In Re. Ikon v. City of Philadelphia ( 2002 )

Opinions of the United
2002 Decisions States Court of Appeals
for the Third Circuit
1-11-2002
In Re. Ikon v. City of Philadelphia
Precedential or Non-Precedential:
Docket 01-1553
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Filed January 11, 2002
UNITED STATES COURT OF APPEALS
FOR THE THIRD CIRCUIT
No. 01-1553
IN RE: IKON OFFICE SOLUTIONS, INC.,
SECURITIES LITIGATION
City of Philadelphia, through its Board of Pensions and
Retirement, Oliver Scofield and Lawrence Porter, as
representatives of a certified Class consisting of all
persons who purchased the common stock, convertible
preferred stock, and/or call options of IKON Office
Solutions, Inc. during the period from October 15, 1997,
through and including August 13, 1998,
Appellants
On Appeal from the United States District Court
for the Eastern District of Pennsylvania
(MDL No. 1318)
District Judge: Honorable Marvin Katz
Argued October 11, 2001
BEFORE: BECKER, Chief Judge, SCIRICA and
GREENBERG, Circuit Judges
(Filed: January 11, 2002)
Todd S. Collins (Argued)
Merrill G. Davidoff
Jacob A. Goldberg
Douglas M. Risen
Berger & Montague
1622 Locust Street
Philadelphia, PA 19103
Jared Specthrie (Argued)
Justin C. Frankel
Milberg Weiss Bershad Hynes &
Lerach
One Pennsylvania Plaza
New York, NY 10119-0165
Lynn Lincoln Sarko
Britt L. Tinglum
Keller Rohrback
1201 Third Avenue, Suite 3200
Seattle, WA 98101-3052
Stuart H. Savett
Savett Frutkin Podell & Ryan
325 Chestnut Street, Suite 700
Philadelphia, PA 19106-2614
Attorneys for Appellants
Lawrence S. Robbins (Argued)
Gary A. Orseck
Kathryn S. Zecca
Robbins, Russell, Englert, Orseck &
Untereiner
1801 K Street, Suite 411
Washington, DC 20006
Edward M. Posner
William M. Connolly
Drinker Biddle & Reath
One Logan Square
18th & Cherry Streets
Philadelphia, PA 19103
Jonathan C. Medow
Brian J. Massengill
Mayer, Brown & Platt
190 South LaSalle Street
Chicago, IL 60603
2
Kathryn A. Oberly
Patricia A. McGovern
Ernst & Young LLP
787 Seventh Avenue
New York, NY 10019
Attorneys for Appellee
OPINION OF THE COURT
GREENBERG, Circuit Judge.
This shareholders' class action case comes on before this
court on plaintiffs-appellants' appeal from a February 6,
2001 order of the district court granting summary
judgment to the defendant-appellee Ernst & Young LLP
("Ernst"). See In re IKON Office Solutions Sec. Litig., 131 F.
Supp. 2d 680 (E.D. Pa. 2001). Appellants are
representatives of a certified class consisting of all persons
who purchased common stock, convertible preferred stock,
and/or call options of IKON Office Solutions, Inc. ("IKON")
from October 15, 1997, through August 13, 1998. In their
complaint they alleged that Ernst, IKON's accounting firm,
violated section 10(b) of the Securities Exchange Act, 15
U.S.C. S 78j(b), and Rule 10b-5, 17 C.F.R.S 240.10b-5,
promulgated thereunder, by issuing an unqualified audit
report approving IKON's financial statements for fiscal year
1997 knowing that they overstated IKON's pre-tax income
or, even if Ernst did not have actual knowledge of the
overstatement, by recklessly performing its audit.
The district court granted Ernst's motion for summary
judgment on the grounds that the appellants failed to raise
a genuine issue of material fact with respect to two
elements of a prima facie section 10(b) claim: scienter (that
Ernst harbored an intent to deceive or acted with reckless
disregard for the truth and accuracy of IKON's financial
disclosures) and causation (that the inflated value of IKON's
stock price dropped when the market reevaluated the
security after a corrective disclosure). In addition, and in
the alternative, the court granted Ernst's motion for partial
summary judgment, ruling that it could not be liable to
3
certain members of the class under section 10(b) by reason
of an October 15, 1997 press release IKON issued because
Ernst itself did not communicate misrepresentations to
investors in the press release -- the only activity proscribed
by the statute.
Because the record fails to establish a triable issue with
respect to scienter, we will affirm the judgment of the
district court without addressing loss causation or whether
Ernst can be held liable under section 10(b) for IKON's
October 15, 1997 press release.
I. BACKGROUND
A. Factual History
IKON, which is headquartered in Malvern, Pennsylvania,
supplies copiers, printing systems, and related services
throughout the United States, Canada, and Europe. Its
shares are traded publicly on the New York Stock
Exchange. Between 1995 and 1998, IKON embarked on a
"transformation" business plan in which it acquired and
consolidated close to 200 independent copier, technology-
services, and outsourcing and imaging companies. See J.A.
1331 (Jarrell Report). IKON intended to become an
international provider of "office technology solutions,"
serving as a single source for networking services, office
technology, and software needs, rather than simply
distributing and servicing office products in domestic
markets. See J.A. 1330-31 (Jarrell Report).
Ernst, a "Big Five" accounting firm,1 served as the
independent, outside auditor of IKON's September 30 fiscal
year-end financial statements for a number of years,
_________________________________________________________________
1. The "Big Five" accounting firms are Arthur Andersen LLP, Deloitte &
Touche LLP, Ernst & Young LLP, KPMG LLP and
PricewaterhouseCoopers LLP. For many years, the accounting industry
was dominated by eight national firms. In 1989, the"Big Eight" was
reduced to six members with the mergers of Ernst & Whinney and
Arthur Young into Ernst & Young and Touche Ross and Deloitte Haskins
& Sells into Deloitte & Touche. In 1998, the "Big Six" became the "Big
Five" as Price Waterhouse merged with Coopers Lybrand to become
PricewaterhouseCoopers.
4
including the time encompassing the audit of IKON's 1997
consolidated financial statements. See J.A. 113-14 (2d Am.
Cplt. at P 101). Ernst designed its year-end audits to
evaluate whether IKON's financial statements accurately
and fairly reflected its financial position in accordance with
Generally Accepted Accounting Principles ("GAAP").2 In
addition, Ernst performed certain internal audit functions
for IKON, such as monitoring and evaluating its compliance
with its own internal accounting policies and procedures.
See J.A. 115 (2d Am. Cplt. at P 105).
This dispute focuses on the soundness of Ernst's audit
for fiscal year 1997. On October 15, 1997, after Ernst had
completed the bulk of its audit work,3 IKON issued a press
release discussing fourth-quarter and year-end results. See
J.A. 5150-55. The release reported income from continuing
operations totaling $204.9 million for fiscal 1997, a 15
percent increase from fiscal 1996. See J.A. 5151. Ernst
reviewed the press release before it was issued without
proposing any modifications. See J.A. 3523 (Dillon Dep. 26-
27).
On December 24, 1997, Ernst publicly issued its
unqualified, or "clean," audit opinion,4 stating that it had
conducted its audit in accordance with Generally Accepted
Auditing Principles ("GAAS"),5 and concluding that IKON's
_________________________________________________________________
2. GAAP is "a technical accounting term that encompasses the
conventions, rules, and procedures necessary to define accepted
accounting practices at a particular time." See American Institute of
Certified Public Accounts ("AICPA"), Statement of Auditing Standards No.
