Amicus Curiae Brief — Dura Pharmaceuticals, Inc. v. Broudo

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Supreme = U.S.

(3) SEP 1 3 2004

No. 03-932

OFFICE OF THE CLERK |

In the Supreme Court of the Gnited States

DURA PHARMACEUTICALS, INC. et al.,

Petitioners,

Vv.

MICHAEL BROUDO, et ai.,

Respondents.

On Writ of Certiorari to the United States

Court of Appeals for the Ninth Circuit

BRIEF FOR THE AMERICAN INSTITUTE OF

CERTIFIED PUBLIC ACCOUNTANTS AS AMICUS

CURIAE IN SUPPORT OF PETITIONERS

RICHARD I. MILLER LAWRENCE S. ROBBINS*

American Institute of KATHRYN S. ZECCA

Certified Public Accountants BRIAN M. WILLEN

1211 Avenue of the Americas Robbins, Russell, Englert,

New York, NY 10036 Orseck & Untereiner LLP

(212) 596-6200 1801 K Street, N.W.

Suite 41]

Washington, D.C. 20006

(202) 775-4500

* Counsel of Record

Counsel for Amicus Curiae

American Institute of Certified Public Accountants

TABLE OF CONTENTS

Page

ee SEED Se bc cccccdecccccccceseve ii

INTEREST OF THE AMICUS CURIAE ...........045. l

SUMMARY OF ARGUMENT .................-005: 2

EEE Sc cdbcaenekoedeedseeun cékeevereneses 3

I. CONGRESS CODIFIED THE LOSS CAUSATION

REQUIREMENT IN THE PSLRA TO HELP CURB

VEXATIOUS PRIVATE SECURITIES CLASS

ACTIONS AGAINST ACCOUNTING FIRMS AND

NEE s Fes cndecencendcensccteveaseceeceses 3

Il. THE NINTH CIRCUIT’S UNDERSTANDING OF

LOSS CAUSATION IS INCONSISTENT WITH THE

PED Sed thresh cdaccceavoneenbeevesceesinesc 6

A. The “lookback” provision of the PSLRA

confirms that loss causation cannot consist

merely of purchase-time inflation ............. 7

B. The Ninth Circuit’s decision undermines the

unity of the PSLRA by creating two different

definitions of loss causation ................. 8

Il. THE DECISION BELOW IMPROPERLY

CONFLATES LOSS CAUSATION WITH

TRANSACTION CAUSATION ................ 10

IV. THE NINTH CIRCUIT’S UNDULY PROAD

DEFINITION OF LOSS CAUSATION IMPOSES

EXCEPTIONAL BURDENS ON ACCOUNTING

FIRMS ENGAGED IN AUDIT WORK .......... 14

A. The highly judgmental nature of financial

statement auditing makes violations easy to

allege and difficult to rebut ...............-.

B. Because auditors are especially vulnerable to

vexatious securities class actions, they will be

greatly harmed by the weakened loss

causation rule adopted by the Ninth Circuit ....

CONCLUIIOIN onc ccccscccccccesseseuuen mene

(ii)

TABLE OF AUTHORITIES

Page(s)

Cases:

Akerman v. Oryx Communications, Inc.,

I, ED oo co ccc ccccccccccees )

Arthur Young & Co. v. Reves,

EE, ED oo ccc cc cccccccccs 10

AUSA Life Ins. Co. v. Ernst and Young,

I ED ccc cccccccccceccece 11

Basic, Inc. v. Levinson, 485 U.S. 224 (1988) .. 1, 10,11, 12

Bastian v. Petren Resources Corp.,

892 F.2d 680 (7th Cir. 1990) ................ 12, 23

Behlen v. Merrill Lynch,

311 F.3d 1067 (11th Cir. 2002) ........ cece eeeee 5

Bily v. Arthur Young & Co.,

3 Cal. 4th 370 (Cal. 1992) ............ 17, 18, 19, 20

Blue Chip Stamps v. Manor Drug Stores,

ED ococecadcocscecccccecess 4,15

Burke v. Jacoby, 981 F.2d 1372 (2d Cir. 1992) ......... 10

Central Bank of Denver, N.A. v.

First Interstate Bank of Denver,

ET Gib eeéecccecesceceseces passim

Currie v. Cayman Resources Corp.,

835 F.2d 780 (11th Cir. 1988) .................. 10

(iii)

Edenfield v. Fane, 507 U.S. 761 (1993) .........0645. 16

Ernst & Ernst v. Hochfelder,

Ge ee SSE whe wacccccencdansecedeewens l

Estate of Cowart v. Nicklos Drilling Co.,

Se es PED 0008064 00esedeindedncedeans 9

Greebel v. FTP Software, Inc.,

eee SP SE oh vvecécccccdcctecens 5

Huddleston v. Herman & MacLean,

640 F.2d 534 (Sth Cir. 1981) ................ 11,22

In re IKON Office Solutions,

BEE Ca ED 6 vesncedsedcduiee ses 20

In re Initial Public Offering Securities Litig.,

297 F. Supp. 2d 668 (S.D.N.Y. 2003) ............ 13

In re Merrill Lynch & Co. Research Reports

Securities Litig.,

273 F. Supp. 2d 351 (S.D.N.Y. 2003) ............ 12

Knapp v. Ernst & Whitney,

Fae CUS PG BOUND ceccvcccctédcccedens 6

McGonigle v. Combs,

Pee Pea OOP GD UOUED cccccccccccencccases 6

Rebenstock v. Deloitte & Touche,

907 F. Supp. 1059 (E.D. Mich. 1995) ............. 9

Robbins v. Kroger Properties, Inc.,

116 F.3d 1441 (11th Cir. 1997) ................. 11

SEC v. Blavin, 760 F.2d 706 (6th Cir. 1985) ........... 25

(iv)

Semerenko v. Cendant Corp.,

Be Fee CE GE ED co vccccccccccecceces 13

Shalala v. Guernsey Mem. Hosp.,

DOP ET SED Sc ncerecccccsveecnccecesese 16

Sullivan v. Stroop, 496 U.S. 478 (1990) ...........055. 9

Thor Power Tool v. Commissioner of Internal Revenue,

GP es SEENON ccdccesscscctesccesceesées 16

United Savings Ass'n v. Timbers of Inwood Forest Assocs.,

GP POE occvecencccccccecieuecsys 9-10

United States v. Arthur Young & Co.,

SEED obacneandssdncdécdeconenes 15

Statutes and Regulations:

SP es OF PU cneccecddunsdccucdvedseneceos 9

SP ts OS SEED ecbecccscidccdccubacdonsedeseua 19

SP as OF ED wc nceccvenencescddacsteses 6,7

FP ee OF) PGE Osc cwccncdecccsudscasosdéoves 7

BP ee OF EE Sh evbssccccudcesceseseassouns 18, 25

Miscellaneous:

AUDITING STANDARDS, AU § 150.02 ..............4.. 16

Robert W. Berliner, Audit Reports,

440 PRACTICING LAW INSTITUTE LIT. 41

EE EEE we dondeccccnacdececcceconese 18

(v)

Roger Buffington, A Proposed Standard of Common

Law Liability for the Public Accounting Profession,

5 S. CAL. INTERDISCIPLINARY L.J. 485 (1997) ...... 18

DOUGLAS R. CARMICHAEL, ET AL.,

AUDITING CONCEPTS AND METHODS

DL CD cavencedauscédncsascesess 16, 17, 20

John C. Coffee, Gatekeeper Failure and Reform:

The Challenge of Fashioning Relevant Reforms,

84 BOSTON U. L. REV. 301 (2004) ............04.. 5

Jay Feinman, Liability of Accountants for

Negligent Auditing: Doctrine, Policy,

and Ideology, 31 FLA. ST. U. L. REV. 17 (2003)... 20,22

Diana R. Franz, et al., The Impact of Litigation

Against an Audit Firm on the Market Value of

Nonlitigating Clients, 13 J. ACCT. AUDITING & FIN.

