and an invoice from Lucent to Winstar. Moreover, neither the purchase order nor the invoice included an itemized list of the goods sold or indicated the shipping terms, even though the items were to be shipped on September 30, 1999, and delivered on October 4, 1999.
Five other transactions that were not part of Winstar's core business were consummated at the end of one of Winstar's fiscal quarters and were barely documented. Winstar nevertheless recognized a total of $49.7 million in revenue associated with these five transactions. First, Winstar recognized $5 million in revenue in the first quarter of 1999 for a "feasibility study" that Winstar was scheduled to conduct for Lucent, but which had not been delivered by at least 2000. Second, Winstar recognized $21.1 million in revenue in the first and second quarters of 1999 in connection with the sale of Lucent equipment to Williams Communications, Inc. ("Williams"). The equipment was shipped by Lucent, not Winstar, on the last business day of the first and second quarters (March 31, 1999 and June 30, 1999, respectively), with no written agreement. Third, Winstar recognized $9.1 million in revenue in the second quarter of 1999 in connection with the sale of Lucent equipment to VoCall Communications Corporation ("VoCall") on June 30, 1999. Although the sale was referenced in a series of non-numbered purchase orders, it was not referenced
Each of these transactions appears to have violated the provisions of Staff Accounting Bulletin No. 101 ("SAB 101"), issued by the Securities and Exchange Commission ("SEC"), which states that four conditions must be satisfied before revenue can be recognized: (1) "Persuasive evidence of an arrangement [for the sale of goods or services] exists," (2) "Delivery has occurred or services have been rendered," (3) "The seller's price to the buyer is fixed or determinable," and (4) "Collectibility is reasonably assured." SAB 101 at 3.
GT requested that Winstar's counterparties provide additional documentary evidence of the relevant sales underlying each
In connection with at least three other transactions, Winstar employed a bifurcated accounting scheme that GT ultimately approved prior to its audit of Winstar's financial statements. Two of these transactions involved leasing or subleasing fiber optic network capacity in units called indefeasible rights of use ("IRUs"). Winstar accounted for these IRUs using a dubious bifurcated accounting method, pursuant to which it recognized as much as 94 percent of the revenue from the leases upon execution of the lease, reflecting the cost of optical equipment ("optronics") that transmitted data over fiber optic cable ("cable" or "fiber"). Winstar then would recognize the balance of the revenue in later quarters, as payments were received over the span of the lease, representing the customer's actual use of the network. In other words, Winstar split the value of the leases so that the revenue associated with the optronics was reported separately from revenue associated with the cable. By employing this accounting method, Winstar was able to recognize $30.9 million in revenue up front in 1999.
During discovery, a forensic accountant retained by the Plaintiffs opined that the rules of the Financial Accounting Standards Board and interpretive rules of the SEC prohibited the division of leases for fiber optic networks because both the cable and the optronics were essential to the network. Winstar conceded that the fiber and the optronics were not separable, and that no other company previously had employed this bifurcated method in accounting for IRUs. Indeed, Winstar specifically advised GT that the bifurcated approach had been criticized by the accounting firm Deloitte & Touche LLP ("Deloitte").
GT was in any event aware that revenue associated with an IRU contract could be recognized only if the leased circuit was operational, or "lit," in the language of the fiber optics field. In the third and fourth quarters of 1999, however, Winstar had failed to "light" many of its IRU circuits, a fact that should have precluded the company from recognizing revenue associated with those IRUs.
In the midst of GT's audit, Winstar sent form letters dated December 30, 1999, and December 31, 1999, to the counterparties to the two IRU transactions, Wam!Net, Inc. and Cignal, respectively, to confirm that the IRU circuits had been "deliver[ed]" and "accept[ed]." A representative of Cignal signed a form letter confirming delivery and acceptance of the circuits. By contrast, Wam!Net's Senior Vice President of Finance responded to a letter from Winstar as follows: "To our knowledge [the circuits] are not currently in place." A subsequent amended letter from a different Wam!Net employee, which does not appear in the record but which Cummings referenced in an email, purported to "accept" the circuits but did not address the earlier letter response. After receiving the amended letter, GT did not further review whether the circuits were installed and operational. Even though it appears not to have received the amended letter until after February 11, 2000, GT approved Winstar's recognition of revenue for the
While GT appears to have neglected to verify that Wam!Net's IRU circuits were operational, there was evidence that GT actually knew that the leased Cignal IRU circuits were inoperative. GT nevertheless approved Winstar's recognition of revenue for the Cignal IRUs in the third quarter of 1999.