69, P 69.02 (1992), quoted in Sanders v. Jackson, 209 F.3d 998, 1001
n.3 (7th Cir. 2000). GAAP principles and standards provide a common
framework by which financial statements from divers companies may be
compared and adjudged.
3. The final audit opinion was dated October 15, 1997, with the
exception of note 8, dated October 27, 1997. See J.A. 4701 (Graham
Report).
4. An "unqualified" or "clean" audit opinion is the highest level of
assurance that an auditor can give on an organization's financial
statements. Accountants will "qualify" their opinion where discrepancies
are identified in a client's financial statements.
5. GAAS are the standards prescribed by the Auditing Standards Board
of the American Institute of Certified Public Accountants for the conduct
of auditors in the performance of an examination. See SEC v. Arthur
Young & Co., 590 F.2d 785, 788 n.2 (9th Cir. 1979).
5
1997 financial statements fairly reflected its financial
position. See J.A. 4701 (Graham Report). Relevant portions
of that unqualified audit opinion, which appeared in IKON's
1997 Annual Report to the Securities and Exchange
Commission on Form 10-k, follow:
We have audited the accompanying consolidated
balance sheets of IKON Office Solutions, Inc . . . and
the related consolidated statements of income, changes
in stockholders' equity and cash flows for each of the
three years in the period ended September 30, 1997
. . . . We conducted our audits in accordance with
generally accepted auditing standards. Those
standards require that we plan and perform the audit
to obtain reasonable assurance about whether the
financial statements are free of material misstatement.
An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the
financial statements. An audit also includes assessing
the accounting principles used and significant
estimates made by management as well as evaluating
the overall financial statement presentation. We believe
that our audits provide a reasonable basis for our
opinion. In our opinion, the consolidated financial
statements referred to above present fairly, in all
material respects, the financial position of IKON Office
Solutions, Inc., and subsidiaries at September 30,
1997 and 1996, and the consolidated results of their
operations and their cash flows for each of the three
years in the period ended September 30, 1997, in
conformity with generally accepted accounting
principles.
See J.A. 117 (2d Am. Cplt. at P 109).
Following the release of the audit opinion and IKON's
contemporaneous December 24, 1997 10-k filing with the
SEC, share values of IKON common stock experienced a net
gain. See J.A. 1371 (Chart Common 1). Within a matter of
months, however, IKON's prospects soured. On April 22,
1998, before the stock market opened, IKON announced
that its second quarter earnings for fiscal year 1998 would
be $0.35 per share, instead of $0.38 as expected by
analysts. IKON also warned that third and fourth quarter
6
earnings would fall below expectations. See J.A. 1624-25
(PR Newswire). IKON cited several reasons for the earnings
shortfall, including issues related to its transformation
process, competitive pressures, and costs associated with
product rationalization. IKON, however, did not mention
accounting charges to rectify discrepancies in its 1997
financial statements.
Later that morning the investment banking firm of
Goldman, Sachs & Co. downgraded IKON to "market
perform" from "recommend list," while Prudential Securities
downgraded IKON from "buy" to "hold." See J.A. 1340
(Jarrell Report). As a result, the price of IKON common
stock dropped precipitously from $34.625 a share on April
21, 1998, to close at $25.25 a share on April 22, 1998 --
a one-day decline of 27.08 percent. See J.A. 1371 (Chart
Common 1).
IKON's stock continued to decline over the remainder of
the spring and summer of 1998. On June 26, 1998, after
the market closed, IKON announced that it would miss its
earnings estimate for the third quarter of 1998. See J.A.
1341 (Jarrell Report). The following trading day, June 29,
1998, shares of its common stock declined $6.75 to close at
$15.31. See J.A. 1371 (Chart Common 1). On July 9, 1998,
IKON CEO John Stuart resigned and was replaced by IKON
Vice-President James Forese. See J.A. 1342 (Jarrell Report).
With its market performance and economic prospects
deteriorating, IKON engaged Ernst to review the books of
each of its North American and United Kingdom business
services, a project known as the "Special Procedures." See
J.A. 1131-32 (Letter to Dinkelacker). Specifically, IKON
instituted the Special Procedures when internal audit work
in IKON's Florida district revealed signs of operational
deficiencies and accounting errors, including problems with
reconciling intercompany transactions. See J.A. 1087-1130
(June 2, 1998 IKON Report on Florida district).
To assist in this process, the IKON Board of Directors
hired the accounting firm of Arthur Andersen ("Andersen")
to review Ernst's work. See J.A. 3184-85 (McAleer Dep.
138-41). Andersen was permitted to review all work papers
prepared in connection with Ernst's 1997 audit, IKON's
7
first and second limited 1998 quarterly reviews, and the
Special Procedures.
On August 4, 1998, IKON issued a press release
indicating that it was conducting a "full review of
operations previously announced." See J.A. 1915 (IKON
Press Release). On August 14, 1998, after the conclusion of
an exhaustive review process, IKON announced the results
of the Special Procedures: it would take a $110 million
charge against earnings -- $94 million in pre-tax charges
applied to its 1998 third quarter earnings, and would
restate its previously reported, unaudited 1998 second
quarter earnings to reflect $16 million in pre-tax charges.
See J.A. 2459 (IKON Press Release). The $110 million in
charges included $28 million to cover defaults on leases,
$20 million for unpaid accounts receivable, $35 million for
adjustments due to the breakdown in internal controls at
four operating units, $20 million due to asset impairment,
and $7 million in miscellaneous adjustments. The press
release did not disclose whether the $110 million charge
also corrected errors made in connection with IKON's 1997
year-end consolidated financial statements. The price of
IKON common stock rose by 62 cents, from $9.31 to $9.94
a share on August 14 following the announcement of the
results of the Special Procedures.
B. Procedural History
Shortly after IKON announced these disclosures,
appellants commenced 16 actions against IKON and certain
individual defendants related to it, alleging violations of
sections 10(b) and 20(a) of the Securities Exchange Act of
1934, 15 U.S.C. SS 78j(b) and 78t(a), and of Rule 10b-5, 17
C.F.R. S 240.10b-5. In June 1999, prior to the close of
discovery, appellants filed an amended complaint, adding
Ernst as a defendant on the claim under section 10(b) and
Rule 10b-5 alleging, in essence, that Ernst knew or should
have been aware that IKON's 1997 financial statements
substantially overstated pretax income.
Thereafter, the district court consolidated the actions and
appointed the lead plaintiffs, the City of Philadelphia
through its Board of Pensions and Retirement, Oliver
Scofield, and Lawrence Porter, to represent the interests of
8
a class certified to incorporate all those who acquired IKON
securities between October 15, 1997 (the day of IKON's
press release regarding its 1997 year-end results), and
August 13, 1998 (the day before IKON announced the $110
million in charges against earnings).
In November 1999, the IKON defendants agreed to a
settlement with the class for $111,000,000. The district
court approved the settlement on May 9, 2000, leaving
Ernst as the sole remaining defendant. See In re IKON
Office Solutions, Inc. Sec. Litig., 194 F.R.D. 166 (E.D. Pa.
2000).