Pence btbcbeudceeesseuvesnseeinesaesss 24

H. R. Rep. No. 104-369 (Nov. 28, 1995) ...........445. 5

Sally L. Hoffman, The CPA's Professional Standards:

What Are They? Who Sets Them? What Are the Key

Issues Today?, $J077 ALI-ABA 119 (May 2004) ... 19

Frederick L. Jones & K. Raghunandan, Client Risk and

Recent Changes in the Market for Audit Services,

17 J. ACCT. & PUB. POL’Y 169 (1998) ............ 23

R. KAY & D. SEARFOSS, HANDBOOK OF ACCOUNTING

AND AUDITING (1994 Update) .................. 16

Richard 1. Miller & Michael R. Young,

Financial Reporting and Risk Management in the

21st Century, 65 FORDHAM L. REV. 1987 (1997) .... 21

(vi)

Richard M. Phillips & Gilbert C. Miller,

The Private Securities Litigation Reform Act of

1995, Rebalancing Litigation Risks and Rewards for

Class Action Plaintiffs, Defendants and Lawyers,

51 Bus. LAWYER 1009 (1996) ................. 4, 6

Jamie Pratt & James D. Stice, The Effects of

Client Characteristics on Auditor Litigation Risk

Judgments, Required Audit Evidence, and

Recommended Fees, 69 ACCT. REV. 639 (1994) .... 24

Price WaterhouseCoopers LLP,

2002 Securities Litigation Survey ................ 24

Kevin P. Roddy, Seven Years of Practice and

Procedure Under the Private Securities Litigation

Reform Act of 1995 (July 24-26, 2003) ............ 24

S. Rep. 104-98 (June 19, 1995) ...........cceceecess 4-5

SAS No. 99, Consideration of Fraud in a

Financial Statement Audit, AU § 316............. 19

SEC, Office of the Gen. Counsel, Report to the President

and the Congress on the First Year of Practice

Under the Private Securities Litigation Reform

BE Be CESD 60b00sncéesncsccesces 23-24

John Siliciano, Negligent Accounting and

the Limits of Instrumental Tort Reform,

OG DGsces. L. REV. IDZD(ISSS) .. cc ccccccccccece 5

Michael R. Young, The Liability of Corporate Officials

to Their Outside Auditors for Financial Statement

Fraud, 64 FORDHAM L. REV. 2155 (1996) ......... 17

(vii)

INTEREST OF THE AMICUS CURIAE'

For more than 100 years, the American Institute of

Certified Public Accountants (AICPA) has served as the

national organization of the certified public accounting

profession. The AICPA’s nearly 340,000 members, all of

whom are certified public accountants, provide accounting

services to companies and individuals through firms of all sizes,

as solo practitioners, and as employees of companies,

government, and academia. Among the AICPA’s most

important roles is to promote and maintain high professional

standards among its members. To this end, the Institute has

been a principal force in developing accounting and auditing

standards, drafting model legislation, sponsoring educational

programs, and issuing professional publications to improve the

quality of the services provided by CPAs.

The AICPA also has a strong interest in judicial decisions

affecting the scope and bases of accountants’ liability under the

federal securities laws. To that end, the AICPA has participate-

as amicus curiae in a wide variety of cases, including this

Court’s most significant securities fraud cases in each of the last

three decades: Central Bank of Denver, N.A. v. First Interstate

Bank of Denver, 511 U.S. 164 (1995); Basic Inc. v. Levinson,

485 U.S. 224 (1988); and Ernst & Ernst v. Hochfelder, 425 U.S.

185 (1976).

The present case, this Court’s first foray into the issue of

loss causation under the Private Securities Litigation Reform

Act of 1995, is of paramount importance to the accounting

profession. Loss causation is an indispensable element of the

private action available under Section 10(b) of the Securities

Exchange Act of 1934, one that helps to separate cases

involving genuine injury from those in which di-appointed

' The parties’ letters of consent to the filing of this brief have been

lodged with the Clerk. Pursuant to Rule 37.6 of the Rules of this

Court, the AICPA states that no counsel for a party has authored this

brief in whole or in part and that no person or entity, other than

amicus curiae, its members, or its counsel, has made a monetary

contribution to the preparation or submission of this brief.

investors seek to blame others for the consequences of ordinary

market risk. If deployed in the misguided fashion endorsed by

the Ninth Circuit, loss causation ceases to protect secondary

actors, such as auditors of financial statements, against

assuming the role of insurers for investment losses not

meaningfully linked to their own actions. It is to highlight both

the flaws in the Ninth Circuit’s analysis and the serious practical

significance of this issue for the hundreds of thousands of

certified public accountants nationwide that the AICPA

respectfully submits this amicus brief.

SUMMARY OF ARGUMENT

The federal securities laws are at once important tools for

protecting investors against fraud and potentially dangerous

vehicles for coercing unfair settlements from innocent

defendants. In 1995, concerned that the balance had tipped too

far in favor of vexatious litigation, Congress enacted the Private

Securities Litigation Reform Act (PSLRA), which significantly

tightened the pleading requirements for securities fraud class

actions. Among the most important aspects of the PSLRA was

the codification of the judge-made loss causation requirement.

This case presents an important and recurring question

regarding that requirement: whether, in a case involving a fraud-

on-the-market presumption of reliance, plaintiffs can establish

the element of loss causation merely by pleading and proving

that a defendant’s misrepresentations artificially elevated the

price « f a security, or whether plaintiffs must further plead and

prove that the alleged fraud actually caused a subsequent

decline in the value of the investment. In adopting the former

position, the Ninth Circuit fundamentally misconstrued the

nature and purpose of loss causation as it has now been codified

by Congress. The court’s decision effectively nullifies loss

causation as an independent element of a private cause of action

under Section 10(b) of the Securities Exchange Act of 1934, 15

U.S.C. § 78)j(b), and Rule 10b-5, 17 C.F.R. § 240.10b-5, and

contravenes the plain language of the PSLRA.

In so doing, the court of appeals failed to appreciate the

important function that loss causation plays in securities fraud

litigation. The loss causation element separates genuine fraud

cases from those in which disappointed purchasers are simply

looking to recover against a deep pocket defendant whose

actions are not meaningfully related to the gravamen of the

claim. In the latter circumstances, certified public accountants

— often the only solvent defendants left in the wake of a

corporate collapse — frequently become the deep pockets of

choice. The judgement-oriented standards of the auditing

process — together with often misguided expectations about

what an audit is intended to accomplish — make it all too

tempting to bring CPAs into securities fraud class actions. And,

given the realities of such litigation, it can be all too difficult

and too costly for them to get out.

