New Mexico State Investment Co, et al v. Ernst & Young LLP, et al

Filing

FILED OPINION (ALFRED T. GOODWIN, JOHNNIE B. RAWLINSON and JACK ZOUHARY) For the reasons set forth above, we REVERSE the ruling granting Defendant EY s Motion to Dismiss, and REMAND the case for further proceedings consistent with this Opinion. Judge: ATG , Judge: JBR , Judge: JZ Authoring. FILED AND ENTERED JUDGMENT. [7716588]

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FOR PUBLICATION

UNITED STATES COURT OF APPEALS
FOR THE NINTH CIRCUIT
NEW MEXICO STATE INVESTMENT
COUNCIL, Lead Plaintiff,
Plaintiff-Appellant,
and
SONAM BAKSHI, individually and on
behalf of all others similarly
situated; BAKERS LOCAL NO. 433
PENSION FUND; MINNESOTA BAKERS
UNION PENSION FUND; TWIN CITIES
BAKERY DRIVERS PENSION FUND,
Plaintiffs,
v.
ERNST & YOUNG LLP,
Defendant-Appellee,
and
HENRY SAMUELI; WILLIAM J.
RUEHLE; BROADCOM CORPORATION;
DAVID A. DULL; ALAN E. ROSS;
WERNER F. WOLFEN; GEORGE L.
FARINSKY,
Defendants.





No. 09-55632
D.C. No.
2:06-CV-05036R-CW
OPINION



Appeal from the United States District Court
for the Central District of California
Manuel L. Real, District Judge, Presiding
Argued and Submitted
November 1, 2010—Pasadena, California
Filed April 14, 2011
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Before: Johnnie B. Rawlinson and Alfred T. Goodwin,
Circuit Judges, and Jack Zouhary, District Judge.*
Opinion by Judge Zouhary

*The Honorable Jack Zouhary, United States District Judge for the
Northern District of Ohio, sitting by designation.

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COUNSEL
Thomas A. Dubbs (argued), Joseph A. Fonti, and Stephen W.
Tountas, Labaton Sucharow LLP, New York, New York, for
lead plaintiff-appellant New Mexico State Investment Council.
Robert B. Hubbel (argued), Michael M. Farhang, and Alexander K. Mircheff, Gibson, Dunn & Crutcher LLP, Los Angeles,
California, for defendant-appellee Ernst & Young, LLP.

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OPINION
ZOUHARY, District Judge:
INTRODUCTION
Lead Plaintiff New Mexico State Investment Council, individually and on behalf of all others similarly situated
(“Plaintiffs”), appeals the district court’s grant of Defendant
Ernst & Young’s (“EY”) Motion to Dismiss. The claims
against EY stem from a securities class action complaint
against Broadcom Corporation (“Broadcom”), certain Broadcom officers and directors, and Broadcom’s auditor EY (collectively, “Defendants”), for a fraudulent $2.2 billion stock
options backdating scheme. Plaintiffs specifically allege that
EY, as Broadcom’s auditor, knew of, or recklessly disregarded, Broadcom’s fraudulent backdating actions yet issued
unqualified audit opinions attesting to the validity of Broadcom’s financial statements. The district court granted EY’s
Motion to Dismiss, finding the Consolidated Amended Class
Action Complaint (“Complaint”) failed to adequately plead
scienter against EY.
Plaintiffs contend on appeal that the Complaint contains
well-pled factual allegations sufficient to survive a motion to
dismiss. EY argues dismissal was proper and, in the alternative, the district court’s judgment should be affirmed based on
Plaintiffs’ failure to sufficiently plead loss causation, a ground
the district court explicitly did not reach.1
1

EY argues this Court can affirm “on any ground supported by the
record, even if the district court did not rely on the ground.” Livid Holdings, Ltd. v. Salomon Smith Barney, Inc., 416 F.3d 940, 950 (9th Cir.
2005). While correct, the U.S. Supreme Court cautions: “It is the general
rule, of course, that a federal appellate court does not consider an issue not
passed upon below.” Singleton v. Wulff, 428 U.S. 106, 120 (1976); see
also Peterson v. Highland Music, Inc., 140 F.3d 1313, 1318 (9th Cir.
1998). Because the district judge stated explicitly that he did not reach the
issue of loss causation with respect to EY, we will not second guess the
district court in the absence of a record.