On February 6, 2001, one month prior to trial, the
district court on Ernst's motion entered summary judgment
in its favor completely extinguishing the case on two
independent grounds -- appellants' failure to adduce
sufficient evidence of both scienter and loss causation. In
addition, the court, as we have indicated, granted Ernst a
partial summary judgment. Appellants filed a timely notice
of appeal on March 5, 2001.
C. Jurisdiction
We have jurisdiction over this appeal of a final judgment
of the district court pursuant to 28 U.S.C. S 1291. The
district court exercised federal question jurisdiction under
28 U.S.C. SS 1331 and 1337, because the case arose under
the Securities Exchange Act of 1934, 15 U.S.C. S 78aa, and
Rule 10b-5 promulgated thereunder.
II. DISCUSSION
A. Standard of Review
We review an order granting summary judgment de novo,
applying the same test the district court employed. See
Lucent Info. Mgmt., Inc. v. Lucent Tech. Inc., 186 F.3d 311,
315 (3d Cir. 1999). Fed. R. Civ. P. 56(c) provides, in
pertinent part, that a court may grant summary judgment
only if "the pleadings, depositions, answers to
interrogatories, and admissions on file, together with the
affidavits, if any, show that there is no genuine issue as to
any material fact and that the moving party is entitled to
judgment as a matter of law."
9
In determining whether summary judgment is warranted,
we view the record and draw inferences in a light most
favorable to the non-moving party. See Arnold M. Diamond,
Inc. v. Gulf Coast Trailing Co., 180 F.3d 518, 521 (3d Cir.
1999). If a non-moving party fails to make a showing
sufficient to establish the existence of an element essential
to that party's case on which it bears the burden of proof
at trial, there is no issue as to a genuine issue of a material
fact and thus the moving party is entitled to judgment as
a matter of law. See Anderson v. Liberty Lobby, Inc., 477
U.S. 242, 248, 106 S.Ct. 2505, 2510 (1986).
Moreover, a party will not be able to withstand a motion
for summary judgment merely by making allegations;
rather, the party opposing the motion must go beyond its
pleading and designate specific facts by use of affidavits,
depositions, admissions, or answers to interrogatories
showing there is a genuine issue for trial. See Celotex Corp.
v. Catrett, 477 U.S. 317, 324, 106 S.Ct. 2458, 2553 (1986);
see also GFL Advantage Fund, Ltd. v. Colkitt, 272 F.3d 189,
199 (3d Cir. 2001). Only evidence "sufficient to convince a
reasonable factfinder to find all of the elements of[the]
prima facie case" merits consideration beyond the Rule 56
stage. Keller v. Orix Credit Alliance, Inc., 130 F.3d 1101,
1108 (3d Cir. 1997) (en banc).
B. Section 10(b)
Section 10(b) prohibits the "use or employ, in connection
with the purchase or sale of any security, . . .[of] any
manipulative or deceptive device or contrivance in
contravention of such rules and regulations as the
Commission may prescribe . . . ." 15 U.S.C. S 78j(b). Rule
10b-5, promulgated under section 10(b), makes it unlawful
for any person "[t]o make any untrue statement of a
material fact or to omit to state a material fact necessary to
make the statements made in the light of the
circumstances under which they were made, not misleading
. . . in connection with the purchase or sale of any
security." 17 C.F.R. S 240.10b-5(b).
To state a valid claim under section 10(b) and Rule 10b-
5, a plaintiff must show that the defendant (1) made a
misstatement or an omission of a material fact (2) with
10
scienter (3) in connection with the purchase or the sale of
a security (4) upon which the plaintiff reasonably relied and
(5) that the plaintiff 's reliance was the proximate cause of
his or her injury. See GFL Advantage Fund, 272 F.3d at
212; Weiner v. Quaker Oats Co., 129 F.3d 310, 315 (3d Cir.
1997).
1. Scienter
Liability under section 10(b) may extend to secondary
actors in the securities markets, as for example where an
outside accounting firm prepares a fraudulent audit report
that it knows will reach and likely influence the investing
public. See Central Bank of Denver, N.A. v. First Interstate
Bank of Denver, N.A., 511 U.S. 164, 191, 114 S.Ct. 1439,
1455 (1994) ("[a]ny person or entity, including a lawyer,
accountant, or bank . . . may be liable as a primary violator
under 10b-5"); Semerenko v. Cendant Corp., 223 F.3d 165,
181 (3d Cir. 2000) (the "in connection with" prong is
satisfied where the misrepresentations are material and
disseminated to the public in a medium upon which a
reasonable investor would rely). Of course, imposition of
liability on this basis is consistent with the primary
purpose of the Securities Exchange Act of 1934 which is to
protect against manipulated stock prices by imposing strict
and extensive disclosure requirements, irrespective of the
type of actor that disseminates information to the investing
public. See S. Rep. No. 792, 73d Cong., 2d Sess., 1-5
(1934), reprinted 1934 WL 1289.
However, by its terms, section 10(b) does not prohibit
aiding and abetting. See Central Bank, 511 U.S. at 191,
114 S.Ct. at 1455.6 To establish securities fraud, plaintiffs
_________________________________________________________________
6. In Central Bank, the Supreme Court considered whether section 10(b)
liability could extend to actors who do not commit a manipulative or
deceptive act within the meaning of section 10(b) but who instead aid
and abet a violation. In that case, the plaintiffs sought to hold a bank
that served as indenture trustee for two separate bond issues liable
under section 10(b) and Rule 10b-5 for agreeing to delay an independent
review of appraisal of land which secured bonds until approximately six
months after the bonds were to be sold. The bonds were defaulted on
before completion of the independent appraisal. See 511 U.S. at 168,
11
must establish a more exacting threshold of scienter-- "a
mental state embracing intent to deceive, manipulate or
defraud," Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193
n.12, 96 S.Ct. 1375, 1381 n.12 (1976), or, at a minimum,
"highly unreasonable (conduct), involving not merely
simple, or even inexcusable negligence, but an extreme
departure from the standards of ordinary care, . . . which
presents a danger of misleading buyers or sellers that is
either known to the defendant or is so obvious that the
actor must have been aware of it." SEC v. Infinity Group
Co., 212 F.3d 180, 192 (3d Cir. 2000), cert. denied, 121
S.Ct. 1228 (2001) (citing McLean v. Alexander , 599 F.2d
1190, 1197 (3d Cir. 1979)); see Healey v. Catalyst Recovery
of Pa., 616 F.2d 641, 649 (3d Cir. 1980) (section 10b
recklessness closer to intentional conduct than
indifference); see also In re Advanta Sec. Litig., 180 F.3d
525, 535 (3d Cir. 1999). Simple computation errors or
slight accounting mistakes will not suffice to establish
scienter.7
Appellants advance the following claims to demonstrate
_________________________________________________________________
114 S.Ct. at 1443. The Supreme Court, finding no basis within the
language or legislative history of the statute and reluctant to allow
plaintiffs to circumvent the reliance requirement of section 10(b) simply
by demonstrating that a defendant gave some modicum of aid to those
engaged in proscribed activities, refused to find an implied private right
of action to impose aiding and abetting liability under section 10(b). See
id. at 176-80, 114 S.Ct. at 1447-50.
