Wink, Wink, Nudge Judge: Persuading U.S. Courts to Take Accountants Seriously in Federal Securities Cases, with Help from the U.K. Companies Act
The 2008 collapse of Lehman Brothers reopened wounds many thought were healed by the Sarbanes-Oxley Act (SOX) in 2002. The Lehman litigation finally ended in late 2013 with audit firm Ernst & Young paying $99 million to investors who claimed the firm misled them with generally accepted accounting principles (GAAP). Other defendants, including banks, officers, and directors, paid out more than $500 million. The bright line standards of GAAP and SOX were obviously not enough to protect Lehman plaintiffs or defendants. Why not? The 2006 fraud trial of Enron CEO Jeffrey Skilling offers clues. When asked at trial whether U.S. accounting principles (GAAP) permitted Enron’s accountants to mislead Enron’s auditors, Skilling’s accounting expert Walter Rush replied: “[T]his isn't even an issue under GAAP. GAAP doesn't talk about misleading. GAAP doesn't talk about integrity. GAAP talks about accounting rules, how you measure assets and liabilities, what kind of disclosures you make.” At about the same time, the SEC’s Chief Accountant declared that most financial statements are misleading. Against this backdrop, in leading recent securities fraud cases, federal courts have disregarded or studiously avoided GAAP and accounting experts, examining more broadly whether financial statements are “fairly presented” or “not misleading,” thus dismissing costly accounting testimony as irrelevant and suddenly exposing defendants — like those in Lehman — to unforeseen legal exposure. Meanwhile, leading accounting scholars and professional associations, domestic and international, have vociferously decried the FASB’s narrow focus on GAAP compliance to the virtual exclusion of fairness and integrity in financial reporting. This article documents the tendency of federal courts to ignore accounting experts in federal securities fraud cases, chronicles the ongoing debate over GAAP compliance and fair presentation, summarizes relevant U.S. and U.K. statutes and regulations, and recommends reforms suggested by the U.K. Companies Act 2006, the IASB, and the FASB’s own Concepts Statement No. 8 that may help to restore the marketplace and courtroom relevance of accounting experts.