Danske Invest Management A/S purchased American Depositary Shares, a type of security, issued by Longtop Financial Technologies Ltd. When making the purchase, Danske relied in part on Longtop audited by Deloitte Touche Tohmatsu. When the value of the ADSs declined after disclosure that Longtop’s financial results were inflated by fraudulent behavior of its employees, Danske brought an action against Deloitte under Section 10(b) and Rule 10b–5 of the Securities Exchange Act of 1934. Danske alleged that had Deloitte insisted on obtaining third-party confirmations of Longtop’s major revenue contracts in 2009, as it had done in 2008 and originally proposed to do in 2009 in e-mails to Longtop management, Deloitte would have uncovered Longtop’s fraud. Danske also alleged that performing thirdparty confirmations of the revenue contracts was a required procedure under the circumstances and that Longtop’s excuse that this procedure would delay the filing of its 2009 Form 20-F with the SEC should have increased Deloitte’s professional skepticism. Danske argued that Deloitte was reckless because it agreed to perform alternative testing on revenue to confirm Longtop’s major revenue contracts rather than obtaining third-party confirmations.
Deloitte did confirm Longtop’s accounts receivable. Direct confirmation of revenue contracts is not a presumptively required audit step under GAAS. Deloitte initially took the position that third-party confirmation of revenue contracts was required, based on its reading of international auditing standards and a concept release proposed by the PCAOB for notice and comment, but was persuaded by Longtop’s CEO, Derek Palaschuk, that under American GAAS, this procedure was not required. Palaschuk pointed out that conducting third-party confirmations of revenue contracts was not presumptively required under the GAAS and also gave numerous reasons why it was not necessary under the circumstances. He noted that Longtop (1) had no individually material contracts for the 2009 fiscal year and no long-term material contracts; (2) had never modified a contract; (3) had bad debt of less than 0.5 percent of its sales; and (4) had many contracts with and was, therefore, under the scrutiny of large companies, making fraud more difficult. Deloitte was ultimately persuaded by Palaschuk’s argument, but noted that it would need to re-visit the issue if new auditing standards were to be released.
Danske’s argued that Palaschuk’s resistance when Deloitte proposed conducting client confirmations of revenue contracts was a significant red flag and that therefore Deloitte’s behavior amounted to scienter under Rule 10b–5. Did the court agree?
