Public Employees' Retirement Ass'n v. Deloitte & Touche LLP

PUBLISHED

UNITED STATES COURT OF APPEALS

FOR THE FOURTH CIRCUIT

PUBLIC EMPLOYEES’ RETIREMENT 

ASSOCIATION OF COLORADO; GENERIC

TRADING OF PHILADELPHIA, L.L.C.,

Plaintiffs-Appellants,

v.  No. 07-1704

DELOITTE & TOUCHE LLP;

DELOITTE & TOUCHE ACCOUNTANTS,

Defendants-Appellees.



Appeal from the United States District Court

for the District of Maryland, at Baltimore.

Catherine C. Blake, District Judge.

(1:03-md-01539-CCB; 1:03-cv-01825-CCB)

Argued: October 28, 2008

Decided: January 5, 2009

Before WILKINSON and AGEE, Circuit Judges, and

John T. COPENHAVER, JR., United States District Judge

for the Southern District of West Virginia,

sitting by designation.

Affirmed by published opinion. Judge Wilkinson wrote the

opinion, in which Judge Agee and Judge Copenhaver joined.

COUNSEL

ARGUED: Andrew John Entwistle, ENTWISTLE & CAP-

PUCCI, L.L.P., New York, New York, for Appellants. Daniel

2 PUBLIC EMPLOYEES’ RETIREMENT v. DELOITTE & TOUCHE

F. Kolb, DAVIS, POLK & WARDWELL, New York, New

York; John T. Behrendt, GIBSON, DUNN & CRUTCHER,

L.L.P., New York, New York, for Appellees. ON BRIEF:

Johnston de F. Whitman, Jr., Richard W. Gonnello, Jordan A.

Cortez, ENTWISTLE & CAPPUCCI, L.L.P., New York,

New York; ADELBERG, RUDOW, DORF & HENDLER,

L.L.C., Baltimore, Maryland, for Appellants. Marshall R.

King, Lee G. Dunst, LaShann M. DeArcy, GIBSON, DUNN

& CRUTCHER, L.L.P., New York, New York, Daniel F.

Goldstein, BROWN, GOLDSTEIN & LEVY, L.L.P., Balti-

more, Maryland, for Appellee Deloitte & Touche Accoun-

tants; Sharon Katz, Jane Alexandra Small, Joshua D. Liston,

DAVIS, POLK & WARDWELL, New York, New York, Max

H. Lauten, KRAMON & GRAHAM, P.A., Baltimore, Mary-

land, for Appellee Deloitte & Touche LLP.

OPINION

WILKINSON, Circuit Judge:

This class action securities fraud lawsuit arises out of

improper accounting by Royal Ahold, N.V., a Dutch corpora-

tion, and U.S. Foodservice, Inc. ("USF"), a Maryland-based

Ahold subsidiary. The misconduct of Ahold and USF is not

disputed in this appeal; at issue is the liability of Ahold’s

accountants, Deloitte & Touche LLP ("Deloitte U.S.") and

Deloitte & Touche Accountants ("Deloitte Netherlands"), for

their alleged role in the fraud perpetrated by Ahold and USF.

Under the Private Securities Litigation Reform Act

("PSLRA"), Pub. L. No. 104-67, 109 Stat. 737, plaintiffs must

plead facts alleging a "strong inference" that the defendants

acted with the required scienter. As recently explained by the

Supreme Court in Tellabs, Inc. v. Makor Issues & Rights,

Ltd., 127 S. Ct. 2499 (2007), a strong inference "must be

more than merely plausible or reasonable — it must be cogent

and at least as compelling as any opposing inference of non-

PUBLIC EMPLOYEES’ RETIREMENT v. DELOITTE & TOUCHE 3

fraudulent intent." Id. at 2504-05. Because we find the infer-

ence that the Deloitte defendants lacked the necessary scienter

more compelling than any competing inference that they

knowingly or recklessly perpetrated a fraud on Ahold’s inves-

tors, we affirm the district court’s judgment that plaintiffs’

motion for leave to file a second proposed amended complaint

was futile.

I.

Ahold owns and operates grocery stores and food service

companies in the United States and other countries. Deloitte

U.S. is an American accounting firm that audited Ahold’s

American subsidiaries and acted as a filing reviewer for

Ahold’s filings with the Securities and Exchange Commission

("SEC"). Deloitte Netherlands is a Dutch accounting firm that

served as Ahold’s outside auditor. Although they work

closely together, the two Deloittes are legally distinct entities.

Beginning in the 1990s, and continuing until 2003, Ahold

perpetrated two frauds that led it to significantly overstate its

earnings on financial reports. First, Ahold improperly "con-

solidated" the revenue from a number of joint ventures with

supermarket operators in Europe and Latin America ("the JV

fraud"). That is, for accounting purposes Ahold treated these

joint ventures as if it fully controlled them — and thus treated

all revenue from the ventures as revenue to Ahold — when

in fact Ahold did not have a controlling stake. Under Dutch

and U.S. generally accepted accounting principles (GAAP),

Ahold should only have consolidated the revenue proportion-

ally to Ahold’s stake in the ventures.