7. To prevail on a section 10(b) claim, however, appellants need not
demonstrate that the audit for fiscal year 1997 amounted to a
"pretended audit" as Ernst maintains throughout its brief. In McLean, we
suggested the type of circumstantial evidence that could support an
inference of bad faith, for instance, "[a] showing of shoddy accounting
practices amounting at best to a pretended audit , or of grounds
supporting a representation so flimsy as to lead to the conclusion that
there was no genuine belief back of it." McLean, 599 F.2d at 1198(citations and internal quotation marks omitted) (emphasis added). We
did not intend in McLean, however, to restrict the scienter threshold to
the precise contours of this list. Rather, if a plaintiff can show -- by
whatever means -- that defendants "did not have an honest belief in the
truth of their statements, then they are liable, so far as (scienter) is
concerned." Id.12
that Ernst knew of or was reckless in failing to discover
deficiencies in IKON's financial statements in connection
with IKON's October 15, 1997 press release and Ernst's
December 24, 1997 audit opinion:8 (1) that Ernst failed to
investigate sufficiently evidence of fraud by IKON or take
into account other conspicuous risk factors or "red flags"
that would have alerted Ernst to the fallacious
computations; and (2) that Ernst impermissibly relied on
IKON's internal controls in preparing its audit calculations.
As a result of these alleged deficiencies and other violations
of GAAS, appellants attribute $20.8 million in known errors
and $30.1 million in reckless errors to Ernst's audit
opinion.
We have concluded, however, after an intensive study of
the formidable record in this case, that even when viewed
with hindsight it does not supply a basis from which to
_________________________________________________________________
8. The district court entered judgment for Ernst as to the period from
October 15, 1997, until December 24, 1997, in which appellants
predicated their theory of liability on IKON's October 15 press release.
The district court held that IKON's press release, which neither
mentioned Ernst by name, nor attributed any representations to Ernst,
could not "form a basis for a Section 10(b) claim," because, in light of
Central Bank, Ernst at best facilitated the principal actor's disclosures
and, therefore, did not "make" a material misstatement (or omission)
upon which the investing public relied. See 131 F. Supp. 2d at 685 n.5
(citing Wright v. Ernst & Young LLP, 152 F.3d 169, 175 (2d Cir. 1998)).
Noting further that some courts have applied a "substantial
participation" test with respect to primary liability for secondary
actors,
the district court found no basis for liability to attach to Ernst under
this
standard because the company neither drafted nor directed any
meaningful aspect of the press release such that IKON's representations
could be attributed to Ernst. See id. (citing Cashman v. Coopers &
Lybrand, 877 F. Supp. 425, 433 (N.D. Ill. 1995)). While a number of
courts have rejected the "substantial participation" test as inconsistent
with Central Bank's repudiation of aiding-and-abetting liability for
section 10(b), see Anixter v. Home-Stake Production Co., 77 F.3d 1215,
1226 (10th Cir. 1996), we need not address this issue because we affirm
the district court on scienter grounds only. As appellants conceded at
oral argument, if the record cannot plausibly support an inference of
intent to deceive or recklessness on Ernst's part in preparing its 1997
audit, then appellants' section 10(b) claim must fail for the entirety of
the class period, including from October 15, 1997, to December 24,
1997.
13
draw a reasonable inference that Ernst recklessly or
knowingly issued a materially false and misleading audit
opinion after reviewing IKON's 1997 year-end financial
statements.9 While a determination of whether a party acted
with scienter, intertwined as it may be with an assessment
of witness credibility, often cannot be undertaken
appropriately on summary judgment proceedings,10 in this
case, even accepting arguendo that, as appellants assert,
$54.9 million of the $110 million charge taken at the
conclusion of the Special Procedures should have been
recorded as of September 30, 1997, we are satisfied that
the record establishes that Ernst's failure to do so was not
without a good faith belief or reasonable basis.
At the outset, the magnitude of Ernst's audit for fiscal
year 1997 bears mentioning: six full scope audits, including
one performed at IKON's leasing arm, IKON Capital, Inc.;
eight localized audits at IKON business units that
generated 50 percent of its revenues; a host of procedures
performed at IKON's corporate headquarters; full reviews of
previous years' audits; extensive external testing of IKON's
account balances as the primary support for the audit
opinion; work-output totaling 70 percent more than the
hours budgeted to the Northern California district (1,014 as
opposed to 600), where the implementation of a new
computer system impeded review; all told, over 10,000
hours of labor expended on an account to which 8,250
hours originally were budgeted (a 20 percent overall
increase). See J.A. 5447-51 (Mulherin Decl.PP 11, 12, 18,
21, 23); J.A. 4778-82 (workpaper); J.A. 3149, 4803-06
(workpapers); J.A. 3147 (workpaper).
_________________________________________________________________
9. As this litigation is well beyond the pleading stage, appellants
overstate the significance of caselaw suggesting that allegations of
violations of GAAP or GAAS, coupled with allegations of ignoring "red
flags," can be sufficient to withstand a motion to dismiss in a securities
fraud action. See Reply Br. of Appellants at 10-11 (citing, inter alia, In
re
Baan Co. Sec. Litig., 103 F. Supp. 2d 1, 17 (D.D.C. 2000); In re Leslie
Fay Cos., Inc. Sec. Litig., 835 F. Supp. 167, 175 (S.D.N.Y. 1993)).
10. See Hunt v. Cromartie, 526 U.S. 541, 552, 119 S.Ct. 1545, 1552
(1999) ("Credibility determinations, the weighing of the evidence, and the
drawing of legitimate inferences from the facts are jury functions")
(citations and internal quotation marks omitted).
14
It is equally notable that Arthur Andersen, after
conducting its independent review during the Special
Procedures, found nothing that "would be a significant
issue" regarding the quality of Ernst's opinion, and that in
coming to this conclusion Andersen was assessing the work
of a major rival in the national accounting market. See J.A.
3185 (McAleer Dep. 142). Though not performing an
outright audit of the 1997 opinion or financial statements
for compliance with GAAS or GAAP, Andersen allocated
hundreds of hours of labor to its examination of the work
papers produced by Ernst in 1997. See J.A. 3184-85
(McAleer Dep. 138 44). After this examination Andersen
concluded that the "balance sheet was solid" as of
September 30, 1997, and that the computation of reserves
was neither aggressive, nor conservative but rather
"essentially in the middle, solid," and, in fact, concurred in
IKON's decision not to restate the 1997 financial
statements. See J.A. 3185, 3188 (McAleer Dep. 144, 155-
56). One Andersen partner involved in reviewing the 1997
working papers, Thomas Costello, stated that Andersen
became aware of "nothing . . . that was viewed to be a
significant deficiency" with respect to GAAS. See J.A. 3256
(Costello Dep. 208). Likewise, the Chairman of the Audit
Committee for the IKON Board, James R. Birle, indicated
that Andersen did not "find anything fundamentally wrong
with what [Ernst] ha[d] done, so they gave them a passing
grade." See J.A. 3301 (Birle Dep. 113). While appellants are
correct that Andersen's conclusions do not provide cover
categorically to insulate Ernst from liability, 11 the fact that
Andersen endorsed IKON's decision not to restate the 1997
financial statements nevertheless is highly probative of the
competence of Ernst's 1997 audit opinion and undermines
any suggestion that Ernst could not reasonably have
opined that IKON's financial statements fairly presented its
financial condition in accordance with GAAP. See In re
Worlds of Wonder Sec. Litig., 35 F.3d 1407, 1426 (9th Cir.
