Investors Stated Securities Fraud Claim Against Outside Auditor that Allegedly Ignored Red Flags

A federal judge ruled that investors in a private securities fraud action against a failed financial services company adequately alleged the outside auditor’s scienter, its misstatements, and loss causation. The court ruled that the complaint adequately alleged the auditor’s recklessness, if not actual knowledge, based on its awareness of red flags and its duty to investigate. Thus, Judge Sweet refused to dismiss the securities charges against the audit firm. In Re Bear Stearns Companies,Inc. Securities, Derivatives, and ERISA Litigation (SD NY) 08 MDL 1963, Jan. 19, 2011.

The financial instruments (fair value)balance sheet line item was the largest asset on the company’s balance sheet, comprising one third of the company’s total assets. It was alleged that the audit firm failed to perform targeted procedures to assess the internal controls over financial reporting of the fair value of financial instruments, as required by PCAOB Auditing Standards Nos, 2 and 5, resulting in the disclosure of the fair value of financial instruments that were not valued in accordance with GAAP.

It is more specifically alleged that, in violation of AS Nos. 2 and 5, the auditor recklessly disregarded proper testing of company-level controls including risk management processes, internal controls of the company’s risk management processes, and varying pricing approaches by trading desks which enabled the company’s disclosure of its low VaR number.

Investors further alleged that the auditor failed to test internal controls for potential abuses in the company’s mortgage origination business, thereby allowing the company to continue to use lax underwriting and loan origination standards.

Investors said that the company’s concentration of mortgage securities in excess of its internal policy limits constituted another red flag which left it exposed to declines in the riskiest part of the housing market, and represented reckless disregard for the guidance provided by the AICPA’s Statement of Position 94-6, on the disclosure of significant risks and uncertainties.