Second, USF falsely reported its income from promotional

allowances ("the PA fraud"). Also known as vendor rebates,

promotional allowances ("PAs") are payments or discounts

that manufacturers and vendors provide to retailers like USF

in order to encourage the retailers to promote the manufactur-

ers’ products. In order to increase its stated income, USF pre-

4 PUBLIC EMPLOYEES’ RETIREMENT v. DELOITTE & TOUCHE

maturely recognized income from PAs and inflated its

reported PA income beyond amounts actually received.

On February 24, 2003, Ahold announced that its earnings

for fiscal years 2001 and 2002 had been overstated by at least

$500 million as a result of the fraudulent accounting for pro-

motional allowances at USF and that Ahold would be restat-

ing revenues because it would cease treating the joint ventures

as fully consolidated. After this announcement, Ahold com-

mon stock trading on the Euronext stock exchange and Ahold

American Depository Receipts trading on the New York

Stock Exchange lost more than 60% of their value. Subse-

quent to the February 2003 announcement, Ahold made fur-

ther restatements to its earnings totaling $24.8 billion in

revenues and approximately $1.1 billion in net income.

As a result of the frauds, the SEC filed civil enforcement

actions against Ahold and several individual defendants. Sep-

arately, twenty-one private class action securities and ERISA

actions were filed against Ahold, both Deloittes, and other

defendants. On June 18, 2003, the Judicial Panel on Multidis-

trict Litigation transferred them to the U.S. District Court for

the District of Maryland. In re Royal Ahold N.V. Securities &

"ERISA" Litig., 269 F. Supp. 2d 1362 (J.P.M.L. 2003). Subse-

quently, several more related actions were also transferred to

the District of Maryland.

On November 4, 2003, the district court consolidated all

the actions and designated plaintiffs Public Employees’

Retirement Association of Colorado and Generic Trading of

Philadelphia, LLC as Lead Plaintiffs. In re Royal Ahold N.V.

Securities and ERISA Litig., 219 F.R.D. 343 (D. Md. 2003).

On February 18, 2004, the Lead Plaintiffs filed a Consoli-

dated Amended Securities Class Action Complaint ("CAC")

against Ahold, several Ahold subsidiaries, both Deloittes, and

some of Ahold’s underwriters, officers, and directors. The

CAC charged Ahold, its subsidiaries, the Deloittes, and the

individual defendants with violations of § 10(b) of the Securi-

PUBLIC EMPLOYEES’ RETIREMENT v. DELOITTE & TOUCHE 5

ties Exchange Act of 1934, 15 U.S.C. § 78j(b), and Rule 10b-

5(b), as well as 10b-5(a) and (c), 17 C.F.R. § 240.10b, pro-

mulgated thereunder, and also charged some defendants with

other violations of the securities laws not relevant here.

Both Deloittes moved to dismiss the CAC on several

grounds. The district court on December 21, 2004, dismissed

all of the claims against both Deloitte defendants for failure

to state a claim, and held that with respect to the § 10(b)

claims the complaint did not plead facts alleging a strong

inference of scienter as required by the PSLRA. In re Royal

Ahold N.V. Securities & ERISA Litig., 351 F. Supp. 2d 334,

385-96 (D. Md. 2004). The district court also dismissed some

but not all of the claims against the other defendants on vari-

ous grounds.1 See id. at 411. The plaintiffs continued the liti-

gation on the remaining claims and proceeded with discovery.

On November 28, 2005, Ahold and the Lead Plaintiffs

announced a $1.1 billion settlement resolving the Class’s

claims against all the defendants other than Deloitte U.S. and

Deloitte Netherlands.

On March 6, 2006, the Lead Plaintiffs filed a motion to

amend the original complaint accompanied by a proposed

Second Consolidated Amended Securities Class Action Com-

plaint ("SAC"). The SAC alleged two causes of action: one

under Rule 10b-5(b), and one under both 10b-5(a) and (c).

After briefing and oral argument, the district court denied the

motion on the basis of futility, for it determined that the

amended motion still did not meet the PSLRA’s requirement

that it allege a strong inference of scienter against the Deloit-

tes. Plaintiffs timely appealed.

1

The district court also dismissed all allegations regarding conduct

before July 30, 1999 as time-barred. In re Royal Ahold, 351 F. Supp. 2d

at 364-68. Thus, the Class Period at issue in this litigation runs from July

30, 1999 to February 23, 2003.

6 PUBLIC EMPLOYEES’ RETIREMENT v. DELOITTE & TOUCHE

II.

