In In re Advanced Battery Technologies, Inc., No. 14-1410 (2d Cir. Mar. 25, 2015), the Second Circuit affirmed the denial of a motion to amend a dismissed Section 10(b) and Rule 10b-5 class action complaint against a pair of auditor defendants because of inadequate scienter allegations. The decision emphasizes the high bar a plaintiff must overcome to allege scienter against independent auditors and, importantly, rejects the use of an accounting expert’s conclusory opinion to bolster allegations of reckless and unreasonable conduct.
The Proposed Complaint
The proposed complaint alleged that two auditors (one engaged from 2006 to 2010, the other from 2010 to 2012) had committed securities fraud in their audits of the company Advanced Battery Technologies, Inc. (ABAT) for the fiscal years of 2007 through 2010. ABAT was a Delaware corporation with its primary operations in China that employed a reverse merger to access U.S. capital markets. ABAT filed disclosures with both the Securities and Exchange Commission (SEC) and China’s State Administration of Industry and Commerce (AIC). The plaintiffs alleged that ABAT’s regulatory filings with the AIC reported losses, while its regulatory filings with the SEC reported significant profits. Additionally, ABAT allegedly made material misrepresentations or omissions regarding two transactions. First, ABAT failed to disclose that its chairman and CEO owned a science and technology company that ABAT paid $20 million to acquire in 2010 when the company was having significant financial difficulties. Second, ABAT allegedly misrepresented that it wholly owned a purported subsidiary of ABAT that was, in fact, actually owned by the same chairman and CEO and other investors.
With respect to the auditors, the proposed complaint alleged that their audit opinions were materially false and misleading, did not comply with various professional accounting standards, and “ignored or recklessly disregarded numerous red flags that should have alerted them to ABAT’s fraudulent financial statements.” Specifically, the plaintiffs focused on the different regulatory submissions made by ABAT to the AIC and the SEC, and its related-party acquisition of the science and technology company. The plaintiffs asserted these red flags should have been discovered by the auditors who allegedly had “ready access to ABAT’s financial records” and “presumably relied on the same underlying financial records and data . . . that had formed the basis for ABAT’s AIC filings.” Importantly, the plaintiffs also set forth an accounting expert’s opinion that the auditors’ failure to identify the red flags was “an extreme departure from the reasonable standards of care [they were] obligated to meet as ABAT’s auditor[s].”
In considering the adequacy of the proposed complaint, the Second Circuit first noted that the plaintiffs did not allege any motive for the auditors to commit fraud. Accordingly, the securities claim rested entirely on a theory of recklessness, which required “the strength of the circumstantial allegations [to] be correspondingly greater.” The recklessness theory would require the plaintiffs to allege that the auditors engaged in “conduct that is highly unreasonable, representing an extreme departure from the standards of ordinary care.” The Second Circuit also observed that the auditors’ alleged conduct “‘must, in fact, approximate an actual intent to aid in the fraud being perpetrated by the audited company,’ as, for example, when a defendant conducts an audit so deficient as to amount to no audit at all, or disregards signs of fraud so obvious that the defendant must have been aware of them.”
Applying the foregoing legal principles, the Second Circuit determined that the plaintiffs’ allegations in the proposed complaint failed to constitute strong circumstantial evidence of recklessness. The Second Circuit specifically found:
- None of the accounting standards upon which the plaintiffs relied triggered a legal duty to inquire about or review ABAT’s foreign regulatory filings – despite the accounting expert’s “conclusory statement” that such a review was required under the reasonable standards of care for auditors.
- The “unusually high profit margins” ABAT reported to the SEC “triggered, at most, a duty to perform a more rigorous audit of those filings . . . [but] did not obligate [the auditor] to review ABAT’s AIC filings.” Similarly, the use of a reverse merger by ABAT did not create a duty to review the AIC filings.
- Plaintiffs’ allegation that the relevant auditor had access to the raw data underlying ABAT’s AIC filings, but recklessly did not notice the discrepancies between that data and the SEC filings, ignored the “somewhat more compelling inference  that ABAT maintained two sets of data – one for its Chinese regulators and another for its regulators in the United States – and fed [the auditor] false data to complete its audits.”
- Allegations surrounding one of the auditor’s failures to uncover the true ownership status of the subsidiary at most rose to the level of negligence, even when considered with other facts in the proposed complaint.
- Claims that adequate diligence would have uncovered the fraud surrounding ABAT’s acquisition of the science and technology company failed as a matter of law to plead scienter. In particular, the allegation that ABAT paid an “inflated purchase price” was insufficient to establish scienter because the proposed complaint failed to allege that the auditor knew that ABAT paid an inflated price.
In sum, the Second Circuit concluded that the allegations against both auditors were not actionable as conduct “approximat[ing] an actual intent to aid in the fraud being perpetrated by the audited company” or “an extreme departure from the standards of ordinary care.”
The Advanced Battery decision highlights that securities fraud claims that rely on circumstantial allegations to establish scienter are particularly susceptible to dismissal at the pleading stage. This susceptibility is compounded in the case of auditors, who ordinarily “have no ‘motive’ to commit fraud,” requiring a plaintiff to fall back on a theory of conscious recklessness to adequately plead scienter. However, the Second Circuit standard for conscious recklessness by an independent auditor requires conduct that “approximate[s] an actual intent to aid in the fraud being perpetrated,” leaving little pleading daylight between conscious recklessness and intentional fraudulent conduct. Moreover, the decision reinforces the legal principle that alleged accounting irregularities and failures to adhere to accounting standards, standing alone, are insufficient to establish recklessness, even if the violations of those standards are supported by the opinion of an accounting expert. Finally, the case underscores that allegations of ignored red flags will not support an inference of scienter where competing inferences demonstrate either that the auditor never had access to the data that contained the red flags or that the auditor’s failure to uncover the red flags was not due to “an extreme departure from the standards of ordinary care.”