In Ferris, Baker Watts, Inc. v. Ernst & Young, LLP, No. Civ.03-3339RHK/AJB (D. Minn., Nov. 24, 2003), the U.S. District Court for the District of Minnesota dismissed with prejudice FBW's claim that E&Y violated Section 10(b) as the result of certain misrepresentations in its 2001 audit opinion for MJK Clearing, a now-bankrupt securities broker-dealer. A copy of the opinion is available here. FBW alleged that in reliance on E&Y's audit, it sent (and lost) $20 million of cash collateral to MJK in exchange for certain "manipulated--and essentially worthless--securities."

FBW alleged that among other things, it reviewed and relied upon E&Y's statement that it had reviewed the financial statements in accordance with customary audit procedures. In fact, FBW alleged, E&Y violated numerous accounting and auditing principles, which indicated "such pervasive indifference to GAAP and GAAS requirements, and such egregious violations, that they cumulatively amount to circumstantial evidence establishing a strong inference of scienter."

The Court disagreed, stating flatly that

FBW is wrong. As the Eighth Circuit has stated, "Allegations of GAAP violations are insufficient, standing alone, to raise an inference of scienter. Only where these allegations are coupled with evidence of corresponding fraudulent intent [or recklessness] might they be sufficient."; While FBW cites authority--all outside of the Eighth Circuit--for the proposition that particularly egregious or widespread GAAP and GAAS violations might be sufficient to generate an inference of scienter, the Eighth Circuit has held squarely to the contrary.

The reason for this rule is clear. GAAP are "far from being a canonical set of rules that will ensure identical accounting treatment of identical transactions. [GAAP], rather, tolerate a range of 'reasonable' treatments, leaving the choice among alternatives to management." To allow a strong inference of scienter on the basis of GAAP and GAAS violations alone would--almost by definition--"countenance pleading fraud by hindsight." This the Court cannot do. (Citations omitted).