This appeal turns on Ahold’s accountants’ alleged role in

the JV and PA frauds. Accordingly, we shall review the

frauds and the Deloittes’ roles in them as indicated by the

record. Although Ahold began consolidating its joint ventures

in 1992, the purported class period did not begin until July 30,

1999. Our discussion of events before that date serves only to

provide background for later events.

A.

With respect to the JV fraud, both Deloittes advised Ahold

on the consolidation of the joint ventures. Five joint ventures

are at issue in this litigation: JMR, formed in August 1992;

Bompreço, formed in November 1996; DAIH, formed in Jan-

uary 1998; Paiz-Ahold, formed in December 1999; and ICA,

formed in February 2000. Ahold had a 49% stake in JMR and

a 50% share of each of the other ventures at their respective

times of formation.

Prior to Ahold’s entering into the first joint venture,

Deloitte Netherlands and Deloitte U.S. gave Ahold advice

about revenue consolidation under Dutch and U.S. GAAP.

For example, several months before the first joint venture was

formed, Deloitte U.S. partner David Herskovits sent Ahold

Senior Vice President Cor Sterk a memorandum providing

details on the consolidation of joint venture revenue. It

explained that control of a joint venture is required for consol-

idation of the venture’s revenue and discussed what situations

are sufficient to demonstrate control. The memo indicated that

control could be shown by a majority voting interest, a large

minority voting interest under certain circumstances, or by a

contractual arrangement.

Ahold began consolidating the joint ventures as they were

formed. The various Joint Venture Agreements ("JVAs") did

not indicate that Ahold controlled the ventures. For example,

PUBLIC EMPLOYEES’ RETIREMENT v. DELOITTE & TOUCHE 7

the JMR joint venture agreement specified that decisions

would be made by a board of directors, "deciding unani-

mously," and that the board would consist of three members

appointed by Ahold and four members appointed by JMH,

Ahold’s partner in the venture.

However, Ahold represented to Deloitte Netherlands that it

nonetheless possessed the control requisite for consolidation.

Deloitte Netherlands initially accepted these representations

for the consolidation of JMR and Bompreço. But as consoli-

dation continued, the Deloittes became concerned that Ahold

lacked the control necessary to consolidate these first two

joint ventures. On August 24, 1998, Deloitte Netherlands

partner John van den Dries sent a letter to Michiel Meurs,

Ahold’s CFO, advising him that Ahold’s representations of

control would no longer suffice, that Ahold would need to

produce more evidence of control in order to justify continu-

ing consolidation of joint venture revenue under U.S. GAAP,

and that without such evidence a financial restatement would

be required.

In response to Deloitte Netherlands’ requests, Ahold

drafted a "control letter" addressed to BompreçoPar S.A., its

partner in the Bompreço joint venture. The letter stated that

the parties agreed that if they were unable to reach a consen-

sus decision on a particular issue, "Ahold’s proposal to solve

that issue will in the end be decisive." After reviewing the

draft letter, Deloitte Netherlands advised Ahold that if coun-

tersigned by the joint venture partner the letter would be suffi-

cient evidence to consolidate the venture. The letter was

signed by Ahold and BompreçoPar in May 1999. By late

2000, Ahold had obtained similar countersigned control let-

ters for the ICA, DAIH, and Paiz-Ahold joint ventures. Based

on these letters and other evidence, Deloitte Netherlands con-

cluded that consolidation was appropriate.

However, in October 2002 the Deloittes learned of a "side

letter" sent to Ahold in May 2000 by one of Ahold’s ICA

8 PUBLIC EMPLOYEES’ RETIREMENT v. DELOITTE & TOUCHE

joint venture partners, Canica. The letter stated that Canica

did not agree with the interpretation of the shareholder agree-

ment stated in the ICA control letter. At this point, Deloitte

Netherlands and Deloitte U.S. began trying to get Ahold to

obtain an amendment to the shareholder agreement in order to

justify ongoing consolidation. At a February 14, 2003 meet-

ing, Deloitte Netherlands and Deloitte U.S. told Ahold that

Ahold lacked the necessary control for consolidation.

On February 22, 2003, Ahold revealed to Deloitte Nether-

lands side letters contradicting the Bompreço, DAIH, and

Paiz-Ahold control letters. Two days later, Ahold announced

that it had improperly consolidated its joint ventures and

would be restating its revenues.

B.

Now we turn to the PA fraud. Ahold acquired USF in early

2000. Prior to the acquisition, Deloitte U.S. participated in

Ahold’s due diligence on USF. In a February 2000 memo,

Deloitte U.S. noted that USF’s internal system for recording

promotional allowances received was weak because it heavily

relied on vendors’ figures, and that the system could "easily

result in losses and in frauds." Deloitte U.S. also noted in the

memo that USF’s use of value added service providers, spe-

cial purpose entities that bought products from vendors and

then resold them to USF for a higher price, needed to be eval-

uated for their "tax and legal implications and associated busi-

ness risks."