In order to preserve the balance that Congress intended, it

is therefore essential to ensure that the PSLRA’s overriding goal

of distinguishing genuine securities fraud claims from bogus

ones not be compromised. By failing to take loss causation

seriously, the decision below ignores Congress’ design and

subjects auditors (and other secondary actors, including lawyers

and market analysts) to strike suits based on statements that

played no role in bringing about the investment loss that

plaintiffs suffered. The decision below therevy casts CPAs in

a role they were never supposed to play: insuring disappointed

investors against losses caused by the actions of others or by the

ordinary vicissitudes of the market.

ARGUMENT

I. CONGRESS CODIFIED THE LOSS CAUSATION

REQUIREMENT IN THE PSLRA TO HELP CURB

VEXATIOUS PRIVATE SECURITIES CLASS

ACTIONS AGAINST ACCOUNTING FIRMS AND

OTHERS

Although private securities suits play an important role in

regulating the securities markets and compensating defrauded

investors, the abusive potential of such litigation, particularly

class actions, has long been acknowledged. “There has been a

widespread recognition that litigation under Rule 10b-5 presents

a danger of vexatiousness different in degree and kind from that

which accompanies litigation in general.” Blue Chip Stamps v.

Manor Drug Stores, 421 U.S. 743, 739 (1975). Plaintiffs in

such cases have found that defendants — especially secondary

actors like accounting firms — can often be compelled, “as a

business judgment, to abandon substantial defenses and to pay

settlements in order to avoid the expense and risk of going to

trial.” Central Bank of Denver, N.A. v. First Interstate Bank of

Denver, 511 U.S. 164, 189 (1995). Strike suits have been a

perpetual concern for financial service professionals because

“even a compiaint which by objective standards may have very

little chance of success at trial has a settlement value to the

plaintiff out of proportion to its prospect of success at trial * *

*” Blue Chip Stamps, 421 U.S. at 740.

The problem of vexatious 10b-5 class actions became

especially acute in the late 1980s and early 1990s, a time when

private securities litigation had become more frequent and more

costly. To address what majorities in both political parties had

come to see as a system “seriously out of balance,” Congress

enacted the PSLRA in 1995. Richard M. Phillips & Gilbert C.

Miller, The Private Securities Litigation Reform Act of 1995,

Rebalancing Litigation Risks and Rewards for Class Action

Plaintiffs, Defendants and Lawyers, 51 BUS. LAWYER 1009,

1009 (1996). The statute codified the private right of action for

securities fraud and imposed important restrictions on its use. Its

chief purpose was to curb abusive practices in private securities

litigation:

[T]he evils flowing from abusive securities litigation start

with the filing of the complaint and continue through to the

final disposition of the action. A complaint alleging

violations of the Federal securities laws is easy to craft and

can be filed with little or no due diligence. A drop in a

public company’s stock price, a failed product development

project, or even unpredictable adverse market conditions

that affect earnings results for a quarter can trigger

numerous securities fraud lawsuits against a company.

S. Rep. 104-98, at 8 (June 19, 1995). Of particular concern was

the use of frivolous lawsuits to coerce defendants to settle in

order to avoid the exorbitant costs of litigation. See Behlen v.

Merrill Lynch, 3\1 F.3d 1087, 1090-91 (1 1th Cir. 2002) (citing

H.R. Rep. No. 104-369, at 31 (Nov. 28, 1995)); Greebel v. FTP

Software, Inc., 194 F.3d 185, 191 (1st Cir. 1999) (“The

enactment of the PSLRA in 1995 marked a bipartisan effort to

curb abuse in private securities lawsuits, particularly the filing

of strike suits.”).

Certified public accountants proved particularly vulnerable

to this onslaught. Although CPAs perform a variety of services

for their clients, they face litigation most frequently in

connection with their role as auditors of public companies’

financial statements. See John Siliciano, Negligent Accounting

and the Limits of Instrumental Tort Reform, 86 MICH. L. REV.

1929, 1931 (1988). In the typical case, plaintiffs claim that the

auditor’s unqualified opinion on the company’s financial

statements induced them to invest.

Allegations of this kind in the early 1990s saddled the

largest accounting firms with litigation expenses of more than

three-quarters of a billion dollars and exposed them to potential

liability in the untold billions. Indeed, one major firm,

Laventhol & Horwath, failed as a result. See John C. Coffee,

Gatekeeper Failure and Reform: The Challenge of Fashioning

Relevant Reforms, 84 BOSTON U. L. REV. 301, 318 n.51 (2004).

As this Court has observed, “[l]itigation under 10b-5 * * *

requires secondary actors to expend large sums even for pretrial

defense and the negotiation of settlements.” Central Bank of

Denver, 511 U.S. at 189 (noting statements in the congressional

record that in 83% of 10b-5 cases major accounting firms pay

$8 in legal fees for every $1 paid in claims). Congress took

careful note of these trends when it passed the PSLRA. See S.

Rep. 104-98, at 21 (“Accounting firms particularly have been

hard hit by securities litigation.”); see also ibid. (noting that

when “peripheral defendants are sued, the pressure to settle is

overwhelming — regardless of the defendant’s culpability”).

To help protect against these dangers, the PSLRA imposed

a “strong pleading requirement” for 10b-5 actions, which

included the express codification of the loss causation

requirement. S. Rep. 104-98, at 15; see generally Phillips &

Miller, 51 Bus. LAWYER at 1018-29 (describing the harmful

effects of class action securities litigation that led Congress to

enact the PSLRA). Section 21D(b)(4) of the Act thus provides

that “[iJn any private action arising under this chapter, the

plaintiff shall have the burden of proving that the act or

omission of the defendant alleged to violate this chapter caused

the loss for which the plaintiff seeks to recover damages.” 15

U.S.C. § 78u-4(b)(4). As we explain below, however, the Ninth

Circuit’s decision in this case fails to take this requirement

seriously as an independent element of Rule 10b-5. Moreover,

by allowing plaintiffs to satisfy loss causation even where they

cannot meaningfully connect the alleged fraud with any

economic injury that they have suffered, that decision

significantly undermines the PSLRA’s goal of reducing

vexatious securities fraud litigation.

Il. THE NINTH CIRCUIT’S UNDERSTANDING OF

LOSS CAUSATION IS INCONSISTENT WITH

THE PSLRA

Although the PSLRA has been law for nearly a decade, few

courts have paid serious attention to the statute in applying the

loss causation requirement. The Ninth Circuit’s opinion in this

case is a perfect example; in discussing loss causation, the court

never mentions the PSLRA, choosing rather to focus on cases

that either ignore the statute or were decided before it was

enacted. See Pet. App. 8a-9a (citing Knapp v. Ernst & Whitney,

90 F.3d 1431, 1437-38 (9th Cir. 1996); McGonigle v. Combs,

968 F.2d 810 (9th Cir. 1992)). This omission is unfortunate, as

a careful analysis of the statute confirms that the approach

adopted by the court of appeals is indefensible, for at least two

independent reasons.

