Monroe v. Hughes, 92-35306

• Decision Date: 21 July 1994
• Docket Number: No. 92-35306,92-35306
• Citation: 31 F.3d 772
• Parties: , Fed. Sec. L. Rep. P 98,331 James G. MONROE and Penelope E. Monroe, individually and on behalf of all similarly situated persons, Plaintiffs-Appellants, v. Gary C. HUGHES; Thomas R. Hudson; and Deloitte & Touche, fka Deloitte, Haskins & Sells, Defendants-Appellees.
• Court: U.S. Court of Appeals — Ninth Circuit

Page 772

31 F.3d 772

63 USLW 2078, Fed. Sec. L. Rep. P 98,331

James G. MONROE and Penelope E. Monroe, individually and on behalf of all similarly situated persons, Plaintiffs-Appellants, v. Gary C. HUGHES; Thomas R. Hudson; and Deloitte & Touche, fka Deloitte, Haskins & Sells, Defendants-Appellees.

No. 92-35306.

United States Court of Appeals, Ninth Circuit.

Argued and Submitted Aug. 30, 1993.

Decided July 21, 1994.

Karen Kennard, McCutchen, Doyle, Brown & Enersen, San Francisco, CA, and Eric H. Fisher, Associate Gen. Counsel, New York City, for defendant-appellee Deloitte & Touche.

Henry Kantor, Kantor and Sacks, Portland, OR, and Keith E. Tichenor, Pozzi, Wilson, Atchison, O'Leary & Conboy, Portland, OR, for plaintiffs-appellants.

Appeal from the United States District Court for the District of Oregon.

Before: BROWNING, SCHROEDER and HALL, Circuit Judges.

SCHROEDER, Circuit Judge:

In this suit, investors in a failed company allege various Securities Act violations. The defendants include an accounting firm that provided the audit report accompanying the prospectus for the securities purchased by the plaintiffs. The plaintiffs claim that the accountants violated Sec. 11 of the Securities Act of 1933, 15 U.S.C. Sec. 77k, and Sec. 10(b) of the Securities and Exchange Act of 1934, 15 U.S.C. Sec. 78j(b), as well as SEC Rule 10b-5, 17 C.F.R. Sec. 240.10b-5. They also claim violations of Oregon's Blue Sky laws. The district court granted summary judgment for the accounting firm, holding that the complaint and supporting affidavits of plaintiffs do not establish any basis for recovery against the accounting firm under the securities laws. We affirm because we agree with the district court that the record does not disclose any issues of fact concerning whether the defendant's audit report contained material misstatements or omissions.

The plaintiffs-appellants, James and Penelope Monroe, represent a class of investors who purchased debentures offered by Hughes Homes, Inc., a privately owned retailer of manufactured housing based in Tacoma, Washington. Defendant-appellee, Deloitte and Touche, formerly known as Deloitte, Haskins and Sells, served as Hughes' independent auditor for the fiscal years ending June 30, 1987 and June 30, 1988. As part of its 1988 audit, Deloitte reviewed Hughes Homes' system of internal controls, the procedures used by the company to assure the reliability of its financial records, and found them flawed but functional. In September of that year, Deloitte's auditors drafted a letter advising Hughes' management of the internal control weaknesses and conferred with the company's president and chief executive officer, and with the chief financial officer, about the weaknesses. Because the management took several months to respond, however, Deloitte did not issue its final management letter, including the management response, until July 26, 1989. The letter was distributed to Hughes' audit committee at that time.

In the meantime, Deloitte completed its audit and issued an unqualified audit report on September 9, 1988. The report represented that the financial statements of Hughes Homes were in compliance with Generally Accepted Accounting Principles (GAAP), and that Deloitte had conducted the audit according to Generally Accepted Auditing Standards (GAAS). As the district court noted, in drafting the report, Deloitte took into account the weaknesses in the internal controls by adjusting the scope of its audit to perform independent testing in order to verify the accuracy of the company's financial records.

In April, 1989, Hughes Homes, in conjunction with underwriter Paulson Investment Co., issued and sold 3,450 units of convertible subordinated debentures in common stock purchase warrants at $1,000 per unit, for a total of approximately $3.5 million. The prospectus for this sale included Deloitte's 1988 audit report as well as unaudited financial statements for the six-month period from June 30, 1988 through December 31, 1988. Deloitte had reviewed these statements, and the firm provided comfort letters to the underwriters in connection with the unaudited statements. The Monroes were among the purchasers of the debentures.