After Ahold’s acquisition of USF was finalized, Deloitte

U.S. became USF’s external auditor. When performing an

Opening Balance Sheet audit of USF, Deloitte U.S. discov-

ered that a USF division in Buffalo, New York had been

fraudulently accounting for PA income. This fraud required a

restatement of $11 million of PA income. USF also down-

wardly adjusted its income by $90 million as a result of

PUBLIC EMPLOYEES’ RETIREMENT v. DELOITTE & TOUCHE 9

Deloitte U.S.’s advice that it be less aggressive in its method

for recognizing PA income.

USF used at interim periods a method known as the "PA

recognition rate" to estimate promotional allowance income,

in which PAs were estimated as a percentage of USF’s total

sales. The rate used by USF was 4.58 percent at the time of

Ahold’s acquisition of USF, but rose as high as 8.51 percent

in 2002. When USF booked final numbers, Deloitte U.S. in its

audits tested USF’s recognition of PAs by requesting written

confirmation of PA amounts from vendors and by performing

cash receipt tests. Using this confirmation process, Deloitte

U.S. was able to test between 65 and 73 percent of PA receiv-

ables in its audits for 2000 and 2001.

Because USF lacked an internal auditing department, in

April 2000 Ahold USA, Inc. (Ahold’s American holding com-

pany) hired Deloitte U.S. to perform internal auditing services

at USF. The internal auditors did not report to the Deloitte

U.S. external auditors.2 Instead, they reported initially to

Ahold USA’s internal audit director and, later, to USF’s inter-

nal audit director after he was hired. The audit was managed

by Jennifer van Cleave under the supervision of Patricia Gru-

bel, a Deloitte U.S. Partner.

One of the internal audit’s objectives was to determine

whether USF’s tracking of PAs was adequate. In van Cleave’s

attempt to verify USF’s PA numbers, she requested a number

of documents from USF management, including vendor con-

tracts. Management refused to produce a number of the

requested documents. Several members of management also

refused to meet with van Cleave when she asked to conduct

exit meetings. Van Cleave was thus unable to complete all of

the audit’s objectives.

2

Under the professional standards then in effect, an auditing firm could

provide both internal and external auditing services to the same client. See

The American Institute of Certified Public Accountants, Principles of Pro-

fessional Conduct, § 101.15 (2000). (J.A. 4502-04.)

10 PUBLIC EMPLOYEES’ RETIREMENT v. DELOITTE & TOUCHE

In a February 5, 2001 draft report, van Cleave described

how management’s failure to produce requested documents

resulted in her inability to complete some of the goals of the

audit. Grubel instructed van Cleave to soften the report’s lan-

guage, and the version submitted to Michael Resnick, Direc-

tor of USF’s Internal Audit Department, simply stated that

Deloitte U.S. "was unable to obtain supporting documentation

for some of the promotional allowance sample items" without

more specifically detailing management’s failures.

In its February 2003 external audit for 2002, Deloitte U.S.

discovered through the PA confirmation process that USF had

been inflating its recorded PA income. An investigation

ensued. Ultimately, USF’s former Chief Marketing Officer

("CMO"), Mark Kaiser, was convicted on all counts of a fed-

eral indictment that alleged that he had induced USF’s ven-

dors to falsely report PA income amounts and receivable

balances to Deloitte U.S. and that he had concealed the exis-

tence of written contracts with USF vendors from Deloitte

U.S.

Two other USF executives pled guilty to federal securities

fraud charges; in their plea colloquies, they admitted that USF

lied to and deceived Deloitte U.S., and that they induced ven-

dors to sign false audit confirmation letters that falsely over-

stated PA payments. In addition, seventeen individuals

associated with USF vendors pled guilty to various charges,

and admitted that they signed false audit confirmation letters

in order to conceal the PA fraud from Deloitte U.S.

III.

A.

In passing the PSLRA in 1995, Congress imposed height-

ened pleading requirements for private securities fraud

actions. As a general matter, heightened pleading is not the

norm in federal civil procedure. The drafters of the original

PUBLIC EMPLOYEES’ RETIREMENT v. DELOITTE & TOUCHE 11

Federal Rules of Civil Procedure rejected technical pleading

requirements and instead sought to ensure "that pleadings

[would] be construed liberally so as to do substantial justice."

5 Charles Alan Wright & Arthur R. Miller, Federal Practice

and Procedure § 1202, at 87 (3d ed. 2004). Embodying this

goal, Federal Rule of Civil Procedure 8 requires merely "a

short and plain statement of the claim showing that the

pleader is entitled to relief." Fed. R. Civ. P. 8(a)(2).