A. The “lookback” provision of the PSLRA confirms

that loss causation cannot consist merely of

purchase-time inflation

First, the Ninth Circuit’s understanding of loss causation is

inconsistent with the so-called “lookback” provision, which

limits damages in 10b-5 actions in which, as here, “the plaintiff

seeks to establish damages by reference to the market price of

a security.” 15 U.S.C. § 78u-4(e)(1). In such cases

the award of damages to the plaintiff shall not exceed the

difference between the purchase or sale price paid or

received, as appropriate, by the plaintiff for the subject

security and the mean trading price of that security during

the 90-day period beginning on the date on which the

information correcting the misstatement or omission that is

the basis for the action is disseminated to the market.

Ibid. This provision makes clear that damages in a securities

fraud case such as this one do not accrue at the time of the

purchase, but instead are measured based upon fluctuations in

the price of the security that accompany a corrective disclosure.”

In turn, it is clear from the PSLRA’s loss causation provision

(Section 21D(b)(4)) that a plaintiffs “loss” necessarily derives

from the same source as damages. See 15 U.S.C. § 78u-4(b)(4)

(requiring the plaintiff to show that the fraud “caused the Joss

for which the plaintiff seeks to recover damages’’) (emphases

added).

The PSLRA thus expressly hitches damages to post-

transaction fluctuations in the price of the security — and, in

turn, links the loss causation requirement directly to damages.

That is, because plaintiffs may recover damages in an amount

limited by events following a corrective disclosure, it follows

? Like the fraud-on-the-market presumption, the lookback provision

relies on the notion that efficient markets synthesize relevant public

information in pricing stocks. It thus assumes that in the absence of

a corrective disclosure, any artificial valuation caused by the fraud

will continue to be reflected in the price of the security.

that the “loss” for which those damages provide compensation

must similarly be defined by what happens once the alleged

fraud is finally revealed. Indeed, in this respect the statute

rejects the very premise of the Ninth Circuit’s decision: that a

plaintiff's loss (and thus his damages) can be measured at the

time that he purchases the security at issue. Instead, the statute

decrees that both are to be assessed based upon the market’s

reaction to a corrective disclosure that brings the fraud to light.

So understood, the lookback rule works in tandem with the

loss causation provision to further Congress’s goal of tightening

the substantive and procedural requirements for private

securities litigation. The former fixes the maximum damages

that the plaintiff may recover, while the latter insists that

plaintiffs may obtain only the portion of that maximum that was

actually attributable to the defendant’s fraud. The Ninth

Circuit’s approach, which decouples plaintiffs’ “loss” from the

damages they are eligible to receive, is entirely inconsistent

with this scheme.

B. The Ninth Circuit’s decision undermines the unity of

the PSLRA by creating two different definitions of

loss causation

Nor can the decision below be reconciled with Section 105

of the PSLRA. Section 105 amended Section 12 of the

Securities Act of 1934, 15 U.S.C. § 771(a), by giving defendants

in cases brought under that provision an affirmative defense of

loss causation.’ See 15 U.S.C. § 771(b). This defense allows the

defendant to show that “any portion or all of the amount

recoverable * * * represents other than the depreciation in value

of the subject security resulting from such part of the prospectus

or oral communication, with respect to which the liability of that

person is asserted.” Jbid. Any such portion or amount not

> Section 12 confers a private right of action against those who, under

certain circumstances, make false or misleading statements in

connection with the sale of securities.

traceable to the false statement “shall not be recoverable.”

Ibid.*

Section 105 thus expressly defines “loss causation” as that

which links the defendant’s false statements and the

“depreciation in value of the subject security.” In other words,

the PSLRA views loss causation as the device that distinguishes

those portions of a security’s post-transaction decline that relate

back to the fraud from those that do not. It asks whether there

were post-transaction factors — unrelated to the deceptive

statements — that were actually responsible for some, or all, of

the plaintiff's ultimate financial loss.

This statute’s express definition further dooms the Ninth

Circuit’s analysis. For, if loss causation in Section 12 cases

allows defendants to point to the existence of post-transaction

evenis 2s reasons for the loss, loss causation in Rule 1 0b-5 cases

should equaliy require plaintiffs to plead and prove the absence

such events. In holding otherwise and defining loss causation

in terms of purchase-time inflation, the court below left the

same term with two fundamentally different meanings in the

same statute. “This result is contrary to the basic canon of

statutory construction that identical terms within an Act bear the

same meaning.” Estate of Cowart v. Nicklos Drilling Co., 505

U.S. 469, 479 (1992); see also Sullivan v. Stroop, 496 U.S. 478,

484 (1990); cf. United Savings Ass'n v. Timbers of Inwood

Forest Assocs., 484 U.S. 265, 371 (1988) (noting that a

provision that may seem ambiguous in one context is often

clarified “by the remainder of the statutory scheme — because

* The same loss causation defense has long existed in cases brought

under Section 11 of the Securities Act of 1934, 15 U.S.C. § 77k(e)(3).

See Akerman v. Oryx Communications, Inc., 810 F.2d 336 (2d Cir.

1987) (defendant may reduce his liability by “proving that the

depreciation in value resulted from factors other than the material

misstatement in the registration statement”) (emphasis added). And

it is well accepted that the “causation analysis under § | | is essentially

the same as Rule 10b-5’s proximate cause element.” Rebenstock v.

Deloitte & Touche, 907 F. Supp. 1059, 1065 (E.D. Mich. 1995).

the same terminology is used elsewhere in a context that makes

its meaning clear”).

Il, THE DECISION BELOW IMPROPERLY

CONFLATES LOSS CAUSATION WITH

TRANSACTION CAUSATION

The PSLRA’s definition of loss causation is entirely

consistent with the Rule 10b-5 case law that had evolved prior

to the statute’s enactment. As long as loss causation has

existed, it has been understood as a separate and distinct

element from that of transaction causation. A 10b-5 plaintiff

must satisfy both in order to recover. See Burke v. Jacoby, 981

F.2d 1372, 1378 (2d Cir. 1992); Arthur Young & Co. v. Reves,

937 F.2d 1310, 1327-28 (8th Cir. 1991); Currie v. Cayman

Resources Corp., 835 F.2d 780, 785 (llth Cir. 1988).

Transaction causation asks what caused the plaintiff to invest in

the first place; loss causation asks what caused the investment

to lose money. In derogation of this longstanding separation —

as well as the express codification of loss causation as an

independent requirement in 10b-5 cases — the decision below

impermissibly conflates these two requirements, thereby

stripping loss causation of its independent force in fraud-on-the-

market securities fraud cases such as this one.

In Basic Inc. v. Levinson, 485 U.S. 224, this Court held that,

under certain circumstances, private plaintiffs in cases brought

under 10b-5 are entitled to a rebuttable presumption that they

relied on public misrepresentations made by the defendant that

would have led a reasonable investor to misjudge the value of

the security. In this way, plaintiffs need not prove that they

themselves were aware of the allegedly misleading statements

made by the defendant, but can instead rely on the market’s

absorption of that infurmation. The theoretical justification for

this so-calied “fraud-on-the-market” presumption is that

efficient capital markets incorporate all relevant public

information (whether that information is accurate or not) into

the transaction price of the security: “Because most publicly

available information is reflected in market price, an investor’s

reliance on any public material misrepresentations, therefore,

may be presumed for purposes of a Rule 10b-5 action.” /d. at

247.