Winstar employed a similar bifurcated accounting method in the fourth quarter of 1999 for its sale of radios to Lucent. The agreement between the two companies provided for Winstar to install the radios, but Winstar recognized revenue for the transaction immediately, upon delivering them to Lucent.
Several of the transactions discussed above involved "round-trip" transactions with Cignal and Wam!Net at a time when the two customers were struggling financially. "`Roundtripping' typically refers to reciprocal agreements, involving the same products or services, that lack economic substance but permit [both] parties to book revenue and improve their financial statements." Teachers' Ret. Sys. of LA v. Hunter, 477 F.3d 162, 169 (4th Cir.2007). The two principal round-trip transactions that were the focus of discovery involved a scheme pursuant to which Winstar overpaid both companies for purportedly unrelated goods and services in exchange for their purchase of IRUs, equipment, and services from Winstar by the end of Winstar's third fiscal quarter of 1999 (Cignal), and the end of the fourth quarter of 1999 (Wam!Net).
Both round-trip transactions were material to Winstar's financial performance in 1999. In the larger of the two transactions, Winstar recognized approximately $39 million in revenue in the third and fourth quarters of 1999 in connection with sales to Cignal while it paid Cignal $29.5 million under a separate agreement during the same time period and an additional $4.8 million in the first quarter of 2000. Similarly, Winstar recognized $19.6 million in revenue in connection with sales to Wam!Net in the fourth quarter of 1999, even as it paid Wam!Net $25 million in the same quarter for "prepaid marketing" and the lease of a "data service center." In February 2000 GT questioned the "[a]rms length nature of the [round-trip] transactions." It later acknowledged that the transactions "raise[d] a concern" within GT "as to whether or not absent Winstar's payment ... collectability was reasonably assured." Nevertheless, GT approved Winstar's recognition of the full amount of revenue for both transactions.
By letter dated February 10, 2000, GT issued an unqualified audit opinion letter stating that Winstar's annual Form 10-K report for fiscal year 1999 complied with GAAP and fairly represented Winstar's financial condition at the end of that year:
Joint App. at 529.
From December 1998 to February 2001, the Jefferson Plaintiffs purchased over $200 million worth of Winstar stock. The investment portfolios of most of the Jefferson Plaintiffs were managed by Ronald Clark, the Chief Investment Officer for Allianz of America ("Allianz"). The remaining entities deferred to Clark to select their investments in United States securities. Although Clark enjoyed ultimate authority for these investment decisions, he relied on recommendations from a team of analysts, including Livia Asher, who recommended that Allianz purchase Winstar stock. Based on Asher's recommendation, Clark caused Allianz and the other Jefferson Plaintiffs to invest in Winstar.
Clark, it appears, did not personally review Winstar's financial statements prior to making the decision to invest in Winstar. Instead, he relied on Asher to review the statements as part of her job. During discovery, however, Asher acknowledged that she was uncertain of the date of, or reason for, her recommendation that Allianz purchase Winstar stock. Nor could she specifically recall reading Winstar's 1999 Form 10-K report. However, Asher testified that she "probably flipped through every single page" of the report, based on her practice. She explained, "I can't imagine any reason why I would not have looked at this, ... given our position in the stock and given what I would normally do." Asher added that she habitually read auditors' opinion letters included in Forms 10-K to make sure that auditors believed that an issuer's reports were "kosher," but she did not specifically recall reviewing GT's audit report.