However, for several reasons it has long been believed that

heightened pleading requirements are necessary for allega-

tions of fraud. Frequently stated reasons include protecting

defendants’ reputations from baseless accusations, eliminating

unmeritorious suits that are brought only for their nuisance

value, discouraging fishing expeditions brought in the dim

hope of discovering a fraud, and providing defendants with

detailed information in order to enable them to effectively

defend against a claim. See 5A Wright & Miller § 1296, at 31-

39. Thus Rule 9(b) of the Federal Rules creates an exception

to Rule 8’s relaxed standard. When "alleging fraud or mis-

take," plaintiffs "must state with particularity the circum-

stances constituting fraud or mistake." Fed. R. Civ. P. 9(b).

Under § 10(b) of the Securities Exchange Act, it is unlaw-

ful "[t]o use or employ, in connection with the purchase or

sale of any security . . . any manipulative or deceptive device

or contrivance in contravention of such rules and regulations

as the [SEC] may prescribe . . . ." 15 U.S.C § 78(j)(b). Pursu-

ant to § 10(b), the SEC has promulgated Rule 10b-5, which

forbids employing "any device, scheme, or artifice to defraud,

. . . mak[ing] any untrue statement of a material fact or omit[-

ting] to state a material fact . . . or . . . engag[ing] in any act,

practice, or course of business which operates or would oper-

ate as a fraud or deceit upon any person." 17 C.F.R.

§ 240.10b-5. Section 10(b) creates a private right of action for

purchasers or sellers of securities who have been injured by

the statute’s violation. See, e.g., Superintendent of Ins. of

12 PUBLIC EMPLOYEES’ RETIREMENT v. DELOITTE & TOUCHE

State of N.Y. v. Bankers Life & Casualty Co., 404 U.S. 6, 13

n.9 (1971).

As § 10(b) prohibits fraud, claims brought under it prior to

the PSLRA were governed by Federal Rule of Civil Proce-

dure 9(b), not Rule 8. Tellabs, 127 S. Ct. at 2507. However,

circuits split on the question of how much factual specificity

Rule 9(b) required of complaints alleging claims under

§ 10(b). See William C. Baskin III, Note, Using Rule 9(b) to

Reduce Nuisance Securities Litigation, 99 Yale L.J. 1591,

1593-94 (1990). Thus, Congress passed the PSLRA to estab-

lish a uniform pleading standard that would reduce frivolous

securities fraud suits. "As the Committee of Conference that

reported the PSLRA noted, ‘[Rule 9(b)] has not prevented

abuse of the securities laws by private litigants. Moreover, the

courts of appeals have interpreted Rule 9(b)’s requirement in

conflicting ways, creating distinctly different standards

among the circuits.’" Teachers’ Retirement Sys. of La. v.

Hunter, 477 F.3d 162, 171 (4th Cir. 2007) (quoting H.R. Rep.

No. 104-369, at 41 (1995) (Conf. Rep.), reprinted in 1995

U.S.C.C.A.N. 730, 740).

The PSLRA imposed a number of requirements designed to

discourage private securities actions lacking merit. Among

them is the requirement that in a private securities action "in

which the plaintiff may recover money damages only on

proof that the defendant acted with a particular state of mind,

the complaint shall, with respect to each act or omission

alleged to violate this chapter, state with particularity facts

giving rise to a strong inference that the defendant acted with

the required state of mind." 15 U.S.C § 78u-4(b)(2). Com-

plaints that do not adequately plead scienter are to be dis-

missed. Id. § 78u-4(b)(3)(A).

Because the PSLRA did not define "a strong inference," the

courts of appeals again disagreed on how much factual speci-

ficity plaintiffs must plead in private securities actions. See

Makor Issues & Rights, Ltd. v. Tellabs, Inc., 437 F.3d 588,

PUBLIC EMPLOYEES’ RETIREMENT v. DELOITTE & TOUCHE 13

601 (7th Cir. 2006) (listing approaches of different circuits),

vacated and remanded, 127 S. Ct. 2499. The Supreme Court

recently resolved that issue in Tellabs, in which the Court pre-

scribed the following analysis for Rule 12(b)(6) motions to

dismiss § 10(b) actions:

First, . . . courts must, as with any motion to dis-

miss for failure to plead a claim on which relief can

be granted, accept all factual allegations in the com-

plaint as true . . . .

Second, courts must consider the complaint in its

entirety, as well as other sources courts ordinarily

examine when ruling on Rule 12(b)(6) motions to

dismiss . . . . The inquiry, as several Courts of

Appeals have recognized, is whether all of the facts

alleged, taken collectively, give rise to a strong infer-

ence of scienter, not whether any individual allega-

tion, scrutinized in isolation, meets that standard.