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PROCEDURAL HISTORY and BACKGROUND
Procedural History
This case finds its roots in a large accounting fraud related
to stock option backdating. Broadcom, a semiconductor company with revenues in excess of $2.5 billion in 2006, 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.
In October 2008, Plaintiffs filed a Consolidated Amended
Class Action Complaint on behalf of all persons who purchased Broadcom Class A common stock between July 21,
2005 and July 13, 2006. The Complaint seeks damages under
Section 10(b) of the Securities Exchange Act of 1934, 15
U.S.C. § 78j(b), and Securities Exchange Commission Rule
10b-5 for Defendants’ fraudulent accounting practices, alleging they caused Broadcom’s stock price to be artificially
inflated.
Defendants moved to dismiss. The district court heard oral
argument in February 2009 and granted Defendant EY’s
Motion to Dismiss, stating: “I think the allegations are deficient on actual knowledge of the defendant . . . , and I think
there’s a little bit of a heavier burden of allegations on
accountants on the question of scienter.” “Plaintiff has failed
adequately to plead scienter as against EY[.]”
The Complaint
The lengthy Complaint includes nearly thirty-five pages of
allegations that EY, as Broadcom’s auditor, was complicit in
a stock option backdating scheme involving options to purchase over 239 million shares of Broadcom stock between
1998 and 2005. Broadcom used stock options as part of a
compensation package for officers, directors, and key

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employees. The recipient of the option was given the opportunity to purchase a certain number of shares of company stock
at a given price on or after a predetermined date.2 Broadcom’s
option plan provided for a vesting schedule of four years,
meaning an employee could only exercise his or her option
over a four-year period.
Backdating of options is akin to betting on a horse race
after the horse has already crossed the finish line. Backdating
of options occurs when a company’s officers or directors
responsible for administering the stock option plan monitor
the price of the company stock and then award a stock option
grant as of a certain date in the past when the share price was
lowest, thus locking in the largest possible gain for the option
recipient.
A backdated option is not in and of itself improper under
the law or accounting principles. See Edward J. Goodman
Life Income Trust v. Jabil Circuit, Inc., 594 F.3d 783, 788
(11th Cir. 2010). However, when a company chooses to issue
such “in the money” options (so called because the options
represent an immediate paper profit), accounting principles
require the company to record an expense for the “profit,”
treated as compensation to the option recipient over the vesting period. If the company does not properly record the backdated options, then the company’s reported net income is
2
For example, if the company granted an option to an employee to purchase 100 shares at a “strike price” of $10/share, the employee can purchase 100 shares for $1,000, regardless of the market price for the shares
on the date the employee exercises the option. Thus, if the market price
for the shares on the day the option was exercised was $15/share, the
employee had an immediate paper profit of $5/share. If, however, the market price for the stock is lower than the strike price on the day the option
can be exercised, the option is worthless because the stock could be purchased on the open market cheaper than by exercising the option. Options
typically vest over a set time period. E.g., if the grant was 100 shares at
$10/share over four years, the employee could exercise the option to purchase 25 shares per year (4 years x 25 shares = 100 total shares).

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overstated for each of the years the options vest, potentially
deceiving the market and investors.
The Restatement and EY Opinion
Broadcom engaged in an improper stock option backdating
scheme that required the company to restate its financial statements in January 2007 for fiscal years 1998 to 2005 (the “Restatement”). The Restatement acknowledged that Broadcom
had improperly accounted for $2.2 billion in income, largely
due to improper option backdating. Additionally, every financial statement, and quarterly and annual report issued during
the time period covered by the Restatement, was false and
misleading. As a result, Broadcom agreed to a civil penalty of
$12 million in connection with a SEC civil securities fraud
investigation, and various Broadcom officers and directors
face civil and criminal charges.
The crux of Plaintiffs’ claim is that EY, in its role of auditor issuing the unqualified 2005 Opinion, knew of, or was
deliberately reckless in not knowing, that the 2005 Opinion
was materially false and misleading due to Broadcom’s stock
option backdating scheme. The 2005 Opinion covered three
years of Broadcom’s financial statements (2003-05), stating
that the financial statements “present fairly, in all material
respects, the consolidated financial position of Broadcom
Corporation at December 31, 2005 and 2004, and the consolidated results of its operations and its cash flows for each of
the three years in the period ended December 31, 2005, in
conformity with generally accepted accounting principles
[(“GAAP”)].” The 2005 Opinion also stated that EY had performed the audit in accordance with generally accepted auditing standards (“GAAS”).
Allegations Against EY
Plaintiffs’ allegations that EY had the required scienter for
a fraud claim, namely that EY knew, or was deliberately reck-

