In a decision issued earlier this week, the U.S. Court of Appeals for the Second Circuit held that an accountant has a duty to correct its audit opinions, and may in some circumstances incur primary liability under § 10(b) and Rule 10b-5 if it fails to do so.  The decision is notable because it appears to be among the first to hold that an accountant has a duty, in some circumstances, to correct prior opinions.  The decision will likely fuel the increasing debate over auditor liability in private securities cases.

The Second Circuit's ruling in Overton v. Todman & Co. (No. 06-2496) reversed the district court's dismissal of a securities fraud claim against the accounting firm of Todman & Co.  Plaintiffs alleged that, over several years, Todman & Co. issued opinions certifying that a broker-dealer's financial statements were accurate.  Plaintiffs further alleged that Todman & Co. then failed to correct those prior opinions despite "red flags" indicating that the broker-dealer's financial statements understated a material liability.  According to plaintiffs, that liability ultimately led to the broker-dealer's collapse.

The Second Circuit ruled that plaintiffs could proceed with their claim against Todman & Co. despite the absence of any Second Circuit precedent holding that accountants have a duty to correct such prior opinions.  The Second Circuit held that an accountant may violate this so-called "duty to correct" and become primarily liable under § 10(b) and Rule 10b-5 if it:
(1) makes a statement in its audit opinion that is false or misleading when made;
(2) subsequently learns or was reckless in not learning that the earlier statement was false or misleading;
(3) knows or should know that potential investors are relying on the opinion and financial statements;
(4) fails to take reasonable steps to correct or withdraw its opinion and/or the financial statements; and
(5) all the other requirements for § 10(b) and Rule 10b-5 liability are satisfied.

The Second Circuit's decision is likely to fuel the debate over private securities claims against auditors.  Critics of such litigation note that the threat of securities litigation impedes professional judgment in interpreting difficult standards, increases audit costs, and fosters unnecessary complexity in financial reporting.  Recently, the Committee on Capital Markets Regulation called on Congress to consider caps on auditor liability or safe harbors to control such liability.  Similarly, the SEC's Chief Accountant suggested that accountants should consider asking Congress for new protections against auditor liability, similar to protections already in place in some European countries.

View the Overton v. Todman & Co. opinion.