Third, in determining whether the pleaded facts

give rise to a "strong" inference of scienter, the court

must take into account plausible opposing inferences

. . . . The strength of an inference cannot be decided

in a vacuum. The inquiry is inherently comparative:

How likely is it that one conclusion, as compared to

others, follows from the underlying facts? . . . . [T]he

inference of scienter must be more than merely "rea-

sonable" or "permissible" — it must be cogent and

compelling, thus strong in light of other explana-

tions. A complaint will survive, we hold, only if a

reasonable person would deem the inference of

scienter cogent and at least as compelling as any

opposing inference one could draw from the facts

alleged.

127 S. Ct. at 2509-10 (citations and footnote omitted).

14 PUBLIC EMPLOYEES’ RETIREMENT v. DELOITTE & TOUCHE

To be sure, by no means did the PSLRA or the Supreme

Court eliminate the private right of action in § 10(b), which

remains "an essential supplement to criminal prosecutions and

civil enforcement actions brought, respectively, by the

Department of Justice and the [SEC]." Tellabs, 127 S. Ct. at

2504. The "strong inference" requirement is not meant to pre-

vent litigants with meritorious claims from continuing to

uncover fraud and ensure confidence in the securities markets.

Rather, the requirement aims to weed out meritless claims at

the pleading stage, without forcing defendants to go through

a potentially costly discovery process.

Thus, as directed by Tellabs, we must analyze the factual

allegations raised by the plaintiffs, as well as other evidence

in the record, and determine what plausible inferences we can

draw from them. Having drawn all plausible inferences, we

may reverse the district court only if we find the inference

that Deloitte Netherlands and Deloitte U.S. acted with scienter

"at least as compelling" as the inference that the defendants

lacked the required mental state. In this endeavor, we "must

consider plausible nonculpable explanations for the defen-

dant’s conduct, as well as inferences favoring the plaintiff."

Tellabs, 127 S. Ct. at 2510. It is to this comparative analysis

that we now turn.

B.

The "strong inference" requirement and the comparative

analysis of inferences still leave unanswered the question of

exactly what state of mind satisfies the scienter requirement

of a 10b-5 action. In Ernst & Ernst v. Hochfelder, 425 U.S.

185 (1976), the Supreme Court held that a plaintiff must show

that the defendant possessed the "intent to deceive, manipu-

late, or defraud" in an action brought under § 10(b) and Rule

10b-5. Id. at 193. However, the Court has never made clear

what mental state suffices to meet this requirement. See id. at

193-94 n.12 ("We need not address here the question whether,

in some circumstances, reckless behavior is sufficient for civil

PUBLIC EMPLOYEES’ RETIREMENT v. DELOITTE & TOUCHE 15

liability under s 10(b) and Rule 10b-5."); Tellabs, 127 S. Ct.

at 2507 n.3 ("The question whether and when recklessness

satisfies the scienter requirement is not presented in this

case.").

This court has held that "a securities fraud plaintiff may

allege scienter by pleading not only intentional misconduct,

but also recklessness." Ottman v. Hanger Orthopedic Group,

Inc., 353 F.3d 338, 344 (4th Cir. 2003). We have defined a

reckless act in the § 10(b) context as one "‘so highly unrea-

sonable and such an extreme departure from the standard of

ordinary care as to present a danger of misleading the plaintiff

to the extent that the danger was either known to the defen-

dant or so obvious that the defendant must have been aware

of it.’" Id. at 343 (quoting Phillips v. LCI Int’l, Inc., 190 F.3d

609, 621 (4th Cir. 1999)). A showing of mere negligence,

however, will not suffice to support a § 10(b) claim. See Ernst

& Ernst, 425 U.S. at 199.

Thus, the question is whether the allegations in the com-

plaint, viewed in their totality and in light of all the evidence

in the record, allow us to draw a strong inference, at least as

compelling as any opposing inference, that the Deloitte defen-

dants either knowingly or recklessly defrauded investors by

issuing false audit opinions in violation of Rule 10b-5(b) or

10b-5(a) and (c). If we find the inference that defendants

acted innocently, or even negligently, more compelling than

the inference that they acted with the requisite scienter, we

must affirm.3 Plaintiffs must show that defendants actually

made a misrepresentation or omission in their audit opinions

on which investors relied; parties who merely assist another

3

We review a district court’s denial of a motion for leave to amend a

complaint for abuse of discretion. Nourison Rug Corp. v. Parvizian, 535

F.3d 295, 298 (4th Cir. 2008). However, because the district court denied

leave to amend because it determined that the amended complaint would

not survive a motion to dismiss, we review that legal conclusion de novo.

See HCMF Corp. v. Allen, 238 F.3d 273, 277 n.2 (4th Cir. 2001).

16 PUBLIC EMPLOYEES’ RETIREMENT v. DELOITTE & TOUCHE

in violating § 10(b) are not liable under § 10(b).4 See

Stoneridge Investment Partners, LLC v. Scientific-Atlanta,

Inc., 128 S. Ct. 761 (2008).

IV.