_________________________________________________________________
11. This is especially so when it is considered that as a condition to
being awarded the contract, Andersen agreed with Ernst, in writing, not
to report to IKON's board if it determined that the 1997 audit did not
comport with accepted auditing standards. See J.A. 1239-40 (Letter to
Arthur Andersen); 3256-67 (Costello Dep. 208-09).
15
1994) (in establishing scienter, "[t]he plaintiff must prove
that . . . the accounting judgments which were made were
such that no reasonable accountant would have made the
same decisions if confronted with the same facts").
We conclude that none of the specific errors appellants
assert raises a material dispute of fact on which to
predicate a finding of scienter. The record makes clear with
respect to appellants' claim that Ernst ignored allegations
that IKON CFO Kurt Dinkelacker ("Dinkelacker") had been
"cooking the books" and supplying fraudulent numbers
during the 1997 audit that Ernst took appropriate steps to
determine whether the allegations had any merit. To begin
with, the alleged accuser, IKON official Peter Shoemaker,
denied under oath that he ever made the remark. See J.A.
2988-91 (Shoemaker Dep. 7-21). Furthermore, George
Berry ("Berry"), the Ernst partner responsible for the IKON
audit, testified that he understood the remark to mean that
Dinkelacker had been accused of characterizing operational
expenses as "transformation expenses." See J.A. 3048
(Berry Dep. 57-58). However, the allegation was deemed
groundless as Ernst just recently had reviewed IKON's
"transformation expenses" and found no improprieties with
regard to the classification of expenses. See J.A. 351 (Nepa
Dep. 10-11). Finally, IKON's top management engaged
outside counsel, two senior partners in the law firm of
Ballard Spahr Andrews & Ingersoll, LLP, to investigate the
allegation; they subsequently found "nothing to the `cooking
the books' allegation." See J.A. 259-60 (Pl. Response to
Ernst's First Set of Requests for Admissions).
Appellants next argue that a trier of fact may make a
finding of scienter from evidence that Ernst deliberately
disregarded a warning from an IKON officer that various
districts were being forced to perform "unnatural acts" and
boost income by manipulating IKON's reserves. Specifically,
in July 1998, Berry received written notice of these
allegations from IKON official Michael Dudek ("Dudek"),
who relayed information that several IKON employees
indicated that they were uncomfortable with certain
accounting directions which they had been receiving from
IKON Corporate. See J.A. 1136 (Dudek Memoranda).
16
A jury could not plausibly infer an extreme departure
from the standards of ordinary care on the basis of this
evidence. First and most significantly, nothing in the record
links the concerns raised late in 1998 regarding the
manipulation of reserves to Ernst's preparation of its audit
opinion in 1997, the only time-period where Ernst's state of
mind is relevant to the section 10(b) claim involved here.
Furthermore, the record establishes that Ernst responded
appropriately to the allegations of misconduct raised in the
Dudek memoranda: Berry ensured that top IKON
management was aware of the allegations, encouraged
IKON to hire an independent counsel to investigate (which
it did - the Philadelphia law firm of Dechert Price &
Rhoads), delivered the Dudek memoranda to the
independent counsel, and incorporated additional steps
into the Special Procedures to review the newly raised
concerns. See J.A. 354-55 (Nepa Dep. 23-28). The mere fact
that Ernst did not conduct its own fraud investigation or
alert its field auditors to the allegations of fraud is not
probative, as the relevant inquiry is bad faith, not judgment.12
See In re Worlds of Wonder, 35 F.3d at 1426-27 ("self-
righteous" assertion that defendant did not conduct an
audit precisely as plaintiffs might have insufficient to
establish fraud); see also Hochfelder, 425 U.S. at 206, 96
S.Ct. at 1387 (Congress did not intend for anyone to be
made liable except for practices "acted other than in good
faith").
_________________________________________________________________
12. Under the AICPA's professional norms, an auditor need conduct its
own investigation after discovering information which relates to
previously evaluated financial statements only if the information existed
at the time of the original report, is deemed reliable, and would have
changed the report previously made. See J.A. 1137-39 (AU S 561,
"Subsequent Discovery of Facts Existing at the Date of the Auditor's
Report," PP .04-.05). Furthermore, AUS 561 advises the auditor to
"discuss the matter with his client at whatever management levels he
deems appropriate, including the board of directors, and request
cooperation in whatever investigation may be necessary." See J.A. 1137
(P .04). Here, Ernst ensured that board members were aware of the
allegations, confirmed that IKON had retained independent investigators
as well as outside accountants, and, in all respects, fully cooperated in
the investigation.
17
In an effort to obtain a reversal of the summary judgment
and secure a jury trial, appellants lay out the following
scenario: Ernst prepared a checklist entitled "Internal
Control and Fraud Considerations" during the planning
stage of the 1997 audit (J.A. 1144-63); the pre-printed, 20-
page checklist details dozens of possible risk factors; Ernst
checked "yes" for the presence of a handful of risk factors,
including, inter alia, "unduly aggressive earnings targets,"
"excessive interest in maintaining or increasing[IKON's]
stock price or earnings trend," and a commitment to
achieving "what appear to be unduly aggressive or
unrealistic forecasts;" these responses, appellants maintain,
demonstrate conclusively that a "significant risk of financial
error existed" and raise a genuine issue of material fact as
to whether Ernst knew that IKON personnel were under
pressure to fake revenues and artificially inflate operating
results.13 See Br. of Appellants at 17, 19.
_________________________________________________________________
13. Appellants also rely on an August 22, 1997 memorandum from
Dinkelacker to suggest Ernst's actual awareness of IKON's fraudulent
scheme to overstate income. The memo, addressed to various IKON
district presidents and corporate officers and entitled "Follow-up on Cash
Generation Initiative and 4Q Forecast," states, in relevant terms, as
follows:
I would like to have a telephone conversation . . . on IKON's
current
cash flow position and the cash results for July. We need to make
every effort to generate significant cash flows for the remainder
of
the year . . . the updated forecast for the fourth quarter [ ] is
not a
pretty picture . . . we must pull out all the stops to achieve 150
million in operating income from the field for the fourth quarter.
IKON can not afford another miss. I would like to discuss certain
opportunities relating to accounts receivable and inventory
valuation
reserves, and I want to ensure that we have an understanding
around other general issues including the propriety of bonus
accruals.
J.A. 1241 (emphasis in original).
However, even accepting appellants' proffered interpretation that the
memo served as an "injunction" or "command" from Dinkelacker to strip
IKON operating units of reserves for doubtful accounts and lease
defaults, see Br. of Appellants at 14-15, insofar as we are aware nothing
in the record suggests that anyone from Ernst was aware of this memo
as of December 24, 1997, when the final audit opinion issued.
18
Appellants fail, however, to explicate that the checklist
contained 98 "no" answers to potential risks or that it was
prepared in the pre-audit planning stages, before Ernst
actually undertook its review of IKON's 1997 financial
statements to appraise the validity of these concerns.
Indeed, the questionnaire itself makes clear that"the
relative importance of risk factors varies among
engagements" such that the form can provide "only a
portion of the understanding about an entity's internal
control" that is required to plan an audit. See J.A. 1144-45.