Under the approach to loss causation adopted below,

however, any plaintiff who satisfies the presumption of reliance

by pleading that the defendant publicly made a false statement

that may have inflated the transaction price has, a fortiori,

satisfied the pleading requirement for loss causation as well.

The Ninth Circuit’s loss causation rule requires merely an

allegation that “the price at the time of purchase was overstated

and sufficient identification of the cause” (Pet. App. 9a). But

this is nothing more than a restatement of the standard for

transaction causation adopted in Basic. The Ninth Circuit

offered no justification for a rule that merges the two

requirements in this way, despite the fact that such an approach

has been repeatedly rejected by other circuit courts. See AUSA

Life Ins. Co. v. Ernst and Young, 206 F.3d 202, 216 (2d Cir.

2000) (“Loss causation is a separate element from transaction

causation, and, in situations such as the instant one, loss

causation cannot be collapsed with transaction causation.”’); id.

at 226 (Jacobs, J., concurring) (“Loss causation requires the

plaintiffs to prove more than simply that E&Y induced them to

enter into an ultimately unsuccessful investment. Such a ‘but-

for’ analysis would collapse loss causation into transaction

causation.”); Robbins v. Kroger Properties, Inc., 116 F.3d 1441,

1448 (11th Cir. 1997) (refusing to use the Basic presumption “to

alter the loss causation requirement” because that theory “is

used to support a rebuttable presumption of reliance, not a

presumption of causation”); cf. Huddleston v. Herman &

MacLean, 640 F.2d 534, 547 (Sth Cir. 1981) (it is “a

nonsequitur to conclude that the representation that induced

action necessarily caused the consequences of that action”).

By ignoring these well-established principles, the Ninth

Circuit has created a serious tension with the PSLRA’s express

codification of that element. The result is to deprive CPAs (and

others) of a crucial safeguard that Congress intended them to

have against inventive plaintiffs’ lawyers who are able to find

an arguable violation of professional accounting and auditing

standards (as explained below, this is not difficult in light of the

nature of those standards), but who are not able to show that the

eventual revelation of the violation made any difference to the

value of their clients’ investments.

In so doing, the Ninth Circuit upended the traditional focus

of the loss causation requirement on events occurring after an

investor purchases a security. (In contrast to transaction

causation, which focuses on purchase-time events.) The

purpose of that post-transaction focus was to emphasize that not

every instance in which fraud may have induced an investor into

purchasing securities is actionable under Rule 10b-5. See

Bastian v. Petren Resources Corp., 892 F.2d 680, 685 (7th

Cir. 1990). By permitting loss causation to be satisfied solely

on the basis of purchase-time events, the decision below makes

it irrelevant that intervening forces unrelated to the fraud may

actually have caused the investment to lose money. The

consequences of such a holding are unfortunate:

After any drop in price — even if * * * it is entirely unrelated

to defendant’s conduct — a subsequently dissatisfied investor

would be able (with the benefit of hindsight) to point to any

allegedly misleading positive statement issued by anyone *

* * and couple that with an allegation that the price of the

security was inflated as a result to satisfy loss causation. To

allow such a claim would invite self-serving testimony,

strike suits and protracted discovery.

In re Merrill Lynch & Co. Research Reports Securities Litig.,

273 F. Supp. 2d 351, 366 n.28 (S.D.N.Y. 2003).

Finally, the Ninth Circuit’s holding conflicts with the central

premise of the fraud-on-the-market doctrine. The presumption

that this Court endorsed in Basic rests on the premise that an

efficient market incorporates public misrepresentations into the

price of the security at the time of the investment. See 485 U.S.

at 246 (“[T}he market price of shares traded on well-developed

markets reflects all publicly available information, and, hence,

any material misrepresentations.”). By the same token, until an

alleged misrepresentation is corrected and the market learns the

truth, any artificial inflation will remain in the price of the stock.

So long as the market continues to believe the alleged

falsehood, the market will continue to (over)value the stock

accordingly.

This means that unless and until the misinformation is

publicly corrected, investors —- even those who may have paid

“too much” — have not actually been injured by that

misrepresentation. The investors can simply sell on the market

and thereby recover the amount that they overpaid. See

Semerenko v. Cendant Corp., 223 F.3d 165, 185 (3d Cir. 2000)

(“In the absence of a correction in the market price, the cost of

the alleged misrepresentation is still incorporated into the value

of the security and may be recovered at any time simply by

reselling the security at the inflated price.”); Jn re Initial Public

Offering Securities Litig., 297 F. Supp. 2d 668, 672-73

(S.D.N.Y. 2003) (“So long as the amount of inflation is

constant, artificial inflation causes no loss for customers who

buy and sell at inflated prices.”). As such, the decision below

distorts the loss causation requirement by inexplicably

describing as a “loss” an inflationary premium that may still

belong to the plaintiff. A recovery of damages under those

circumstances would represent a pure windfall justified by no

plausible conception of corrective justice.’

* Take an obvious example. An investor purchases a stock that should

be worth $50 a share at an artificially inflated price of $70 based on

false financial statements that overstate the company’s earnings. The

market never learns of the falsity in the financial statements and so the

share price remains at $70. The next day, an earthquake destroys the

company’s main factory and its stock price drops to $60. The Ninth

Circuit’s approach would allow the investor to satisfy loss causation

based on the purchase-time “inflation,” even though that disparity

remains in the stock price and could readily be recovered by selling

the shares. Allowing recovery under those circumstances is both

economically and legally unjustifiable: the plaintiff has suffered no

economic loss that actually related to the defendant's

muisrepresentations, except in the but-for (and thus legally insufficient)

For these reasons, the deflation of the inflationary effect —

generally through a corrective disclosure — is an essential aspect

of loss causation that the plaintiff must plead to survive a

motion to dismiss and must prove in order ultimately to prevail.

It cannot merely be assumed away as the court of appeals did in

this case. Thus, where (as here) plaintiffs are allowed to satisfy

the transaction causation requirement based on the inflated

stock price attributable to the alleged misrepresentation, they

should be precluded from satisfying loss causation unless and

until they allege and show that the price correspondingly

deflated once the truth came out. See Robbins, 116 F.3d at 1448

(requiring evidence that the “price inflation was removed from

the market price”). The Ninth Circuit’s rejection of that

requirement means that, in an auditing case, plaintiffs could

recover from a CPA for any downturn in the value of their

investment, regardless of whether that fall was actually caused

by the alleged defects in the audit report. Such limitless

recovery would effectively convert auditors into insurers,

strictly liable for whatever ill-fortune besets investors in the

audited company.

IV. THE NINTH CIRCUIT’S UNDULY BROAD

DEFINITION OF LOSS CAUSATION IMPOSES

EXCEPTIONAL BURDENS ON ACCOUNTING

FIRMS ENGAGED IN AUDIT WORK

Ensuring that the loss causation requirement is applied correctly

is of paramount importance to the AICPA and its members. As

explained above, the weakened form of loss causation adopted

by the court below undermines the PSLRA’s express goal of

preventing vexatious private securities litigation by relieving

plaintiffs of any burden of showing that their investment loss

was actually caused by the alleged fraud. By misconstruing that

requirement as it did, the Ninth Circuit gutted a critical 10b-5

sense that is already captured by the fraud-on-the-market

presumption. This simply is not an acceptable view of loss causation.

element designed to separate truly victimized investors from

opportunistic ones.