In May of 1989, Deloitte started field work for its 1989 audit, but soon noted a significant deterioration in the company's internal controls from the previous year. Ultimately Deloitte concluded it would be unable to issue an unqualified audit opinion for 1989 because of the now serious deficiencies in internal controls and because of the company's possible inability to continue as a going concern. Hughes Homes collapsed in the fall of 1989 and plaintiffs lost their investments.

The Monroes filed this action in 1990 against Deloitte and the officers of the company. The district court certified the class and thereafter granted summary judgment in favor of Deloitte. The Monroes appeal that judgment, which was certified pursuant to Federal Rule of Civil Procedure 54(b).

Deloitte's Liability Under Sec. 11

Section 11 of the 1933 Act permits an action against an accountant based on material misstatements or omissions in a registration statement, but only as to those portions of the statement that purport to have been prepared or certified by the accountant. See Herman & MacLean v. Huddleston, 459 U.S. 375, 386 n. 22, 103 S.Ct. 683, 689 n. 22, 74 L.Ed.2d 548 (1983). Although issuers are held strictly liable under Sec. 11 for damages resulting from misrepresentations in a registration statement, an accountant has a due diligence defense; Sec. 11 therefore imposes a negligence standard for an accountant's liability. Ernst & Ernst v. Hochfelder, 425 U.S. 185, 208, 96 S.Ct. 1375, 1388, 47 L.Ed.2d 668 (1976).

We have held that an accountant's good faith compliance with Generally Accepted Accounting Principles and Generally Accepted Auditing Standards discharges the accountant's professional obligation to act with reasonable care. See SEC v. Arthur Young & Co., 590 F.2d 785, 788-89 (9th Cir.1979). A corollary rule, however, is that compliance with GAAP and GAAS do not immunize an accountant who consciously chooses not to disclose on a registration statement a known material fact. Id.

The principal issues in this case are whether Deloitte should have stated in its 1988 audit report that it had found deficiencies in internal controls, and whether its failure to do so was a material omission actionable under Sec. 11. In answering these questions negatively, the district court relied upon standards that have been promulgated by the American Institute of Certified Public Accountants, which is the generally recognized authority in the field. In accordance with those standards, when Deloitte discovered problems with internal controls in its 1988 audit, it performed a limited evaluation of Hughes Homes' internal controls to determine how much reliance it, as the auditor, could place on the controls in performing its audit. See Adams v. Standard Knitting Mills, Inc., 623 F.2d 422, 431 (6th Cir.), cert. denied, 449 U.S. 1067, 101 S.Ct. 795, 66 L.Ed.2d 611 (1980); AICPA, Professional Standards (CCH), AU Secs. 320.52, 642.10. After finding flaws in Hughes' internal controls, Deloitte expanded the scope of its audit by performing independent testing to verify the accuracy of the financial statements in accordance with AU Sec. 320.54; see also AU Sec. 320.52(b).

Deloitte's 1988 auditing team determined that three of the flaws in Hughes' internal controls constituted "reportable conditions." A reportable condition is an internal control weakness that, in the auditor's judgment, represents a "significant deficienc[y] in the design or operation of the internal control structure, which could adversely affect the organization's ability to record, process, summarize, and report financial data consistent with the assertions of management in the financial statements." AU Sec. 325.02. AICPA standards not yet in effect at the time of the audit require such conditions to be reported to the audit committee of the client.

Deloitte reported these conditions to Hughes' management and audit committee in accordance with the standards not yet in effect. Because the parties raise no genuine issue as to these facts, the district court correctly held that Deloitte followed applicable accounting standards and that its certifications to that effect in the audit report were correct.

Appellants, nevertheless, contend that the control deficiencies should have been noted on the audit report. Neither applicable professional standards, nor any legal authority of which we are aware, however, treat deficiencies in internal controls of a company as material to the audit report itself. Such deficiencies are reported to management because they represent matters of which management should be cognizant. Adams, 623 F.2d at 431 (primary function of internal controls is to signal to auditor the extent to which the auditor must test a client's records); see generally, S.E.C. v. World-Wide Coin Invs., Ltd., 567 F.Supp. 724, 750 (N.D.Ga.1983). We...