Ethical Obligations and Decision Making in Accounting, 4/e 1
Case 6-1 Advanced Battery Technologies: Reverse Merger
Auditors are not always found guilty of negligence, gross negligence, and fraud when lawsuits
are filed against them. And they do not always settle lawsuits to avoid costly, protracted
litigation. A good example is legal action taken against three accounting firms in In re Advanced
Battery Technologies, Incorporated and Ruble Sanderson v. Bagell, Josephs, Levine & Co., LLC,
The Second Circuit’s opinion in ABAT stated that to allege scienter on a recklessness theory
against an independent audit firm under Section 10(b) of the Securities Exchange Act of 1934
and Rule 10b-5, a plaintiff must allege facts showing that the audit firm’s auditing practices were
so deficient as to amount to fino audit at all” or that the audit firm disregarded signs of fraud that
were fiso obvious” that the audit firm must have been aware of them.
The ABAT ruling is significant because it is the first federal appellate case to expressly reject
scienter arguments based on the alleged discrepancy between a company’s filings with the U.S.
SEC and with China’s State Administration of Industry and Commerce (SAIC), a regulatory
agency to which Chinese companies must submit financial statements as part of an annual
The Second Circuit agreed with the district court that the proposed amended complaint, like the
previous complaint, failed to adequately plead the audit firms’ scienter under the theory of
recklessness and that amendment would be futile. The appellate court explained that the plaintiff
was required to allege conduct fithat is highly unreasonable, representing an extreme departure
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Much of the Second Circuit’s analysis focused on the plaintiff’s argument that the audit firms
acted recklessly by failing to inquire about or review ABAT’s financial filings with China’s
SAIC. In rejecting these arguments, the court noted that none of the fistandards on which [the
lead plaintiff] relies—the Generally Accepted Auditing Standards, Statements on Auditing
Standards, or GAAP [generally accepted accounting principles]—specifically requires an auditor
to inquire about or review a company’s foreign regulatory filings.”
The court declined to adopt the general rule, urged by the plaintiff, that allegations of an audit
firm’s failure to inquire about or review such foreign filings are adequate to plead recklessness
under the PSLRA. Although the court noted that fisuch a legal duty could arise under certain
The ABAT opinion is significant because it illustrates the high burden plaintiffs face in pleading
recklessness in Section 10(b) cases against independent audit firms. Notably, since under the
PSLRA the plaintiffs filing suit must plead with particularity facts alleging that the audit firm’s
work was so deficient as to amount to no audit at all, the historical legal standards for auditor
Questions
1. Do you believe the legal standards of allegations with fiparticularity sufficient facts”
and of fino audit at all” cited in ABAT under Section 10(b) of the Securities
Exchange Act of 1934 are too strict, too lenient, or just about right with respect to
auditors’ legal liability in cases similar to ABAT? Explain.
Since the standard requires that the auditor act with the firequired state of mind” it would
seem the standards are fair in that the scienter requirement requires intent; to prove fraud
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2. In ABAT, the plaintiffs alleged that the auditors falsely represented that they
performed their audits in accordance with professional standards and that ABAT’s
financial statements were fairly presented. The amended complaint alleged that the
audit firms were reckless and committed an fiextreme departure from the
reasonable standards of care” by failing to identify several purported fired flags.”
Do you believe the failure to identify red flags should be sufficient in a court of law
to successfully allege gross negligence? Include in your discussion the purpose of
auditors looking to detect red flags as part of their audits in accordance with GAAS.
Gross negligence is a conscious and voluntary disregard of the need to use reasonable
care, which is likely to cause foreseeable grave injury or harm to persons, property, or
both. It is conduct that is extreme when compared with ordinary negligence which is a
mere failure to exercise reasonable care. Ordinary negligence and gross negligence differ
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3. Do you believe that auditors should be held legally liable when their filings to the
SEC are [overly] optimistic while filings with Chinese regulatory agencies are
[unduly] pessimistic? Explain using ethical reasoning to craft your answer.
The key consideration is whether the difference in filings is due to some conscious effort
to manipulate earnings under one regime or the other, or whether it is a by-product of
different accounting standards in reporting results.
Much of the regulation of public stocks in China is done directly by the Hong Kong
Stock Exchange and the Shanghai Exchange. Both have listing procedures similar to U.S.
exchanges. Companies must report financial results on a timely basis, and audits of
company financial results are performed, although the accounting rules are different from
the U.S.