A.

In light of the foregoing standards, we consider first the JV

fraud. Plaintiffs allege that Deloitte U.S. and Deloitte Nether-

lands allowed Ahold to consolidate the joint ventures despite

knowing, or being reckless with regard to the risk, that Ahold

lacked the control required for consolidation. The thrust of

plaintiffs’ argument is that the control letters and Ahold’s oral

representations were insufficient evidence of control under

Dutch and U.S. GAAP. Thus, they argue, the defendants were

complicit in the fraud. According to plaintiffs, the secret side

letters, in which the joint venture partners contradicted

Ahold’s interpretations of the joint venture agreements in the

control letters, are irrelevant because the control letters them-

selves did not amend the joint venture agreements.

Plaintiffs’ arguments do not provide a basis for a strong

inference that either Deloitte U.S. or Deloitte Netherlands

acted knowingly or recklessly in relation to the JV fraud. The

most plausible inference that one can draw from the fact that

Ahold concealed the side letters from its accountants is that

the accountants were uninvolved in the fraud. Ahold produced

letters attesting to Ahold’s control countersigned by Ahold’s

4

The SAC recounts a number of alleged misrepresentations by Deloitte

Netherlands, including audit opinions issued in conjunction with Ahold’s

1999 SEC Form 20-F, 2000 Form 20-F, 2001 Form 20-F, and Ahold’s

September 2001 Prospectus Supplement. Defendants contend in their brief

that Deloitte U.S. did not issue any audit opinions on Ahold’s or USF’s

financial statements. Brief of Appellees at 1-2. Because this case was

briefed and argued purely as a scienter case, and because defendants make

no argument that Stoneridge precludes liability, we do not consider the

applicability of that case.

PUBLIC EMPLOYEES’ RETIREMENT v. DELOITTE & TOUCHE 17

partners for the ICA, Bompreço, DAIH, and Paiz-Ahold joint

ventures at the Deloitte defendants’ request, all the while con-

cealing the side letters from those same defendants. These

facts lead to a strong inference that the Deloitte defendants

were attempting to ensure that Ahold had sufficient control

over the joint ventures for consolidation and that Ahold was

determined to prevent them from discovering otherwise.

With perfect hindsight, one might posit that defendants

should have required stronger evidence of control from

Ahold. Indeed, as the district court noted, it may have been

negligent for defendants to accept as the only evidence of

control Ahold’s repeated representations that it controlled

JMR, the one joint venture for which Ahold never produced

a control letter. See In re Royal Ahold, 351 F. Supp. 2d at

395-96.5 Nonetheless, the evidence as a whole leads to the

strong inference that defendants were deceived by their clients

into approving the consolidation. Ahold would not have

needed to go out of its way to produce false evidence of con-

trol had the Deloittes been complicit in the fraud, or had they

been so reckless in their duties that their audit "amounted to

no audit at all," as the Southern District of New York has

described the standard. S.E.C. v. Price Waterhouse, 797 F.

Supp. 1217, 1240 (S.D.N.Y. 1992) (citing McLean v. Alexan-

der, 599 F.2d 1190, 1198 (3d Cir. 1979)).

In order to establish a strong inference of scienter, plaintiffs

must do more than merely demonstrate that defendants should

or could have done more. They must demonstrate that the

Deloittes were either knowingly complicit in the fraud, or so

reckless in their duties as to be oblivious to malfeasance that

was readily apparent. The inference we find most compelling

based on the evidence in the record is not that the defendants

were knowingly complicit or reckless, but that they were

5

Because JMR comprised a relatively small portion of Ahold’s financial

results, the district court found that any financial misstatement resulting

from its consolidation was immaterial. 351 F. Supp. 2d at 395-96.

18 PUBLIC EMPLOYEES’ RETIREMENT v. DELOITTE & TOUCHE

deceived by their client’s repeated lies and artifices. Perhaps

their failure to demand more evidence of consolidation was

improper under accounting guidelines, but that is not the stan-

dard, which "requires more than a misapplication of account-

ing principles." Price Waterhouse, 797 F. Supp. at 740.

B.

Next we examine the PA fraud. Plaintiffs argue that

Deloitte U.S. was knowingly complicit in the fraud when it

ignored several "red flags," including: USF’s lack of internal

controls to track PA income; USF management’s obstruction

of the internal audit; and the facts and the circumstances of

USF Chief Financial Officer Ernie Smith’s resignation.6

With respect to USF’s problems with tracking income with

PAs, it is not the case that Deloitte U.S. simply ignored the

weak internal controls, as plaintiffs allege. Rather, Deloitte

U.S. raised this issue numerous times with Ahold and USF

management. Deloitte U.S. designed a confirmation process

to verify USF’s reported PA income in which it contacted

third-party vendors and received letters from them confirming

PA amounts.

