In posts in this space, and in my articles, I’ve criticized the idea that statements may be deemed immaterial or otherwise of little importance to reasonable investors merely because they are generic or stated at a particular level of generality. Lots of really important statements are technically “generic,” I would say. Consider fairness opinions! Or representations that financial statements are in compliance with GAAP!
Well, joke’s on me because in New England Carpenters’ Guaranteed Annuity and Pension Funds v. DeCarlo, 2023 WL 5419147 (2d Cir. Aug. 23, 2023), the Second Circuit held that the general phrasing in a clean audit opinion may, in fact, render the statements immaterial to investors. The court affirmed the dismissal of a securities fraud complaint on the ground that – even though the plaintiffs had shown the audit was shoddy and violated auditing standards (and the underlying financials were false) – the plaintiffs had not included specific allegations that the audit statements were material.
As the District Court concluded, the Complaint fails to allege any link between BDO’s misstatements in the 2013 Auditor Opinion and the material errors contained in AmTrust’s 2013 Form 10-K. The audit statements to which the Appellants point were so general in this case that a reasonable investor would not depend on them as a guarantee. Appellants’ claim that these statements were knowingly and verifiably false when made does not cure their generality, which is what prevents them from rising to the level of materiality required to form the basis for assessing a potential investment. We do not mean to suggest that audit opinions will always fail the materiality test because the statements they contain are too general for investors to rely on. Rather, in this case, as the District Court held, Appellants have failed “to allege any facts relevant to the way or ways in which BDO’s failure to supervise, review, document, and perform in good faith the 2013 audit would have been significant to a reasonable investor in making investment decisions.” We might have come to a different conclusion had such facts been alleged.
(citations and alterations omitted)
I … do not even know what to do with this.
First of all, audit opinion language is fairly standardized; in this case, the false statements were that the audit was conducted in accordance with PCAOB standards and provided a reasonable basis for the audit opinion.
If you assume that audits matter to investors, then it has to matter that an audit was not performed appropriately; what’s the point of even having an audit, then? And as I keep beating this lonely drum, let’s imagine what would have happened if there was no audit opinion, or if there had been one that told the truth – that the audit was shoddy. (According to the Second Circuit, those are exactly the counterfactuals we should be considering). I think it’s fairly obvious that investors would have considered it significant if a publicly traded company suddenly couldn’t offer up audited financials.
Yet the Second Circuit, taking the whole “generalness” thing to the point of parody, held without further comment that audit opinions may not be material if sufficiently nonspecific – which is all of them, because they all say the same thing – and therefore materiality must be explained.
To some extent, the dispute below – and that the Second Circuit hints at – was not exactly about whether the opinion was material, but about whether the precise audit failures were in fact tied to the underlying false financials. But, rather than really say that, the Second Circuit goes much farther, treating the generalized language of the opinion as a reason to doubt its materiality.
And, frankly, even if it turned out the underlying financials were completely accurate, I still don’t think it would make the audit opinion immaterial; the purpose of the opinion is to give investors confidence in the financials. The financials don’t have to be discounted out of fear of inaccuracy, is what the audit opinion tells you.
So, going forward, either every securities fraud complaint will have to include some standardized language about the importance of audit opinions – and these complaints are already well over 100-pages long, which judges complain about all the time – or somehow, each plaintiff will have to find some reason why this audit in specific was really important to investors in X company. And also, every motion to dismiss will have to include that briefing.
In 1999, Chief Judge Young lamented the “Byzantine pleading code established in recent years by Congress and the courts for securities actions.” In re Number Nine Visual Tech. Corp., 51 F. Supp. 2d 1 (D. Mass. 1999). Twenty four years later, I’d say code pleading is looking at securities fraud complaints and wondering how things got so technical.