Winstar's stock reached a price per share of over $60 in March 2000. In May 2000 Lucent provided Winstar with financing in the form of a renewed credit facility in the aggregate amount of $2 billion. Almost a year later, however, in March 2001, Asensio & Company ("Asensio"), an investment firm, issued a press release criticizing Winstar's ability to pay its debts and explaining that certain measurements of Winstar's financial performance were "questionable" due in part to Winstar's "revenue recognition from non-core businesses and sales of equipment and services to related parties." Joint App. at 2412. The same press release warned that "[a]ny adjustment to Winstar's aggressive revenue accounting and capitalization of cash expenditures would negatively and materially impact Winstar's reported [earnings] and analyst's [sic] opinions of its operations." Id. at 2413. On March 19, 2001, Asensio issued another press release reporting on Winstar's "debt collapse," again criticizing its revenue accounting practices and noting, "Winstar has recognized revenues
The Asensio press releases preceded a significant downgrade in Winstar's credit rating on April 3, 2001. Moreover, on April 16, 2001, Winstar announced that Lucent was cancelling Winstar's credit facility, that Winstar would delay filing its Form 10-K report for 2000, and that Winstar was considering a reorganization under Chapter 11 of the Bankruptcy Code.
By the time of the Asensio press releases, Winstar's revenues and its stock price had decreased significantly during a marketwide decline in the prices of technology stocks. However, the press releases, coupled with the subsequent announcements of Winstar's financial troubles, were followed almost immediately by an additional steep decline in Winstar's stock price, from over $10 per share before March 2001 to $0.14 per share by mid-April 2001. On April 18, 2001, Winstar filed for bankruptcy.
During discovery, an economist retained by the Plaintiffs as an expert witness attributed the decline in Winstar's stock price to, among other causes, the partial disclosure of Winstar's alleged fraud by Asensio. The economist calculated that members of the putative class who had purchased Winstar common stock lost as much as $974 million, that class members who purchased Winstar notes lost up to $197 million, and that the Jefferson Plaintiffs lost over $96 million by investing in Winstar stock.
On April 10, 2001, the Lead Plaintiffs filed a putative class action complaint in the Southern District of New York against Winstar, GT, Lucent, and certain Winstar executives alleging securities fraud under Section 10(b) of the Exchange Act, 15 U.S.C. § 78j(b). In December 2001 the Jefferson Plaintiffs filed a separate complaint in the District Court against GT, claiming violations of both Section 10(b) and Section 18 of the Exchange Act, 15 U.S.C. § 78r(a).
In September 2010 the District Court granted GT's motion for summary judgment, concluding that (1) the Plaintiffs had failed to demonstrate that a genuine dispute of material fact existed as to whether GT acted intentionally or recklessly, as required under Section 10(b) of the Exchange Act, and (2) the Jefferson Plaintiffs had failed to demonstrate that such a dispute existed as to whether they actually relied on GT's audit opinion letter, as required under Section 18 of the Exchange Act. In re Winstar Commc'ns Sec. Litig., No. 01 CV 11522(GBD), 2010 WL 3910322, at *5-6 (S.D.N.Y. Sept. 29, 2010).
This appeal followed.
We review a district court's grant of summary judgment de novo, viewing the evidence in the light most favorable to the non-moving party and drawing all reasonable
To sustain a claim under Section 10(b) of the Exchange Act and Rule 10b-5, the Plaintiffs must show "(i) a material misrepresentation or omission; (ii) scienter; (iii) `a connection with the purchase or sale of a security[;]' (iv) reliance by the plaintiff(s); (v) economic loss; and (vi) loss causation." Id. (alteration in original)(quoting Dura Pharms., Inc. v. Broudo, 544 U.S. 336, 341-42, 125 S.Ct. 1627, 161 L.Ed.2d 577 (2005)).
Plaintiffs may satisfy the scienter requirement by producing "evidence of conscious misbehavior or recklessness." See ECA, Local 134 IBEW Joint Pension Trust of Chicago v. JP Morgan Chase Co., 553 F.3d 187, 198 (2d Cir.2009). Scienter based on conscious misbehavior, in turn, requires a showing of "deliberate illegal behavior," Novak v. Kasaks, 216 F.3d 300, 308 (2d Cir.2000), a standard met "when it is clear that a scheme, viewed broadly, is necessarily going to injure," AUSA Life Ins. Co. v. Ernst & Young, 206 F.3d 202, 221 (2d Cir.2000) (alterations omitted).
