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IN RE WORLDCOM

January 18, 2005.

IN RE WORLDCOM, INC. SECURITIES LITIGATION. This Document Relates to: ALL ACTIONS.


The opinion of the court was delivered by: DENISE COTE, District Judge

OPINION AND ORDER

On March 24, 2000, Arthur Andersen LLP ("Andersen") certified that the financial statements of WorldCom, Inc. ("WorldCom") "present fairly, in all material respects, the financial position of WorldCom, Inc. and subsidiaries as of December 31, 1999." It made parallel certifications on March 30, 2001, and March 7, 2002, for the WorldCom financial statements for fiscal years 2000 and 2001. Because of these certifications, Andersen faces claims in this securities class action under both the Securities Act of 1933 ("Securities Act"), which has a strict liability standard, and the Securities Exchange Act of 1934 ("Exchange Act"), whose fraud provision requires the plaintiff to prove that Andersen acted with scienter.

  Following the close of discovery, Andersen has moved for partial summary judgment. It asserts that there is insufficient evidence that the 1999 WorldCom financial statements were materially false. With respect to the 1999 audit only and relying principally on the report of its expert, it also asks for summary judgment on its due diligence defense, arguing that it has established that its conduct of the audit for that year conformed with Generally Accepted Auditing Standards ("GAAS"). Finally, it asserts that there is no evidence that it acted with scienter with respect to its audit of any of these three financial statements and that judgment should be entered in its favor on the Exchange Act claim. For the following reasons, the motion for partial summary judgment is denied. Background

  WorldCom announced on June 25, 2002, that as a result of an internal audit of its capital expenditure accounting, it had determined that its financial statements for 2001 and the first quarter of 2002 were not issued in conformity with Generally Accepted Accounting Principles ("GAAP"). On July 21, WorldCom filed for bankruptcy. Upon emerging from bankruptcy earlier this year, WorldCom restated its financial statements for 2000 and 2001 ("Restatement"), with approximately $76 billion in adjustments. Andersen has withdrawn its audit opinion for the 2001 WorldCom financial statements, but not for the 1999 or 2000 WorldCom financial statements.

  Securities litigation over WorldCom's financial statements began in 2002, even before the dramatic June 25 announcement. The class action litigation was consolidated on August 15, 2002, and the New York State Common Retirement Fund was appointed lead plaintiff ("Lead Plaintiff"). The class action litigation and the actions filed on behalf of individual plaintiffs ("Individual Actions") were consolidated on December 23, 2002, see In re WorldCom, Inc. Sec. Litig., No. 02 Civ. 3288 (DLC), 2002 WL 31867720 (S.D.N.Y. Dec. 23, 2002), and are collectively referred to as the Securities Litigation. The WorldCom civil litigation pending in federal courts across the nation has been transferred to this Court by the Judicial Panel on Multi-District Litigation.

  The defendants in the consolidated class action include former WorldCom executives Bernard J. Ebbers ("Ebbers") and Scott Sullivan ("Sullivan"), the company's CEO and CFO, respectively; WorldCom directors; the investment banks that underwrote two large WorldCom bond offerings in 2000 and 2001 ("Underwriter Defendants"); Citigroup, Inc., Citigroup Global Markets Inc. f/k/a Salomon Smith Barney Inc. ("SSB") and Jack B. Grubman (collectively "Citigroup Defendants"), who are alleged to be responsible for the issuance of misleading analyst reports urging investors to buy WorldCom securities;*fn1 and WorldCom's long-term outside auditor, Andersen. The motions to dismiss the claims against most of the defendants were largely denied in May 2003. See In re WorldCom, Inc. Sec. Litig., 294 F. Supp. 2d 392 (S.D.N.Y. 2003). The motion to dismiss the claims against Andersen and certain Andersen affiliates and partners was granted in part in June 2003. See In re WorldCom, Inc. Sec. Litig., No. 02 Civ. 3288 (DLC), 2003 WL 21488087 (S.D.N.Y. June 25, 2003). As a result of the latter Opinion, the claims against the Andersen affiliates and partners were dismissed.

  The class action complaint names Andersen in a Securities Act Section 11 claim based on its 1999 and 2000 audits. This claim seeks damages in connection with the WorldCom May 2000 bond offering ("2000 Offering") and the WorldCom May 2001 bond offering ("2001 Offering"). The 2000 Offering was for $5 billion; the 2001 Offering was for $11.9 billion and was the largest public debt offering in United States history. WorldCom's audited financial statements for the year ending December 31, 1999 were incorporated by reference into the registration statement for the first of the two offerings, as was Andersen's certification of those financial statements. Its certification of the financial statements for the year ending December 31, 2000 was incorporated by reference into the registration statement for the 2001 Offering. Andersen is also named in an Exchange Act Section 10(b) claim for its audits of the 1999, 2000, and 2001 financial statements.