This is an especially serious problem for certified public

accountants. Under the Ninth Circuit’s rule, any CPA

responsible for auditing the financial statements of a company

whose stock subsequently declines faces liability to a set of

plaintiffs who may not be able even to allege — much less prove

— that the decline was in any way related to the auditor’s actions.

And, given the expense of discovery and litigation in securities

fraud class actions, and the threat of crippling jury verdicts from

those that do go to trial, the pressure to settle cases that are not

dismissed early on can become enormous. See Blue Chip

Stamps, 421 U.S. at 740. This means that accounting firms —

which often are targeted as defendants because others more

directly responsible for the alleged fraud have become

judgment-proof — may be compelled to compensate plaintiffs

even though there is no meaningful connection between the

plaintiffs’ loss and any auditing errors that may have been

committed.

A. The highly judgmental nature of financial

statement auditing makes violations easy to allege

and difficult to rebut

These risks are especially severe in light of the nature of

financial statement auditing. Federal law requires that many

categories of financial statements, including those submitted in

connection with a publicly traded company’s annual report, be

reviewed by an independent auditor. See United States v.

Arthur Young & Co., 465 U.S. 805, 810-11 (1984). Auditing is

an analytic process designed to “add{] credibility to the

information communicated by the accounting process.”

DOUGLAS R. CARMICHAEL, ET AL., AUDITING CONCEPTS AND

METHODS 10 (6th ed. 1996) [hereinafter AUDITING CONCEPTS];

see also Arthur Young, 465 U.S. at 819 n.15 (“The SEC requires

the filing of audited financial statements in order to obviate the

fear of loss from reliance on inaccurate information, thereby

encouraging public investment in the nation’s industries.”’).

It is essential to distinguish the auditing of corporate

financial statements from the job of actually preparing them.

Responsibility for the latter lies in the hands of a company’s

management. See AUDITING STANDARDS, AU § 150.02. The

role of an outside auditor, in turn, is to provide an independent,

professional opinion as to whether those financial statements

fairly present the company’s financial position in conformance

with Generally Accepted Accounting Principles (GAAP). See

Edenfield vy. Fane, 507 U.S. 761, 769 (1993). GAAP

encompasses all the conventions, rules, and procedures that

collectively define accepted accounting practices at a particular

time. See CARMICHAEL, AUDITING CONCEPTS 10. It derives

from a number of sources, including standards promulgated by

AICPA and the Financial Accounting Standards Board (FASB),

prevalent industry practice, as well as expert literature. The

purpose of GAAP is to provide those who prepare financial

statements with the professionally acceptable way (or ways) to

account for a given transaction.

As this Court has recognized, however, GAAP is “far from

being a canonical set of rules that will ensure identical

accounting treatment of identical transactions.” Thor Power

Tool v. Commissioner of Internal Revenue, 439 U.S. 522, 544

(1978). Quite the contrary,

GAAP changes and, even at any one point, is often

indeterminate. “[T]he determination that a particular

accounting principle is generally accepted may be difficult

because no single source exists for all principles.” There are

19 different GAAP sources, any number of which might

present conflicting treatments of a particular accounting

question. When such conflicts arise, the accountant is

directed to consult an elaborate hierarchy of GAAP sources

to determine which treatment to follow.

Shalala v. Guernsey Mem. Hosp., 514 U.S. 87, 101 (1995)

(quoting R. KAY & D. SEARFOSS, HANDBOOK OF ACCOUNTING

AND AUDITING, ch. 5, at 7 (1994 Update)). In addition to being

multifaceted and indeterminate, much of GAAP amounts to

little more than “aspirational norms.” Bily v. Arthur Young &

Co., 3 Cal. 4th 370, 380, 834 P.2d 745, 750 (Cal. 1992).

Because the relevant guidelines may be stated at an extremely

high level of generality, the claim that a violation has occurred

is often easy to make and difficult to refute.

These are the complex criteria against which auditors are

expected to evaluate corporate financial statements. To

determine whether a set of statements complies with GAAP,

certified public accountants rely on a variety of tests and

procedures consistent with Generally Accepted Auditing

Standards (GAAS). These standards define a range of

procedures that a CPA may perform in the course of performing

an audit. “The basic function of an audit under GAAS is to

allow the auditor to formulate an opinion as to whether the

financial statements present fairly the data with which the

auditor has been presented.”’ Michael R. Young, The Liability

of Corporate Officials to Their Outside Auditors for Financial

Statement Fraud, 64 FORDHAM L. REV. 2155, 2162-63 (1996).

Historically, the AICPA has had primary responsibility for

developing GAAS. GAAS comprises ten core auditing

standards, adopted by the membership of the AICPA in 1948

and 1949, and revised by the Auditing Standards Board (ASB).

See CARMICHAEL, AUDITING CONCEPTS 13. In addition, the

ASB has developed and issued 101 Statements on Auditing

Standards (SAS) through a process involving public comment.

See SAS No. 95, Codification of Statements on Auditing

Standards, AU § 105.03 (AICPA 2002).° GAAS also requires

auditors to be aware of and consider certain AICPA interpretive

* These basic auditing requirements are quite broad and open-ended.

For example, according to General Standard 3, “[d]ue professional

care is to be exercised in the performance of the audit and the

preparation of the report.” Similarly, Field Work Standard 2 provides:

“A sufficient understanding of the internal _ntro! structure is to be

obtained to plan the audit and to determine the nature, timing, and

extent of tests to be performed.” CARMICHAEL, AUDITING CONCEPTS

13.

publications, including AICPA’s guides and statements of

position, as well as publications interpreting the SAS.

Professional publications such as journals and textbooks round

out this hierarchy and provide somewhat more detailed

(although less authoritative) guidance to auditors in the field.

See id.; see generally Roger Buffington, A Proposed Standard

of Common Law Liability for the Public Accounting Profession,

5 S. CAL. INTERDISCIPLINARY L.J. 485, 489-90 (1997). Under

Section 103 of the Sarbanes-Oxley Act of 2002, Pub. L. 107-

204 (July 30, 2002), authority to issue Professional Auditing

Standards governing CPAs in the preparation and issuance of

audit reports was conferred upon the Public Company

Accounting Oversight Board (PCAOB). See 15 U.S.C. § 7213.’

It is important to note that even audits performed in full

compliance with GAAS cannot guarantee that every problem

lurking in the financial statements will be discovered. Because

it is impossible to evaluate every single transaction, even for a

small business, auditors invanably rely on sampling techniques

to test the accuracy of financial statements. See Robert W.

Berliner, Audit Reports, 440 PRACTICING LAW INSTITUTE Lit.

41, 55 (July-August 1992). “Audit sampling is the application

of an audit procedure to less than 100 percent of the items

within an account balance or class of transactions for the

purpose of evaluating some characteristic of the balance or

class.” SAS No. 39 (AU 350.01); see also Bily, 834 P.2d at 749

(noting that “an audit rarely, if ever, examines every financial

accounting transaction in the records of a business”). The test

nature of financial auditing, although essential to the process,

does decrease the reliability of an audit as, by definition, it

means that some errors in a given set of financial statements

may go unreviewed and thus undetected.

