United States District Court, S.D. New York
November 28, 2014
IN RE OSG SECURITIES LITIGATION
For Lead Plaintiffs: Samuel H. Rudman, Esq., David A. Rosenfeld, Esq., Mark T. Millkey, Esq., Christopher M. Barrett, Esq., Robbins Geller Rudman & Dowd LLP, Melville, NY.
For Defendant Price WaterhouseCoopers LLP: Miles N. Ruthberg. Esq., Jamie L. Wine, Esq., Kevin M. McDonough, Esq., Latham & Watkins LLP, New York, NY.
For Defendant Ernst & Young: Stanley J. Parzen, Esq., Dana S. Douglas, Esq., Mayer Brown LLP (Chicago), Chicago, IL.
For Defendant Overseas Shipholding Group, Inc.: Lewis J. Liman, Esq., Elizabeth Vicens, Esq., Cleary Gottlieb Steen & Hamilton, LLP, New York, NY.
For Defendant Morten Arntzen: Scott B. Schreiber, Esq., Craig A. Stewart, Esq., Arnold & Porter, Thurman Arnold Building, Washington, DC.
For Defendant Myles R. Itkin: David H. Kistenbroker, Esq., Joni S. Jacobsen, Esq., Ashley J. Burden, Esq., Neil A. Steiner, Esq., Dechert LLP, Chicago, IL.
For Consolidated Defendants Alan R. Batkin, Thomas P. Coleman, Charles A. Fribourg, Stanley Komaroff, Solomon N. Merkin, Joel I. Picket, Ariel Recanati, Oudi Recanati, Thomas F. Robards, Jean-Paul Vettier, Michael J. Zimmerman: Richard A. Rosen, Esq., Paul, Weiss, Rifkind, Wharton & Garrison LLP, New York, NY.
For Consolidated Defendants Citigroup Global Markets Inc, Deutsche Bank Securities Inc., Goldman, Sachs & Co., HSBC Securities (USA) Inc., ING Financial Markets, LLC, Morgan Stanley & Co. LLC (f/k/a Morgan Stanley & Co. Incorporated), DNB Markets, Inc. (f/k/a DnB NOR Markets, Inc.): Adam Selim Hakki, Esq., Daniel Hector Rees Laguardia, Esq., Stuart Jay Baskin, Esq., Shearman & Sterling LLP, New York, NY.
MEMORANDUM OPINION AND ORDER
Shira A. Scheindlin, United States District Judge.
On October 20, 2014, plaintiffs moved for leave to file a fourth amended complaint. The purpose of the amendment is to add fraud claims against the auditor defendants -- PriceWaterhouseCoopers (" PwC" ) and Ernst & Young (" E& Y" ) -- who, under the current complaint, face only negligence claims. According to plaintiffs, discovery of PwC's and E& Y's work papers has elicited new facts -- facts that plausibly give rise to an inference that PwC and E& Y performed, in effect, " no audit at all."  For the reasons set forth below, I disagree. The 10(b) claims against the auditor defendants fail as a matter of law, and plaintiffs' motion for leave to amend is therefore DENIED.
II. STANDARD OF REVIEW
Leave to amend a pleading " shall be freely given when justice so requires."  Such leave is not warranted, however, if " the  amendment [would be] futile,"  which is true insofar as " the proposed claim could not withstand a motion to dismiss pursuant to Rule 12(b)(6)." 
III. APPLICABLE LAW
The securities laws set forth two different grounds of auditor liability.
First, under section 11, auditors can be liable if they " prepare or certif[y] any report or valuation which is used in connection with [a] registration statement" that turns out to be false or misleading. To make out a prima facie section 11 claim, " [a] plaintiff need only plead a material misstatement or omission in the registration statement."  But the statute also provides a good faith defense for auditors who show that, after reasonable investigation, they honestly and reasonably believed that the certified portions of the registration statement were free of material misstatements or omissions.