The simple fact that Ernst identified IKON management's
strong preference for favorable earnings, standing alone,
does not raise an inference of scienter sufficient to survive
a summary judgment motion predicated on the absence of
scienter. See Acito v. Imcera Group, Inc. 47 F.3d 47, 54 (2d
Cir. 1995) (allegation that defendants were motivated to
defraud the public because an inflated stock price would
increase their compensation insufficient because"[i]f
scienter could be pleaded on that basis alone, virtually
every company in the United States that experiences a
downturn in stock price could be forced to defend securities
fraud actions"). In fact, rather than probative of
recklessness, the document tends to corroborate Ernst's
diligence in conducting the 1997 audit, identifying potential
risks at an early stage in accordance with professional
standards. See AU S 316 (1998) (an auditor has a duty to
assess the "risk of material misstatement of financial
statements due to fraud") (quoted in P. Schoenfeld Asset
Mgmt. LLC v. Cendant Corp., 142 F. Supp. 589, 607 (D.N.J.
2001)).
We also reject appellants' argument that scienter credibly
may be inferred from Ernst's reliance on IKON's defective
internal controls.14 While IKON's internal accounting
controls well may have been unreliable during fiscal year
_________________________________________________________________
14. "Internal accounting controls" refers to the mechanism by which
companies monitor their accounting system (their individualized method
of processing transactions) for errors and irregularities in order to
safeguard company assets and ensure that records are sufficiently
reliable. See SEC v. World-Wide Coin Invs., Ltd. , 567 F. Supp. 724, 750
(N.D. Ga. 1983) (citing SEC ruling P No. 82,815, reprinted in 36 Bus.
Law. 3 (April 1981)).
19
1997, the record, except with respect to the fourth quarter,15
does not connect these internal deficiencies to Ernst's
independent, external audit. To the contrary, Ernst adopted
an "effective/not rely" approach during the 1997
year-end audit,16 wherein, after scrutinizing IKON's internal
controls to confirm their effectiveness (and making
recommendations to IKON officers for improvement where
deemed necessary), Ernst nevertheless opted not to defer to
IKON's internal audit findings and processes. See J.A. 627
(Generalized Audit Program Steps, Year Ending Sept. 30,
1997) ("substantive testing without placing reliance on the
related systems is the most efficient way to audit"); see also
J.A. 5450 (Mulherin Decl. PP 17-18) ("[W]e determined that
IKON's overall internal control environment was effective
. . . . However, we would not rely on the testing of controls
as the primary support for our audit opinion. Rather, we
would perform substantive testing -- such as analytical
procedures and tests of details -- to serve as our principal
source of audit evidence"). Absent further evidence
affirmatively linking IKON's internal controls to Ernst's
audit opinion, the record does not raise a genuine issue of
material fact from which a jury could conclude that Ernst
knowingly or blindly adhered to faulty internal controls or
_________________________________________________________________
15. In that quarter, Ernst employed a "roll forward method" that
contemplated some degree of reliance on IKON's internal controls.
Certain location teams performed audit procedures three months prior to
fiscal year-end (June 30, 1997), and then "rolled forward" the results to
fiscal year-end by doing limited testing of account balances and internal
controls for the interim three-month period. See J.A. 5450 (Mulherin
Decl. P 18). Appellants have not specified how Ernst's limited reliance on
IKON's internal accounting processes undermined or otherwise affected
the final audit opinion.
16. Appellants place undue emphasis on the fact that Ernst's 1998
"ineffective/not rely" audit strategy by comparison was far more
effective,
for example, confirming more than 600 accounts receivable in the
Northern California district, as opposed to a sample size of 26 generated
in 1997. See J.A. 1012 (IKON Northern California district, Accounts
Receivable Confirmation, Sept. 30, 1997); 1061 (IKON Northern
California, Trade Accounts Receivable, Sept. 30, 1998). Again, however,
the relevant inquiry for purposes of section 10(b) is recklessness
bordering on an intent to deceive, a finding to which these facts do not
lend support.
20
accounting practices. See Monroe v. Hughes, 31 F.3d 772,
775 (9th Cir. 1994) (deficiencies in internal controls of a
company are immaterial to the audit report itself because
in essence they are matters of which only management
should be aware); Danis v. USN Communications Inc., 121
F. Supp. 2d 1183, 1195 (N.D. Ill. 2000) (without more,
auditor's knowledge about problems in a client's
operational systems could support an inference only of
negligence, not recklessness).
Having failed to present concrete evidence from which a
jury plausibly could conclude that Ernst acted in a reckless
manner, appellants purport to raise a material dispute with
respect to scienter by parsing the 1997 audit for specific
defects as evidence that Ernst acted recklessly with respect
to the 1997 audit as a whole.
However, the discovery of discrete errors after subjecting
an audit to piercing scrutiny post-hoc does not, standing
alone, support a finding of intentional deceit or of
recklessness. See In re Software Toolworks Inc. , 50 F.3d
615, 627 (9th Cir. 1994) ("the mere publication of
inaccurate accounting figures, or a failure to follow GAAP,
without more, does not establish scienter") (citations and
internal quotation marks omitted); SEC v. Price Waterhouse,
797 F. Supp. 1217, 1240 (S.D.N.Y. 1992) (misapplication of
accounting principles by an independent auditor does not
establish scienter). An audit does not guarantee that a
client's accounts and financial statements are correct any
more than a sanguine medical diagnosis guarantees well-
being; indeed, even an audit conducted in strict accordance
with professional standards countenances some degree of
calibration for tolerable error which, on occasion, may
result in a failure to detect a material omission or
misstatement. See AICPA General Standard No. 3 (audit
requires only due professional care) (cited in Vladimir v.
Deloitte & Touche LLP, 1997 WL 151330, at *5 (S.D.N.Y.
Mar. 31, 1997)).
Rather, the "objective of the ordinary examination of
financial statements by the independent auditor is the
expression of an opinion on the fairness with which they
present financial position, results of operations, and
changes in financial position in conformity with generally
21
accepted accounting principles." AU S 110.01 (quoted in
United States v. Weiner, 578 F.2d 757, 786 n.27 (9th Cir.
1978)). In other words, in issuing an opinion, the auditor
certifies only that it exercised appropriate, not flawless,
levels of professional care and judgment. See La Rossa v.
Scientific Design Co., 402 F.2d 937, 943 (3d Cir. 1968)
("Those who hire (experts) are not justified in expecting
infallibility, but can expect only reasonable care and
competence. They purchase service, not insurance.") (citing
Gagne v. Bertran, 275 P.2d 15, 20 (Cal. 1954)).
Thus, to give rise to section 10(b) liability for fraud, the
mere second-guessing of calculations will not suffice;
appellants must show that Ernst's judgment -- at the
moment exercised -- was sufficiently egregious such that a
reasonable accountant reviewing the facts and figures
should have concluded that IKON's financial statements
were misstated and that as a result the public was likely to
be misled. Cf. Denny v. Barber, 576 F.2d 465, 470 (2d Cir.
1978) (rejecting "fraud by hindsight" because the law does
not expect clairvoyance).
Nothing in the record meets this demanding threshold.
For example, appellants assert that Ernst had actual
knowledge of $20.8 million in errors when it rendered its
audit opinion. But they derive this figure from their
singular and fastidious vision as to how the 1997 audit
sensibly should have been conducted. The allegation does
not, however, raise an inference that Ernst harbored an
intent to deceive or exhibited a reckless disregard for the
likelihood of fraud by exercising divergent, but nevertheless
principled, methodologies in auditing IKON's financial
statements.