In AUSA Life, we applied this standard to representations by the accounting firm Ernst & Young ("E & Y"), which, as plaintiffs allege with respect to GT, "consistently noticed, protested, and then acquiesced in" the financial misrepresentations of an audit client under pressure from the client's management. Id. at 205. We held that by issuing an unqualified audit report despite its knowledge of accounting improprieties by the client, E & Y "intentionally engaged in manipulative conduct," id. at 221 (quotation marks omitted), in violation of Section 10(b). We explained that
Id.; see also SEC v. KPMG LLP, 412 F.Supp.2d 349, 379 (S.D.N.Y.2006) (triable issue as to conscious fraud existed when accountant was "[a]ware of [the client's] earnings pressures" but allowed aggressive accounting policies "without any serious study to determine that these unusual, indeed unique, accounting treatments would result in financial statements that fairly represented [the client's] financial condition").
Scienter based on recklessness may be demonstrated where a defendant has engaged in conduct that was "highly unreasonable, representing an extreme departure from the standards of ordinary care ... to the extent that the danger was either known to the defendant or so obvious that the defendant must have been aware of it." Rothman v. Gregor, 220 F.3d 81,
The District Court concluded that Winstar engaged in "dubious accounting practices," that "[m]uch of the supporting documentation that Winstar supplied to GT was a mere contrivance meant to paper the transactions and create the appearance of legitimacy," and that GT "failed to uncover the accounting fraud being perpetuated by the Winstar defendants." Winstar, 2010 WL 3910322, at *3, *5. GT does not seriously dispute these conclusions, which are in any event supported by the record before us. The District Court concluded, however, that the evidence demonstrated only that GT was "performing its role as [Winstar's] independent auditor" and fell short of demonstrating scienter in the form of either conscious misbehavior or recklessness. Id. at *3. We disagree.
Some evidence supports the Plaintiffs' contention that GT consciously ignored Winstar's fraud when it approved Winstar's recognition of revenue for the suspicious 1999 transactions. This evidence goes beyond a mere failure to uncover the accounting fraud and, in general, relates to (1) Winstar's recognition of revenue for the sale of equipment or services without sufficient indicia of delivery, (2) its recognition of all revenue associated with the incomplete sale of telecommunications systems, and (3) its recognition of revenue for sales of IRUs, equipment, and services to financially unstable companies to whom Winstar paid back large sums under separate contractual obligations.
There is also evidence that GT failed to confirm Winstar's representations regarding these transactions or to retain and review documents evidencing each transaction. Indeed, an expert forensic accountant retained by the Plaintiffs testified that GT's failure to exercise due professional care, gather reliable documents, and issue an adverse opinion in this regard represented a violation of Generally Accepted Auditing Standards ("GAAS")
We point to the IRU transactions only as one example of a transaction that suggests that GT acted with scienter. Triable issues regarding GT's scienter exist for the other questionable transactions as well. Broadly speaking, there was admissible evidence
We note that in granting summary judgment in GT's favor, the District Court placed particular emphasis on the magnitude of GT's audit work, both in time spent and documents reviewed. For example, it noted that GT "spent 1,928 hours of professional time," assembled working papers spanning 3,000 pages, and reviewed "copies of contracts, Winstar business plan[s], press releases, board minutes," and memos prepared by Winstar and GT addressing accounting issues. Winstar, 2010 WL 3910322, at *2. The number of hours spent on an audit cannot, standing alone, immunize an accountant from charges that it has violated the securities laws. Here, the Plaintiffs adduced evidence that, notwithstanding the magnitude of its audit, GT repeatedly failed to scrutinize serious signs of fraud by an important client, including: (1) significant end-of-quarter transactions;
In short, regardless of the hours GT spent or the number of documents it reviewed in the course of its 1999 audit of Winstar, a jury reasonably could determine that the audit was so deficient as to be "highly unreasonable, representing an extreme departure from the standards of ordinary care ... to the extent that the danger was either known to [GT] or so obvious that [GT] must have been aware of it." Rothman, 220 F.3d at 90 (quotation marks omitted).