  The class was certified on October 24, 2003. See In re WorldCom, Inc. Sec. Litig., 219 F.R.D. 267 (S.D.N.Y. 2003). Fact discovery in the Securities Litigation ended on July 9, 2004.*fn2 On December 15, the summary judgment motion filed by the Underwriter Defendants was largely denied. See In re WorldCom, Inc. Sec. Litig., ___ F. Supp. 2d ___, No. 02 Civ. 3288 (DLC), 2004 WL 2924601, at *1 (S.D.N.Y. Dec. 15, 2004). The class action trial begins on February 28, 2005.

  The following facts are either undisputed, or as shown by the Lead Plaintiff, unless otherwise indicated. These facts, which are drawn from the parties' substantial submissions, provide background to the legal discussion that follows. Included with this background material is a description of GAAS and the audit process.

  Line Cost Fraud

  WorldCom was a telecommunications company that grew through the acquisition of other companies. By 1998, and through its acquisition of MCI Communications ("MCI"), it became the second largest telecommunications company in the world. By the late 1990s, it faced intense competition due to regulatory and technological changes. See id. at *5.

  To improve the reporting of its financial results, senior management of WorldCom began an illegal manipulation of the public reporting of the company's line costs in the first quarter of 2001 by shifting a portion of them to capital expenditures accounts. Line costs are the costs incurred by WorldCom for the transmission of voice and data over other carriers' networks and were WorldCom's single largest operating expense. Because of their importance as a signifier of WorldCom's financial health, WorldCom's line costs were separately reported as a line item on its financial statements. In carrying out their scheme, WorldCom management would review the financial results toward the end of each quarter and decide how much to shift. The capitalization of line costs was a violation of GAAP and was criminal. See id. at *7.

  The improper capitalization continued through the first quarter of 2002 until the fraud was uncovered by WorldCom's internal audit department. During a meeting on May 21, the WorldCom director in charge of tracking capital expenditures used the term "prepaid capacity" to explain the difference between two sets of schedules that he was being shown. Unfamiliar with that term, the internal audit group asked more questions of several people, but got no satisfactory answers. Using a new software tool, the internal audit group then uncovered the transfer of line costs to capital accounts in a matter of hours. On June 17, WorldCom's controller admitted that there was no support for the transfers. See id. at *9.

  WorldCom actively concealed the line cost capitalization scheme from Andersen. For instance, on August 16, 2001, Andersen advised WorldCom that it would be testing WorldCom's capital expenditure process. On August 22, one of the conspirators ordered the transfer of $544 million of line costs, which had been capitalized after the first quarter of 2001, out of the account in which they had been placed and into ten newly created fixed-asset accounts, which were classified as fiber-optic cable.

  Andersen has also offered evidence that long before the illegal capitalization of line costs began in 2001, WorldCom management acted to conceal its accounting practices from auditors, presumably including Andersen. In October 1999, a member of WorldCom's Financial Planning Department created a cash report that tried to tie WorldCom's accrual accounting back to its cash accounting. His report could not connect the two sets of figures, and he was given a one page list of adjusting entries that were done at such a "high level" that he couldn't make any sense of it. The employee went to Buddy Yates, the Director of General Accounting, and told him that he needed to understand the one page list of adjusting entries better. Yates said, "if you show that . . . piece of paper to our auditors, I'll throw you out that . . . window."

  Although all parties agree that the capitalization of line costs was illegal, the Lead Plaintiff contends that the WorldCom financial statements from 1999 onward contained material misstatements designed to inflate the reporting of revenue. As a consequence, Andersen's annual audits for the years 1999 through 2001 are each at issue in this litigation.

  GAAS and the Audit Process

  Through financial reporting, businesses provide information that is intended to be useful to investors, creditors, and others who must make rational decisions about the company but who do not have access to the internal records of the company. Because outsiders are expected to rely on financial statements, the statements are to be presented in a way that is comprehensible to an informed and careful reader. The overarching goal of financial reporting is

 
to provide information that is useful to present and potential investors and creditors and other users in making rational investment, credit, and similar decisions. The information should be comprehensible to those who have a reasonable understanding of business and economic activities and are willing to study the information with reasonable diligence.
Financial Accounting Standards Board ("FASB"), Statement of Financial Accounting Concepts No. 1 (1978).*fn3 In order to make accounting information useful, preparers must aim to make the information reliable, truthful, verifiable, and most importantly understandable. FASB, Statement of Financial Accounting Concepts No. 2 (1980).