The tabulation breaks down as follows. First, appellants
contend that the lease default reserve (the amount
maintained to offset unpaid leases that are charged back to
individual marketplaces) in IKON Southern California was
understated by $4.2 million. Appellants derive this figure
by subtracting the recorded reserve rate of 1.8 percent from
the historical lease default rate of 6 percent and applying
the difference (4.2 percent) to the Southern California
portfolio of $99,786,309 million (roughly $4.2 million). See
Br. of Appellants at 22. They point to an internal report, in
22
which Ernst auditors noted the 4.2 percent discrepancy
between default rate and reserve rate, to demonstrate
actual knowledge on the part of Ernst of the shortfall. See
J.A. 4820-25 (Report).
Ernst challenges this calculation for its failure to adjust
for "recoveries," the value of equipment retrieved from any
defaulting lessees or the recovery obtained from defaulting
lessees through settlement, litigation, or otherwise.
Notwithstanding this observation, even were we to accept
the accuracy of appellants' $4.2 million figure, 17 the "error"
falls short of raising a material dispute with respect to
scienter. To begin with, the record reveals that the internal
audit report from which appellants purport to discern
Ernst's culpable state of mind was a draft (marked for
"discussion purposes only") and may not have been
completed by the time Ernst concluded its 1997 audit.18
More importantly, there is no evidence to rebut a
conclusion that Ernst took reasonable steps to ensure the
adequacy of IKON's default reserves overall. 19 Appellants
cannot establish scienter merely by pointing to the $35
million reserve adjustment registered during the Special
Procedures in 1998, without affirmatively linking that
_________________________________________________________________
17. It should be emphasized that IKON-Southern California accounted
for only 2.2 percent of IKON's revenues and 0.7 percent of IKON's assets
for 1997. IKON revenues for 1997 totaled over $5.1 billion. See J.A. 5151
(Press Release).
18. The draft report states that the compliance audit at IKON Southern
California was completed as of October 24, 1997. See J.A. 4820 (Report).
However, Ernst's workpapers suggest that the final audit report for IKON
Southern California was not completed during fiscal 1997. See J.A.
4828-31 (workpapers). Furthermore, Carmen Nepa, Ernst's senior audit
manager, testified that he did not become aware of the internal audit
report for Los Angeles until the first quarter of fiscal 1998, after Ernst
had issued its 1997 opinion. See J.A. 3476 (Nepa Dep. 542-43).
19. See J.A. 3478 (Nepa Dep. 550-51) ("the allowance for lease default
was analyzed on a consolidated basis . . . a difference at one location
would not -- would not matter to me as long as I-- as long as we
concluded the consolidated reserve was adequate"); see also J.A. 4889
(Slack Dep. 52) (vice president of IOS Capital, the financial leasing
subsidiary of IKON, testifying that estimated losses for the lease
portfolio
in 1997 reasonably matched the amount reserved by IKON to account
for defaults).
23
amount to problems known as of September 30, 1997. See
Reply Br. of Appellants at 14.
Appellants emphasize a $2.8 million overstatement in Los
Angeles inventory. However, as Ernst correctly notes, that
figure is predicated on a draft summary of findings for the
Southern California district,20 which detailed a potential
risk of misstatement in the event that inventory
discrepancies remained unresolved. It does not, however,
suggest that Ernst failed to address these concerns before
publication of the audit opinion.21 Quite simply, appellants
fail to explain how Ernst's awareness of discrete inventory
problems in one IKON district is tantamount to scienter, to
a mental state suggesting an intent to conceal IKON's true
financial position from investors or a realistic expectation of
likely public confusion regarding IKON's overall financial
health.
Appellants point next to a "known" $3.6 million shortfall
in questionable receivables that were transferred from IKON
Management Services unit ("IMS") to IKON Document
Services ("IDS"). Appellants allege that Ernst knew of the
"IDS/IMS Bad Debt Reserve" when its field auditors alerted
Ernst personnel in Philadelphia to the fact that IDS did not
maintain a separate reserve for dubious accounts
receivable. See J.A. 315 (Summary Review Memo).
However, quite apart from this warning, nothing in the
record supports the claim that IDS was in fact under-
reserved for 1997 or that Ernst Philadelphia did not take
appropriate steps to evaluate accounts receivable.
Furthermore, as Ernst points out, auditing estimated
_________________________________________________________________
20. The report, generated at the close of fiscal year 1997 by an internal
audit, stated that there was a "need for an adjustment" with respect to
approximately $2.8 million of unreconciled inventory and warned of an
"increased risk of material misstatement" if the inventory issues were not
investigated and resolved. See J.A. 4821 (Report).
21. On the other hand, we are troubled by the fact that Ernst has not
come forward with evidence of affirmative steps taken to resolve the risk.
Though the threshold for scienter is considerable, we are wary to raise
the bar even higher and insulate auditors who craftily choose not to
memorialize confirmed problems or to qualify their observations with
highly equivocal terms like "risk," "potential," and "likelihood."
24
reserves for doubtful accounts is a highly imperfect
undertaking that requires an assessment of the risk that
accounts may be defaulted on. As there is no evidence to
suggest that Ernst's method of predicting collectibilty was
unreasonable or grossly inconsistent with acceptable
accounting practices, there is no basis to conclude that
Ernst fraudulently certified that the reserve for doubtful
accounts in IKON's consolidated financial statements
comported with GAAP.22
_________________________________________________________________
22. There has been substantial debate as to whether IKON accounting
policy is equivalent to GAAP, such that Ernst's deviation from IKON's
internal benchmarks for accounts receivable reserves necessarily would
constitute deviation from GAAP and raise an inference of scienter. We
finally may put that dispute to rest. IKON organized accounts receivable
according to the length of time that an account was outstanding and
fixed the amount of reserves required to cover those accounts (33 1/3
percent of the amount reserved for receivables outstanding 91-150 days,
66 2/3 percent for accounts aged 151-180 days, 100 percent for
amounts aged greater than 180 days). See J.A. 4781 (workpaper). Ernst
claims that it did not adhere strictly to IKON's policy in calculating
adequate reserve amounts because, though useful to IKON in ensuring
uniformity and guaranteeing a minimum reserve level for all districts, it
was inflexible and did not take into account the presence of factors
unique to individual districts. This discrepancy, however, is not
dispositive because IKON's internal accounting standards would not
have yielded the only reserve level acceptable under GAAP. GAAP is a
term of art that encompasses a wide range of acceptable procedures. See
Thor Power Tool Co. v. Comm'r, 439 U.S. 522, 544, 99 S.Ct. 773, 787
(1979) (GAAP "are far from being a canonical set of rules that will ensure
identical accounting treatment of identical transactions . . . . [R]ather,
[they] tolerate a range of `reasonable' treatments, leaving the choice
among alternatives to management"); In re GlenFed, Inc. Sec. Litig., 42
F.3d 1541, 1549 (9th Cir. 1994) (en banc) (as accounting concepts are
flexible, circumstances will give rise to fraud only where differences in
calculations are the result of a falsehood, "not merely the difference
between two permissible judgments"); Godchaux v. Conveying
Techniques, Inc., 846 F.2d 306, 315 (5th Cir. 1988) (a reasonable
accountant may choose to apply any of a variety of acceptable
procedures when preparing a financial statement). As such, the fact that
appellants can demonstrate that Ernst's allowance for doubtful accounts
deviated from IKON's accounting policies does not raise a plausible
inference that Ernst was reckless or intended to publish materially false
information, let alone deviated from GAAP.