” The PCAOB is a private, non-profit corporation created by the

Sarbanes-Oxley Act to supervise and regulate the auditing of public

companies. Although not an agency of the federal government, 15

U.S.C. § 7211(b), PCAOB is overseen by the SEC, which appoints its

chairman and members. See id. at § 721 1(e).

This challenge is compounded by the fact that outside

auditors must rely heavily on the financial data provided by the

audited company. Audits are, by their very nature, conducted

in an environment largely controlled by the client. See Bily, 834

P.2d at 762. Although it is appropriate for CPAs to maintain a

degree of professional skepticism about the information they are

given, and not blindly accept the representations of

management, it is simply not possible for an auditor to unearth

any and all misleading assertions that the company includes in

its financial statements. “An auditor is a watchdog, not a

bloodhound.” Bily, 834 P.2d at 762.*

It is for these reasons that CPAs do not certify that audited

financial statements are accurate. The audit report instead states

that in the opinion of the auditor the statements are a “fair

representation” or (“fairly present’’) the actual financial position

of the audited company. The issuance of an unqualified (i.e.

clean) audit report — even one that satisfies all of the

requirements of GAAS — does not and cannot “ensure or

* In October 2002, amidst the recent corporate and accounting

scandals, the ASB promulgated a new auditing standard for

addressing potentially fraudulent financial statements. See SAS No.

99, Consideration of Fraud in a Financial Statement Audit, AU § 316.

The purpose of this new standard was to shift the focus of financial

auditing more to the detection and prevention of management fraud.

This corresponds with the duty previously imposed on auditors by the

PSLRA to take steps to increase the likelihood of detecting fraud. See

15 U.S.C. § 78j-1(a) (audits of financial statements must include

“procedures designed to provide reasonable assurance of detecting

illegal acts that would have a direct and material effect on the

determination of financial statements amounts”). Even under this

standard, however, the auditor is required only to obtain “reasonable

assurances” that fraud has not occurred. SAS No. 99 recognizes that,

given the nature of fraud — and of financial auditing — even a perfect

audit will not necessarily expose concealed chicanery on the part of

corporate managers. See Sally L. Hoffman, The CPA's Professional

Standards: What Are They? Who Sets Them? What Are the Key Issues

Today?, 8J077 ALI-ABA 119, 144 (May 2004).

warrant the accuracy of the financial statements.”

CARMICHAEL, supra, at 9. Indeed, an “audit does not guarantee

that a client’s accounts and financial statements are correct any

more than a sanguine medical diagnosis guarantees well-being;

indeed even an audit conducted in strict accordance with

professional standards countenances some degree of calibration

for tolerable error which, on occasion, may result in a failure to

detect material omission or detection.” Jn re lkon Office

Solutions, 277 F.3d 658, 673 (3d Cir. 2002).

Given the way in which accepted accounting principles

change over time and resist being reduced to a series of bright-

line rules, an auditor’s application of GAAS requires an exercise

of discretionary professional judgment. It does not involve the

mechanical application of mathematical formulae and is closer

to an art than a science. The factors that inform the auditor’s

judgment are numerous and complex, as are the professional

standards that define a job well done. At bottom, then, an audit

opinion is just that: an opinion. It is not — and cannot be — an

objective statement of fact. See Jay Feinman, Liability of

Accountants for Negligent Auditing: Doctrine, Policy, and

Ideology, 31 FLA. ST. U. L. REV. 17, 54 (2003) [hereinafter

Accountants’ Liability}. The California Supreme Court has

aptly described this essential quality of an audit report:

[T]he report is based on the auditor’s interpretation and

application of hundreds of professional standards, many of

which are broadly phrased and readily subject to different

constructions. Although ultimately expressed in shorthand

form, the report is the final product of a complex process

involving discretion and judgment on the part of the auditor

at every stage. Using different initial assumptions and

approaches, different sampling techniques, and the wisdom

of 20-20 hindsight, few CPA audits would be immune from

criticism.

Bily, 834 P.2d at 763. AICPA’s standards are clear about this,

explicitly providing that “a properly designed and executed

audit may not detect a material irregularity.” SAS 53 (§ 316.07)

(AICPA 1989).

Despite these realities, however, an “expectations gap”

persists between what CPAs expect of an audit and what the

public (and often the courts) expect. See Richard I. Miller &

Michael R. Young, Financial Reporting and Risk Management

in the 21st Century, 65 FORDHAM L. REV. 1987, 2016 & n. 129

(1997). This gap contributes to an environment in which

investors are likely to blame auditors for unforseen corporate

collapses and to sue them when they occur. The allegation that

a CPA ran afoul of some aspect of the general rules of GAAS or

failed to identify one of the myriad potential GAAP violations

is easy to make and difficult to rebut. Courts routinely invoke

such alleged violations in sustaining claims against auditors.

See, e.g., Rhode Island Hosp. Trust Nat'l Bank v. Swartz, 485

F.2d 847, 852 (1st Cir. 1972); Jn re Anchor Communications,

Inc., 22 F. Supp. 2d 999, 1005-06 (D. Minn. 1998); Jn re Miller

Indus., Inc., 12 F. Supp. 2d 1323, 1332 (N.D. Ga. 1998).

Especially in a declining market, where the bursting of a bubble

leaves many investors with significant losses, bringing suit

against an auditing firm based on an allegedly deficient audit

can be an easy way to try to recoup those losses. And the Ninth

Circuit’s loose approach to loss causation wrongly allows such

suits to go forward unimpeded.

B. Because auditors are especially vulnerable to

vexatious securities class actions, they will be greatly

harmed by the weakened loss causation rule adopted

by the Ninth Circuit

In addition to the expectations gap, there are other reasons

why CPAs are inviting targets for expansive notions of

securities fraud liability. In the wake of a corporate failure, the

auditor is often the last one standing. In many cases, the issuer

responsible for the allegedly misleading financial statements has

gone bankrupt or become otherwise judgment-proof, leaving the

CPA as the only entity from which plaintiffs can hope to

recover their investment losses. See Daniel L. Brockett, Line

Between Primary and Secondary Liability Still Blurred in

Securities Cases, 50 FED. LAWYER 29, 30 (Aug. 2003). Indeed,

between 30 and 40 percent of securities fraud cases against

auditors involve companies that are in, or about to enter,

bankruptcy. See Zoe-Vonna Palmorose, Who Got Sued? J. OF

ACCOUNTANCY ONLINE (March 1997), available at

www.aicpa.org/pubs/jofa/march97/whosued.htm. Thus, despite

having played a secondary role limited to testing the allegedly

misleading financial statements against a complex and open-

ended set of professional standards, accounting firms frequently

emerge as the lone defendant financially able to satisfy a

judgment. See Feinman, Accountants’ Liability at 57.

