Ernst & Young Must Face Trial for Ignoring Fraud

(CN) - The 9th Circuit on Thursday revived a class action against Ernst & Young, finding that the accounting firm may have ignored years of fraud by client Broadcom and contributed to a $2.2 billion stock-option backdating scheme.

Broadcom, a semiconductor company, paid a $12 million civil penalty to settle Securities and Exchange Commission charges that it improperly accounted for $2.2 billion in income from 1998 to 2005, according to the ruling. Several of the company's executives now face civil and criminal charges.

A class of plaintiffs composed of the New Mexico State Investment Council and several union pension funds claimed in a Los Angeles District Court that Ernst & Young enabled Broadcom's crimes by ignoring red flags and signing off on obviously fraudulent financial statements that caused Broadcom's stock price to be artificially inflated.

Describe in the ruling as "akin to betting on a horse race after the horse has already crossed the finish line," in a typical backdating scheme, a company's directors will monitor the price of the company's stock and award options when the share is at its lowest, thereby allowing stock owners to make the largest possible profit. While not illegal in itself, if the company fails to properly record the backdated options, then its reported net income becomes overstated and could potentially deceive the market and investors.

According to the ruling, "with revenues in excess of $2.5 billion in 2006, [Broadcom] fraudulently overstated its net earnings, and understated its compensation expense, by more than $2.2 billion between 2000 and 2006 due to improper accounting of backdated stock options."

U.S. District Judge Manuel Real dismissed the case against Ernst & Young in 2009, ruling that the plaintiffs had failed to show that the accounting firm knew it had engaged in wrongdoing.

A three-judge panel of 9th Circuit in Pasadena reversed that ruling unanimously on Thursday, sending the complaint back to the District Court. Their decision was authored by U.S. District Judge Jack Zouhary, sitting by designation from Northern District of Ohio.

The panel found numerous examples in the plaintiffs' complaint that Ernst & Young (EY), at the very least, "knew Broadcom's internal controls were weak, and ignored other red flags."

"EY, as Broadcom's auditor from 1998 until being fired in 2008, repeatedly offered unqualified audit opinions despite an awareness of large, undocumented stock option grants, and despite having suspicions of Broadcom's option grant procedures multiple times over the years, from the questionable $700 million May 2000 grant, to the three separate 2001 grants when one of the two compensation committee members was deceased, to assisting Broadcom in 2003 with corrective actions to 'prevent and detect any future instances of improper accounting for equity awards," Zouhary wrote for the court. "During this entire time, EY failed to change course. While Broadcom's bad acts certainly may have played a role in the overall fraud, this court's purpose at this stage ... is simply to test whether the complaint provides a sufficient inference of scienter [knowledge of wrongdoing] for the case to proceed against EY. It does."

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