25
Appellants assert that Ernst missed approximately $4.0
million in known IDS intercompany balances during the
1997 audit, but the evidence on this point suggests nothing
more than simple error, at best approaching negligence, not
scienter. Approximately $7.3 million in intercompany errors
came to light during the Special Procedures, a figure that
includes the $4.0 million related to IDS and IMS. See J.A.
786-89 (Special Procedures Summary of Adjustments).
Appellants maintain that Ernst "knew" of the imbalance
both from a broad familiarity with IKON's historic problems
with expunging redundant balances and from explicit
written warnings sent to Ernst Philadelphia from Ernst
Houston emphasizing the need to eliminate accounts at
IDS/IMS.
Yet those written warnings contain only a very general
admonition "to ensure intercompany accounts eliminate on
a consolidated basis," and appellants offer no additional
evidence to show that the $4.0 million figure discovered in
1998 corresponds with the imbalance identified by Ernst
Houston in 1997. Moreover, to the extent that Ernst may
have erred in failing to eliminate intercompany assets from
pre-tax earnings, an inference of recklessness or intent to
deceive that otherwise might be drawn cannot survive the
fact that Ernst thoroughly reviewed and tested IKON's
intercompany balances. See J.A. 3489 (Nepa Dep. 593);
J.A. 5262-5289 (workpaper); J.A. 928-29 (October 10, 1997
letter).
Finally, appellants claim that there was a known
misrepresentation of $6.2 million involving the 1997
Summary of Audit Differences ("SAD"), the list documenting
discrepancies between IKON's numbers and Ernst's
conclusions. However, as appellants have acknowledged,
Ernst's failure to require IKON to adjust its financial
statements by $6.2 million is only material when
considered in the context of the $14.6 million in claimed
errors with respect to lease default reserve, inventory,
accounts receivable, and intercompany balances that we
already have addressed. See Br. of Appellants at 27.
Considering that these errors have been discounted,
without some additional evidence insinuating scienter, the
$6.2 million pertaining to the SAD does not supply a basis
to establish scienter.
26
The $31 million in allegedly "reckless" misstatements
appellants charge also cannot be the basis to establish
scienter. First, the allegation that Ernst's failure to
reconcile accounts resulted in a $10.4 million
overstatement does not support a finding of the requisite
scienter.23 The claim that appellants' experts, in retrospect,
would have compared assets against balance sheets on a
monthly basis or that IKON's internal policy called for
monthly reconciliation of accounts payable, accounts
receivable, cash, and inventory, does not illustrate that
Ernst's incongruous auditing tactics were unjustified, let
alone reflected an intent to defraud or rash disregard for
the likelihood of deception.
The balance of allegedly "reckless" errors relate to $20.6
million of shortfalls in accounts receivable reserves.24
Appellants' experts opined that IKON's transformation
initiative seriously impaired account collectibility and,
_________________________________________________________________
23. This figure regarding reconciliations was calculated during the
Special Procedures, one year after Ernst issued its 1997 clean audit
opinion. See J.A. 788-89 (Special Procedures Summary of Adjustments).
24. There has been considerable ambiguity surrounding the $20.6
million figure cited by appellants. Initially, appellants included the
allegedly "known" $3.6 million shortfall in IDS/IMS reserves to arrive at
this figure. See Br. of Appellants at 28; see also Reply Br. of Appellants
at 1; Transcript of Oral Argument at 74 ("[t]hat item would probably also
be included in the 20-plus million dollar account receivable. . . There is
a duplication."). Subsequent to oral argument, appellants submitted a
memorandum on October 16, 2001, in which they now maintain that the
$20.6 million does not double count the $3.6 million shortfall in
IDS/IMS reserves and instead consists of $17,089,000 in inadequate
accounts receivable allowance and $3,234,000 in intercompany accounts
that did not eliminate. Appellants presented similar figures to the
district
court. See 131 F. Supp. 2d at 693 n.3. Nevertheless, in the interest of
fairness, we address the $20.6 million only with respect to shortfalls in
accounts receivable reserves, as Ernst was not presented with an
opportunity to address the $3,234,000 in intercompany accounts that
allegedly were not eliminated. See Dillinger v. Caterpillar, Inc., 959
F.2d
430, 446-47 (3d Cir. 1990). In any event, appellants have not directed us
to portions of the record that suggest recklessness on the part of Ernst
for failing to eliminate the $3.3 million in intercompany balances. To the
contrary, the record suggests that Ernst reconciled intercompany
accounts at the consolidated level. See J.A. 5262 (workpaper).
27
therefore, Ernst should have enforced IKON's more
conservative policy to estimate appropriate reserve
minimums.
However, as discussed previously,25 highlighting different
accounting methodologies that Ernst might have employed
-- particularly in the nebulous context of establishing
reserves for vulnerable accounts -- does not suggest that
the approach actually chosen was an extreme departure
from ordinary care.
For example, appellants point to the fact that IKON
Northern California's deficient computer system could not
properly assess the accounts receivable reserves. Yet the
record confirms that Ernst took reasonable, additional
steps to audit those reserves. In its September 30, 1997
summary review memorandum, Ernst details the host of
problems identified and procedures instituted during the
audit of IKON Northern California. See J.A. 887-893. After
IKON conducted an internal audit of approximately 100
accounts receivable and recommended a reserve of at least
$7 million, Ernst auditors reviewed the work and actually
proposed increased reserves for doubtful accounts
receivable. See J.A. 4802 (showing $5.3 million adjustment
on the Summary of Audit Differences). Indeed, rather than
"stripping" reserves as appellants have maintained, IKON
substantially increased its overall allowance for doubtful
accounts by some $20 million on Ernst's recommendation
in 1997. See J.A. 5292, 5298 (workpapers). Plainly, without
some additional support, the GAAP methodologies advanced
by appellants' experts fall short of transforming Ernst's
estimates of accounts receivable reserves into actionable
fraud.
In short, appellants' citations to the record, like
misshapen jigsaw pieces that collectively fail to reveal the
picture embedded within the puzzle, simply raise no
inference that Ernst opined on IKON's consolidated
financial statements with knowing or reckless disregard for
the truth.26 There is no reasonable basis in the record to
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25. See note 22 supra and accompanying text.
26. We do not suggest, however, that individual defects in an audit could
not, in the aggregate, create an inference of scienter, particularly at
the
28
doubt that Ernst harbored an honest and well-founded
belief in the accuracy of its audit, and, without further
substantiating evidence, a jury may not premise a finding
of willful or knowing conduct to defraud or recklessness
merely by judging between competing but nevertheless
sound accounting methodologies.
2. Loss Causation
As there is no triable issue with respect to scienter,
appellants' prima facie section 10(b) claim fails, and we
need not reach the issue of causation.
III. CONCLUSION
For the foregoing reasons, we will affirm the judgment of
the district court entered February 6, 2001.
A True Copy:
Teste:
Clerk of the United States Court of Appeals
for the Third Circuit
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summary judgment stage. To the contrary, in many cases the most
plausible means to prevail on a section 10(b) claim against an auditor --
without that ever-elusive "smoking gun" document or admission -- will
be to show how specific and not insignificant accounting violations
collectively raise an inference of scienter. We conclude only that the
record before us in this case does not rise to such a level.
29