In the SAC plaintiffs describe the confirmation process as

one that "confirmed nothing." Yet instead of merely relying

on USF CMO Mark Kaiser’s representations, as plaintiffs

assert, Deloitte U.S. obtained corroboration from vendors for

the figures provided by USF. Deloitte U.S. would not have

attempted to verify USF’s figures with third parties if it were

complicit in the scheme; nor can it be said that it was anything

but proper to attempt to check the accuracy of representations

made by USF management.

6

Plaintiffs do not distinguish Deloitte U.S. and Deloitte Netherlands in

their complaint, but they have failed to challenge the district court’s con-

clusion that the two firms are separate legal entities.

PUBLIC EMPLOYEES’ RETIREMENT v. DELOITTE & TOUCHE 19

Plaintiffs attempt to suggest that the confirmation process

was unsound because, for example, Deloitte U.S. accepted

confirmation letters via fax and the letters were sent to bro-

kers or sale executives instead of financial officers. But even

if the confirmation process was somewhat flawed — which

defendants contest — the larger fact remains that the PA fraud

went undetected initially only because USF and its vendors

conspired to lie to Deloitte U.S. and to conceal important doc-

uments. Indeed, it was Deloitte U.S.’s confirmation process

itself that ultimately revealed the fraud. In the course of the

2002 audit, Deloitte U.S. learned in early 2003 from a vendor

from which it had requested PA confirmations that employees

had signed inaccurate confirmation letters. Shortly thereafter,

Ahold authorized an internal investigation that revealed the

extent of the fraud. No doubt it would have been better had

the fraud been discovered earlier, but the strongest inference

one can draw from the evidence is that the fraud initially went

undetected because of USF’s collusion with the vendors, not

because of wrongdoing by Deloitte U.S.

As to the internal audit, the internal auditors reported not

to the Deloitte U.S. external auditors but to USF, as was con-

sistent with professional standards. See Standards for the Pro-

fessional Practice of Internal Auditing, Statements on Internal

Auditing Standards Nos. 1-18, § 230. Plaintiffs suggest that

Grubel’s editing of the language in van Cleave’s initial report

indicates scienter. They argue that Grubel’s edits suggest that

Deloitte U.S. was trying to cover up the fact that management

had obstructed the internal audit. But as the district court

noted, "while [the] language in the initial draft of the internal

audit report was softened, the revised language continued to

state the essential point, that the internal auditors had been

unable to obtain certain documents related to promotional

allowances and unable to achieve specific testing objectives."

J.A. 6122.

The rest of the supposed "red flags" pointed to by plaintiffs

also fail to create a strong inference of scienter. With respect

20 PUBLIC EMPLOYEES’ RETIREMENT v. DELOITTE & TOUCHE

to plaintiffs’ allegations that Smith told Deloitte U.S. about

the vendor rebate fraud, the district court twice concluded that

this claim had no support in the record, and we see no reason

to disagree with its conclusion. Plaintiffs allege that facts like

the high CFO turnover at USF and USF’s rapid growth should

have alerted Deloitte U.S. that there was fraud afoot, but they

do not explain why this was the only conclusion Deloitte U.S.

could have drawn without being reckless. There are many

possible reasons other than fraud for high personnel turnover

— personality conflicts, lack of opportunities for advance-

ment, salary and compensation disputes, to name a few.

Seeing the forest as well as the trees is essential. With

respect to both frauds, plaintiffs point to ways that defendants

could have been more careful and perhaps discovered the

frauds earlier. But plaintiffs cannot escape the fact that Ahold

and USF went to considerable lengths to conceal the frauds

from the accountants and that it was the defendants that ulti-

mately uncovered the frauds. The strong inference to be

drawn from this fact is that Deloitte U.S. and Deloitte Nether-

lands lacked the requisite scienter and instead were deceived

by Ahold and USF. That inference is significantly more plau-

sible than the competing inference that defendants somehow

knew that Ahold and USF were defrauding their investors.

It is not an accountant’s fault if its client actively conspires

with others in order to deprive the accountant of accurate

information about the client’s finances. It would be wrong and

counter to the purposes of the PSLRA to find an accountant

liable in such an instance. Because we find no version of the

facts creates a strong inference that the Deloitte defendants

had the scienter required for a cause of action under § 10(b),

the district court rightly denied the plaintiffs’ motion for leave

to amend their complaint.

V.

We establish no blanket immunity for accountants for oth-

erwise actionable statements with a strong inference of

PUBLIC EMPLOYEES’ RETIREMENT v. DELOITTE & TOUCHE 21

scienter. But in this case, the stronger and more plausible

inference is that the Deloittes were, like the plaintiffs, victims

of Ahold’s fraud rather than its enablers. Plaintiffs’ action is

the paradigm situation to which the PSLRA and Tellabs were

meant to apply. Accordingly, the judgment below is

AFFIRMED.