Given their exposure to potentially vast liability, as well as

their concern for their professional reputations, accounting firms

may be forced to settle even where the merits of a suit are

dubious. Against this backdrop, a robust loss causation

requirement guards against the prospect that auditors will be

made to cover investment losses for which their actions were in

no way responsible. The loss causation element serves as an

essential safety net for CPAs accused of fraud, one ensuring that

auditors will be liable only to those investors who were actually

harmed as a result of a misstated audit opinion. Unless that

requirement is construed as Congress intended — as a way to

force plaintiffs to plead and prove that their losses were in some

meaningful way connected to the fraud about which they

complain — CPAs will continue to be threatened with unchecked

liability from a class of disappointed investors who do not

allege, and cannot prove, that they lost money as a result of

anything that the auditor said or failed to say.

The Ninth Circuit’s holding in this case significantly

undermines that crucial aspect of loss causation and thereby

moves the securities laws closer to what they were never

intended to be: a form of cost-free insurance for disappointed

investors. See Huddleston, 640 F.2d at 549. The securities

laws do not promise or deliver~comprehensive investor

insurance. The costs of investment losses caused by factors

other than fraud must be assumed by investors, not by

professionals such as CPAs, lawyers, and market analysts.

That, at any rate, was exactly the reason that Congress codified

the loss causation rule when it sought to rein in private

securities class actions in the PSLRA. Allowing lawsuits to

proceed solely on allegations of transaction causation, which

would leave CPAs vulnerable to suit in the case of any audit that

could be alleged to have been imperfect, over-deters auditors,

over-compensates plaintiffs, and fundamentally distorts the

nature of Rule 10b-5. Accord Bastian, 892 F.2d at 685 (“No

social purpose would be served by encouraging everyone who

suffers an investment loss because of an unanticipated change

in market conditions to pick through offering memoranda with

a fine-tooth comb in the hope of uncovering a

misrepresentation. Defrauders are a had lot and should be

punished, but Rule 10b-5 does not make them insurers against

national economic calamities.”’).

Failure to take loss causativn seriously — thereby subjecting

auditors to virtually unchecked litigation exposure — has serious

social and economic consequences. Securities litigation is

extremely costly; one study found that it costs an auditor an

average of $3.7 million to defend itself against even a weak

securities fraud class action. See Palmrose, supra. In the years

immediately preceding passage of the PSLRA, it was well

documented that rampant class action litigation against CPAs

under Rule 1 0b-5 made accounting firms increasingly unwilling

to perform audits for clients perceived as risky, such as those in

financial distress, smaller or less-well established companies

(including start-ups), and companies operating in volatile

industries such as technology. See Frederick L. Jones & K.

Raghunandan, Client Risk and Recent Changes in the Market

for Audit Services, 17 J. ACCT. & PUB. POL’Y 169, 179 (1998).’

* Class action litigation against accounting firms did decrease in the

first years after passage of the PSLRA, a trend undoubtedly helped by

this Court’s holding in Central Bank of Denver, 511 U.S. at 191, that

aiding and abetting liability was not available under Section 10(b).

See SEC, Office of the Gen. Counsel, Report to the President and the

A shrinking supply forces companies with fewer resources

to endure higher prices for legally required financial audits.

Such high-risk firms are particularly dependent upon the

imprimatur of a well-established, well-respected auditor in order

to gain the confidence of the market. Depriving them of quality

auditing services makes it more difficult for the growth sectors

of the economy to develop to their full potential. Central Bank

of Denver, 511 U.S. at 189. For, even where litigation nsk does

not lead CPAs to forego doing audits altogether, they will

typically insist on higher fees to high-risk clients, costs that

audited companies will undoubtedly attempt to pass on to

consumers. See Jamie Pratt & James D. Stice, The Effects of

Client Characteristics on Auditor Litigation Risk Judgments,

Required Audit Evidence, and Recommended Fees, 69 ACCT.

REV. 639, 655 (1994). Empirical studies have also shown that

litigation against an audit firm — even, or perhaps especially,

frivolous ligation — hurts the stock price of an auditor’s other

clients. See Diana R. Franz, et al., The /mpact of Litigation

Against an Audit Firm on the Market Value of Nonlitigating

Clients, 13 J. ACCT. AUDITING & FIN. 117 (1998).

Congress on the First Year of Practice Under the Private Securities

Litigation Reform Act of 1995, at 22 (Apr. 1997), available at

www.sec.gov/news/studies/lreform.txt. More recently, however, there

has been a resurgence in litigation alleging accounting fraud and

targeting CPAs. See Kevin P. Roddy, Seven Years of Practice and

Procedure Under the Private Securities Litigation Reform Act of 1995

(July 24-26, 2003). In 2002, accounting-related cases represented 68

percent of all private securities class actions, up from 47 percent in

1996. Settlements in accounting cases comprised 67 percent of all

securities-related settlement amounts in 2002.

Price WaterhouseCoopers LLP, 2002 Securities Litigation Survey, at

4. It has thus been accurately observed that accounting fraud seems

to have become “the ‘complaint of choice’ for private securities class

action plaintiffs.” /bid. Independent auditors were named in 34 of

these cases, up from 18 the previous year. In absolute terms, 2002

had the highest number of cases against auditors since 1998, when 39

cases were brought. See id. at 7.

Finally, the expansive approach to loss causation embraced

by the Ninth Circuit gives a windfall to plaintiffs that is not

necessary to ensure that potential wrongdoers are deterred.

There is no reason to fear that applying the loss causation

requirement correctly will somehow create a gap in the

enforcement of the securities laws. First, the SEC is not

required to prove either loss causation or transaction causation

when it brings an enforcement action under Section 10(b). See

Br. of the SEC, Amicus Curiae, in Support of Appellants,

Schoenfeld Asset Mgmt. Corp. v. Cendant Corp., Nos. 99-5356;

99-5355 (3d Cir. Sept. 1999), at 12; SEC v. Blavin, 760 F.2d

706, 711 (6th Cir. 1985). The federal government thus always

retains the power to take appropriate action against individuals

and firms that engage in fraud proscribed by the federal

securities statutes, regardless of whether any particular investors

suffered financial harm as a result of that fraud. There is neither

need nor reason to extend that expansive law enforcement

power to private plaintiffs by recefining loss causation as the

court of appeals has done in this case. Indeed, doing so

potentially delegates too much enforcement power to

unaccountable plaintiffs’ lawyers, trenching on the SEC’s

prosecutorial discretion to bring suit in cases where no

individual investor has suffered an injury fairly traceable to the

alleged fraud.

Separate and apart from SEC enforcement, the auditing of

public companies subject to the securities laws is now

monitored and regulated by the PCAOB. The Board is charged

with overseeing audits “in order to protect the interests of

investors and further the public interest in the preparation of

informative, accurate, and independent audit reports for

companies the securities of which are sold to, and held by and

for, public investors.” 15 U.S.C. § 7211(a). The Board has

broad supervisory and regulatory powers over auditors and is

empowered to investigate and bring disciplinary charges against

accounting firms for violations of the securities laws. See id. at

§ 7215. In addition, state accountancy boards have wide-

ranging disciplinary authority over the accountants whom they

license to practice. This thorough supervision of public

company accounting practices both demonstrates the lack of

need for a relaxed loss causation rule and raises the possibility

that adopting such a rule will lead to excessive regulation

through private litigation in which plaintiffs cannot

meaningfully connect the loss they suffcred with the auditor's

actions.

CONCLUSION

For the foregoing reasons, the judgment of the Ninth Circuit

should be reversed.

Respectfully submitted,