Scienter (Almost) Required For 1933 Act Securities Suits

November 2011

It just got a lot harder to successfully sue preparers of financial statements and their auditors under the 1933 Securities Act. In Fait v. Regions Financial Corporation, et al., the Second Circuit upheld a District Court ruling that threw out a case having remarkably common facts.

The case involves allegations that financial statements were not reasonably prepared in accordance with Generally Accepted Accounting Principles (GAAP) based on readily-available information. The plaintiffs did not allege that the issuer and its auditors did not believe the financial statements were appropriate, or that there was fraud or intentional misconduct.

In this particular case, the specific misstatements involved typical allegations involving the failure to write down goodwill, and the failure to record adequate reserves for loan losses. The Court describes:

“Relying on these allegations, the complaint further contends that the Offering Documents incorporated false and misleading certifications by management that Regions' financial statements complied with the Sarbanes–Oxley Act (“SOX”) and were prepared in accordance with GAAP. It also alleges that E & Y falsely certified that Regions' financial results were presented in accordance with GAAP, that E & Y's audits complied with generally accepted accounting standards (“GAAS”), and that Regions maintained effective internal controls. The complaint alleges that these misleading statements and omissions violated sections 11(a), 12(a)(2), and 15 of the Securities Act of 1933 (“Securities Act” or “1933 Act”). See 15 U.S.C. §§ 77k(a), 77 l (a)(2), 77o.”

The Second Circuit then concludes that no liability could be established, even if the plaintiff’s allegations were true, as follows:

“Although sections 11 and 12 refer to misrepresentations and omissions of material fact, matters of belief and opinion are not beyond the purview of these provisions. However, when a plaintiff asserts a claim under section 11 or 12 based upon a belief or opinion alleged to have been communicated by a defendant, liability lies only to the extent that the statement was both objectively false and disbelieved by the defendant at the time it was expressed.”

With respect to the loan loss reserves, the Second Circuit elaborates its test and related conclusions, as follows:

“Plaintiff does not point to an objective standard for setting loan loss reserves. Thus, in order for the alleged statements regarding the adequacy of loan loss reserves to give rise to liability under sections 11 and 12, plaintiff must allege that defendant's opinions were both false and not honestly believed when they were made. Because the complaint does not plausibly allege subjective falsity, it fails to state a claim. [Citations and footnotes omitted.]”

Although the Court said that it was not requiring a scienter standard for pleading, it is hard to see how the practical effect could be anything but such a requirement. Under this case, it is not sufficient to show that the financial statements were negligently reported under GAAP. Financial statements are full of judgments. If the only accounting misstatements that can sustain liability under sections 11 and 12 of the Securities Act are those that are purely factual, the majority of current accounting-based securities lawsuits will fail.

Plaintiffs’ lawyers often plead 1933 Act claims to avoid the requirement of pleading what the speaker knew or believed. This decision could have an important effect on the way securities claims are asserted/pled.

Fulcrum Inquiry performs forensic accounting and damage analyses for litigation.