  Financial statements are to be prepared by a company in accordance with GAAP. There are "19 different GAAP sources." Shalala v. Guernsey Mem'l Hosp., 514 U.S. 87, 101 (1995). When a conflict among these sources arises, "the accountant is directed to consult an elaborate hierarchy of GAAP sources to determine which treatment to follow." Id. The "single unified purpose" of GAAP is "to increase investor confidence by ensuring transparency and accuracy in financial reporting." In re Global Crossing, Ltd. Sec. Litig., 322 F. Supp. 2d 319, 339 (S.D.N.Y. 2004).

  As the Supreme Court has noted,
GAAP is not the lucid or encyclopedic set of preexisting rules that [it might be perceived] to be. Far from a single-source accounting rulebook, GAAP encompasses the conventions, rules, and procedures that define accepted accounting practice at a particular point in time. GAAP changes and, even at any one point, is often indeterminate. The determination that a particular accounting principle is generally accepted may be difficult because no single source exists for all principles.
Guernsey Mem'l Hosp., 514 U.S. at 100 (citation omitted). Indeed, GAAP "tolerate[s] a range of `reasonable' treatments, leaving the choice among alternatives to management." Thor Power Tool Co. v. Comm'r, 439 U.S. 522, 544 (1979); see also In re Ikon Office Solutions, Inc. Sec. Litig., 277 F.3d 658, 675 (3d Cir. 2002). Although financial accounting is a "process that involves continuous judgments and estimates," it nevertheless has "as its foundation the principle of conservatism, with its corollary that possible errors in measurement should be in the direction of understatement rather than overstatement of net income and net assets." Guernsey Mem'l Hosp., 514 U.S. at 100 (citation omitted).
  It is the task of the auditor to "ensure, within the parameters of the audit letter, that accounts comply with sound accounting practice. The accountant's duty is to do this regardless of pressure from managers to present the company's financial status as favorably as they can." AUSA Life Ins. Co. v. Ernst and Young, 206 F.3d 202, 228 (2d Cir. 2000) (Jacobs, J., concurring). In conducting an audit, an auditor must follow the standards that constitute GAAS. The American Institute of Certified Public Accountants ("AICPA") is the author of the ten GAAS standards. See Codification of Accounting Standards and Procedures, Statement on Auditing Standards No. 1, § 150 (American Inst. of Certified Pub. Accountants 2001).*fn4 These ten standards are divided among three categories: General Standards, Standards of Field Work, and Standards of Reporting. Compliance with GAAS is mandatory. AU § 161.01. Those of particular importance to this litigation include:
— General Standard 2: "In all matters relating to the assignment, an independence in mental attitude is to be maintained by the auditor or auditors." — General Standard 3: "Due professional care is to be exercised in the performance of the audit and the preparation of the report."
— Standard of Field Work 2: "A sufficient understanding of internal control is to be obtained to plan the audit and to determine the nature, timing, and extent of tests to be performed."
— Standard of Field Work 3: "Sufficient competent evidential matter is to be obtained through inspection, observation, inquiries, and confirmations to afford a reasonable basis for an opinion regarding the financial statements under audit."
AU § 150.02.

  In addition to the ten standards that comprise GAAS, the AICPA's Auditing Standards Board has also developed Statements on Auditing Standards ("Statements"), which serve as "interpretations of generally accepted auditing standards." AU § 100; see also Vladimir v. Deloitte & Touche LLP, No. 95 Civ. 10319 (RPP), 1997 U.S. Dist. LEXIS 3823, at *14 n. 6 (S.D.N.Y. Mar. 28, 1997). These Statements are set forth in a several-hundred page volume, and although they are not intended to be as authoritative as a pronouncement by the Auditing Standards Board, the AICPA "requires that members be prepared to justify departures from such Statements." AU § 100. Several of the Statements are of particular importance to this litigation.