Section 18 of the Exchange Act, 15 U.S.C. § 78r(a), requires actual rather than constructive reliance upon a materially false or misleading statement by one who has purchased or sold a security. Heit v. Weitzen, 402 F.2d 909, 916 (2d Cir.1968). The District Court concluded that the Jefferson Plaintiffs failed to show reliance because they could not demonstrate that they or their representatives "actually saw Winstar's 1999 Form 10-K filing, much less read the included independent accountant report of GT." Winstar, 2010 WL 3910322, at *6. Even assuming that such "eyeball" reliance is the sort of actual reliance required by our precedents, the District Court's conclusion somewhat understates the record evidence on this score. Ronald Clark and Livia Asher worked on behalf of the Jefferson Plaintiffs. Although Asher was unable to recall specifically that she reviewed GT's audit opinion letter, there was evidence that she actively reviewed such letters as a matter of practice in deciding whether to recommend certain stocks. At this stage of the proceedings, Asher's testimony is enough; from that evidence, a jury reasonably could infer that she actually reviewed the relevant documents. See, e.g., Fed. R.Evid. 406. Accordingly, we conclude that the District Court erred in granting summary judgment in GT's favor on the Jefferson Plaintiffs' Section 18 claims.
GT argues in the alternative that the District Court's grant of summary judgment should be affirmed because the Plaintiffs failed to show loss causation. We have described loss causation as "the causal link between the alleged misconduct and the economic harm ultimately suffered by the plaintiff." Emergent Capital Inv. Mgmt., LLC v. Stonepath Grp., Inc., 343 F.3d 189, 197 (2d Cir.2003). Among other things, the misconduct must be a "substantial factor in the sequence of responsible causation." AUSA Life, 206 F.3d at 215 (quotation marks omitted). With these principles in mind, however, we have also warned that "if the loss was caused by an intervening event, like a general fall in the price of Internet stocks, the chain of causation will not have been established[, b]ut such is a matter of proof at trial." Emergent Capital, 343 F.3d at 197; see also AUSA Life, 206 F.3d at 214-15 ("[W]hen the plaintiff's loss coincides with a marketwide phenomenon causing comparable losses to other investors, the prospect that the plaintiff's loss was caused by the fraud decreases.").
Relying largely on the deposition testimony of an expert witness economist, the Plaintiffs argue that they have adduced proof of loss causation in the form of the press releases from Asensio and Winstar's April 2001 announcements, which publicly exposed Winstar's substantial financial weaknesses and together suggested for the first time that Winstar had engaged in improper revenue recognition practices for a period of time that included 1999. Although a much closer call, a jury could reasonably infer based on the expert testimony and other evidence that the precipitous decline in Winstar's stock price in 2001 was attributable in part to the alleged fraud.
GT counters that any decline in Winstar's stock price that was not caused by broader market trends resulted not from the alleged fraud but from Lucent's cancellation of its credit facility. This may be true for a portion of the collapse in Winstar's stock price. There is support as well for the argument that the downgrade in Winstar's credit rating resulted in a substantial decline in the stock price. But these facts, if established, hardly foreclose
We have considered GT's other arguments, and we conclude that they are without merit. For the foregoing reasons, we VACATE the District Court's grant of summary judgment, and we REMAND for further proceedings.
SAB 101 at 6 (footnotes omitted). In addition, revenue may be recognized in the absence of delivery only if a transaction meets seven requirements, including (1) that "[t]he risks of ownership ... passed to the buyer"; (2) that "the buyer, not the seller ... request... that the transaction be on a bill and hold basis," based on a "substantial business purpose" of the buyer; and (3) that the seller not retain "any specific performance obligations such that the earning process is not complete." Id. (footnotes omitted). In its Form 10-K, Winstar stated, "Revenues from equipment sales are recognized when the equipment is delivered to the customer. Professional services revenues are recognized under the percentage of completion method." Joint App. at 538.
