11/11/2013 10:56 am ET Updated Jan 23, 2014

Investors' Claim Against Auditor May Proceed

In every financial collapse since the Great Depression, auditors have been sued by investors who suffered financial losses. Lawsuits are frequently based upon allegations of negligence in the performance of financial audits or allegations that the auditors actively participated in defrauding investors. Negligence may be proven by the failure to follow generally accepted auditing standards but proof of fraud is more demanding. Auditors are typically not liable for personally engaging in financial fraud unless they intended to deceive the investors. "Scienter" is the technical term for intent to deceive. In some circumstances courts have determined that gross negligence may be the equivalent of intentional wrongdoing.

The Federal Court of Appeals for the Second Circuit on November 8, 2013, reversed a federal District Court's dismissal of litigation against the accounting firm Pricewaterhouse Coopers (PwC) based upon alleged violations of Section 10(b) of the Securities Exchange Act of 1934 (CILP Associates v. Pricewaterhouse Coopers). Successful Section 10(b) suits require proof of scienter. This particular lawsuit arose from the collapse of the hedge fund Lipper Convertibles.L.P. PwC was Lipper's outside auditor for fiscal years 1996 through 2000. PwC audit letters contained the typical assurance that the audited financial statements "present fairly, in all material aspects, the financial position of Lipper Convertibles, L.P."

Without discussing the tangled financial and legal history surrounding this case in detail, the significant development for the general reader is a possible trial concerning the type of auditor activity that might prove to be the equivalent of financial fraud and whether or not this activity may be linked to a "direct injury" suffered by investors. The way that certain securities allegedly were valued did not follow "fair value methodology" but rather were based upon an estimate of future value. There are a number of factual questions yet to resolve.

The Court wrote: "Here, the scienter issue is highly fact-intensive and will depend on an evaluation of expert witness and deposition testimony." In remanding the case to the District Court the Second Circuit instructed the District Court to determine if there were sufficient indicators of fraud that PwC either knowingly or recklessly failed to review or check. If so, then the case might ultimately proceed to a jury trial. The financial community will doubtless continue to follow this case to discover if it sets any new precedent concerning auditor liability. At the present stage, all one can accurately say is that the facts are unclear and require additional investigation.