  First, GAAS is concerned with the reliable presentation of a company's financial position as a whole. The objective of an audit is to express an opinion on the fairness, in all material respects, with which a company's financial statements present the financial position, results of operations, and cash flows of the company in conformity with GAAP.*fn5 When an auditor represents that a company's financial statements conform, in all material respects, with GAAP, the auditor "indicates [his] belief that the financial statements taken as a whole are not materially misstated." AU § 312.03 (emphasis supplied).*fn6 Indeed, "[f]inancial statements are materially misstated when they contain misstatements whose effect, individually or in the aggregate, is important enough to cause them not to be presented fairly, in all material respects, in conformity with [GAAP]." AU § 312.04 (emphasis supplied). The Statements elaborate on the requirement in General Standard 2 that an auditor maintain independence in attitude. According to the AICPA, an auditor

 
must be without bias with respect to the client since otherwise he would lack that impartiality necessary for the dependability of his findings, however excellent his technical proficiency may be. However, independence does not imply the attitude of a prosecutor but rather a judicial impartiality that recognizes an obligation for fairness not only to management and owners of a business but also to creditors and those who may otherwise rely (in part, at least) upon the independent auditor's report, as in the case of prospective owners or creditors.
AU § 220.02 (emphasis supplied). The auditor, in exercising due professional care, must also employ "professional skepticism," through which "the auditor neither assumes that management is dishonest nor assumes unquestioned honesty. In exercising professional skepticism, the auditor should not be satisfied with less than persuasive evidence because of a belief that management is honest." AU § 230.09 (emphasis supplied).

  The Statements also provide guidance on how to plan for an audit, which necessitates "developing an overall strategy for the expected conduct and scope of the audit," AU § 311.03, and on how to assess risk as part of that preparation. As the auditor plans an audit, she must assess the risk of material misstatements, taking into account the nature and extent of the company's internal control, and "should specifically assess the risk of material misstatement of the financial statements due to fraud." AU § 312.16. In conducting this latter assessment, the auditor should consider risk factors connected with misstatements from fraudulent financial reporting, such as whether management displays "[a]n excessive interest . . . in maintaining or increasing the entity's stock price or earnings trend through the use of unusually aggressive accounting practices," whether there are "[f]ormal or informal restrictions on the auditor that inappropriately limit his or her access to people or information," whether the company reports "assets, liabilities, revenues, or expenses based on significant estimates that involve unusually subjective judgments or uncertainties," and whether the company is facing "[s]ignificant pressure to obtain additional capital necessary to stay competitive considering the financial position of the entity." AU § 316.17.

  Where an auditor determines that there is a "significant risk of material misstatement of the financial statements," whether due to fraud or other causes, this determination should inform "the nature, timing, or extent of procedures; assigning staff; or requiring appropriate levels of supervision." AU § 312.17. Where higher risk is perceived to exist, for example, the auditor may need "to expand the extent of procedures applied, apply procedures closer to or as of year end, particularly in critical audit areas, or modify the nature of procedures to obtain more persuasive evidence." Id.

  Once the auditor has adequately planned for the audit and begins her work, she must obtain and evaluate "sufficient competent" evidence to prove or disprove the financial statements prepared by a company and management's representations about the company and its performance. AU § 326.01. According to the Statements, Evidential matter supporting the financial statements consists of the underlying accounting data and all corroborating information available to the auditor.

 
The books of original entry, the general and subsidiary ledgers, related accounting manuals, and records such as work sheets and spreadsheets supporting cost allocations, computations, and reconciliations all constitute evidence in support of the financial statements. These accounting data are often in electronic form. Accounting data alone cannot be considered sufficient support for financial statements; on the other hand, without adequate attention to the propriety and accuracy of the underlying accounting data, an opinion on financial statements would not be warranted.
AU § 326.15-16.

  The Statements make clear that while "representations from management are part of the evidential matter the independent auditor obtains, . . . they are not a substitute for the application of those auditing procedures necessary to afford a reasonable basis for an opinion regarding the financial statements under audit." AU § 333.02. Significantly, where a representation by management conflicts with other audit evidence, "the auditor should investigate the circumstances and consider the reliability of the representation made." AU § 333.04.

  Since examining every transaction is impossible, an auditor examines supporting evidence through "selective testing." AU § 230.11. Nevertheless, an auditor always has the responsibility to "plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud." AU § 110.02. Given this, a GAAS-compliant audit operates as "a cumulative process; as the auditor performs planning auditing procedures, the evidence obtained may cause him or her to modify the nature, timing, and extent of other planned procedures." AU § 312.33.

  GAAS compliance is imperative. Nonetheless, both parties agree that there are different methodologies for conducting a GAAS-compliant audit. The traditional model is based on substantive auditing procedures; an alternative is a risk-based or control-based audit approach in which the auditor identifies areas of ...


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