Second, auditors can also be liable -- alongside the company and its officers -- under section 10(b). Because section 10(b) claims are fraud claims, they require a showing of scienter. Although " outside auditor[s]," unlike company insiders, " will typically not have an apparent motive to commit fraud,"  the scienter requirement can still be satisfied by showing that an outside auditor acted recklessly. In this setting, recklessness is defined as behavior that " represent[s] an extreme departure from the standards of ordinary care"  -- to an extent that " approximate[s] an actual intent to aid in the fraud being perpetrated by the audited company."  In other words, to satisfy the recklessness requirement, a plaintiff must show that " '[t]he accounting practices were so deficient that the audit amounted to no audit at all, or [to] an egregious refusal to see the obvious." '
On September 10, 2013, I ruled that plaintiffs have successfully pleaded section 11 claims against PwC and E& Y. Now, after reviewing PwC's and E& Y's work papers, plaintiffs seek to add section 10(b) claims, because they believe it is plausible to infer that the auditor defendants were not just negligent but were also reckless. Specifically, plaintiffs point to tax opinions prepared by third-party CPA Frankel, Loughran, Starr & Vallone LLP (" Frankel" ), which incorrectly assessed OSG's section 956 liability, and which -- according to plaintiffs -- the auditor defendants simply assumed to be true, without conducting an independent investigation. In light of this discovery, plaintiffs argue that it would be possible for a fact-finder to conclude that the auditor defendants, in effect, performed no audit at all.
As outside auditors, PwC and E& Y were certainly obligated to investigate representations made by OSG management. The crux of plaintiffs' argument is that the Frankel opinions, because they were included in the company's audit file, should have been treated as representations made by OSG management. If that is true, plaintiffs argue that PwC and E& Y flouted their investigatory obligations -- and whether this amounted to fraud, or only to negligence, is a factual question that plaintiffs should be able to litigate.
For plaintiffs' legal theory to prevail, two premises must be true. First, the auditor defendants' failure to investigate the representations of section 956 liability set out in the Frankel opinions must be sufficient, by itself, to sustain a claim of recklessness. In other words, even if nothing else in their audit was reckless, the auditor defendants might have acted recklessly solely by failing to investigate the section 956 issue. Second, the Frankel opinions must be indistinguishable, for the purpose of assessing the auditor defendants' duties, from tax opinions prepared by OSG management.
The second premise does not withstand scrutiny. Plaintiffs have cited no case -- nor have I been able to locate any -- that supports the proposition that " a tax preparer's analysis, independently done ... is no different [than] if it came from management itself."  Indeed, the only even analogous authority in the Second Circuit cuts the other way. In Oleck v. Fischer, the court held it was reasonable for an outside auditor to rely on an advisory bankruptcy opinion obtained by the company from outside counsel and furnished by the company to the auditor -- i.e., the auditor was under no duty to look past the representations of outside counsel.
Oleck is directly relevant to the instant case. And its result speaks to the relationship between company insiders and outside advisors. The reason auditors are required to investigate in-house representations -- indeed,
the reason why 10(b) 5) violations occur -- is that managers often have an incentive to distort. There is little reason to think that third-party tax preparers, operating at arm's length from the company, share this propensity. If anything, they have the opposite incentive, because they owe their clients a duty of care, and they face potential liability (unconnected to securities fraud) for performing erroneous calculations.
Furthermore, the specific issue addressed in the Frankel opinions -- the meaning of section 956 -- is notoriously esoteric, even among tax lawyers. It is one thing to say that PwC and E& Y should have done more to discover the misstatements of tax liability. That may be true. But it is quite another thing to say that PwC and E& Y, by relying on the representations of a third-party with (1) every incentive to be truthful and (2) expertise in an abstruse area of tax law, " egregious[ly] refus[ ed] to see the obvious"  -- much less that they acted with an intent that " approximates an actual intent to aid in the fraud being perpetrated."  That assertion strains credulity.
Because the section 10(b) claim against the auditor defendants is deficient as a
matter of law, leave to amend would be futile. Therefore, plaintiffs' motion is DENIED. The Clerk of the Court is directed to close Dkt. No. 173.