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less in not knowing, about the fraudulent option backdating,
are as follows:
•

EY knew the material consequences of a May
2000 backdated option grant that would have
resulted in a $700 million charge to Broadcom’s
financial results but, despite violations of GAAS,
signed off on the grant without obtaining documentation;

•

EY knew that several significant option grants
were approved on dates when Broadcom’s compensation committee was not legally constituted
due to the death of one of the two committee
members;

•

EY presided over corrective reforms in 2003 to
prevent and detect any future instances of
improper stock option awards without questioning the integrity of Broadcom’s accounting for
options granted prior to the corrective reforms;

•

EY knew that there was insufficient documentation for nearly half of the $2.2 billion in backdated option grants in violation of GAAS;

•

EY knew that Broadcom’s internal controls were
weak and failed to expand the scope of its audit
procedures as required under GAAS; and

•

EY was deliberately reckless in ignoring a number of “red flags” that should have alerted them
to the potential for material misstatements related
to stock-based compensation.

The Complaint includes additional details with respect to
each of the above allegations, and Plaintiffs argue that these
detailed allegations, both individually and collectively, sup-

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port a strong inference that EY had the necessary scienter to
survive a Motion to Dismiss.
STANDARD OF REVIEW
We review de novo challenges to a dismissal for failure to
state a claim under Federal Civil Rule 12(b)(6). Livid Holdings, Ltd., 416 F.3d at 946. Such review is generally limited
to the face of the complaint, materials incorporated into the
complaint by reference, and matters of judicial notice. Metzler
Inv. GMBH v. Corinthian Colls., Inc., 540 F.3d 1049, 1061
(9th Cir. 2008) (citing Tellabs, Inc. v. Makor Issues & Rights,
Ltd., 551 U.S. 308, 322 (2007)). In undertaking this review,
we will “accept the plaintiffs’ allegations as true and construe
them in the light most favorable to plaintiffs,” Gompper v.
VISX, Inc., 298 F.3d 893, 895 (9th Cir. 2002), and will hold
a dismissal inappropriate unless the complaint fails to “state
a claim to relief that is plausible on its face,” Bell Atl. Corp.
v. Twombly, 550 U.S. 544, 570 (2007).
ALLEGATIONS OF SCIENTER
[1] To adequately plead scienter, a securities fraud complaint must “state with particularity facts giving rise to a
strong inference that the defendant acted with the required
state of mind.” 15 U.S.C. § 78u-4(b)(2)(A). A complaint can
plead scienter by raising a strong inference that the defendant
possessed actual knowledge or acted with deliberate recklessness. Zucco Partners, LLC v. Digimarc Corp., 552 F.3d 981,
991 (9th Cir. 2009). Contrary to the district court’s comment
that scienter allegations against accountants or auditors carry
“a little bit of a heavier burden,” this Court has previously
advised against developing “separate[ ] rules of thumb for
each type of scienter allegation.” South Ferry LP, No. 2 v.
Killinger, 542 F.3d 776, 784 (9th Cir. 2008).
A securities fraud complaint will survive a motion to dismiss under Rule 12(b)(6) “only if a reasonable person would

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deem the inference of scienter cogent and at least as compelling as any opposing inference one could draw from the facts
alleged.” Tellabs, Inc., 551 U.S. at 324. Thus, a court reviewing scienter allegations under the Private Securities Litigation
Reform Act of 1995 (“PSLRA”) must “consider the complaint
in its entirety.” Id. at 322. The court must determine whether
“all of the facts alleged, taken collectively, give rise to a
strong inference of scienter, not whether any individual allegation, scrutinized in isolation, meets that standard.” Id. at
323. Finally, when “determining whether the pleaded facts
give rise to a ‘strong’ inference of scienter, the court must
take into account plausible opposing inferences.” Id. This “inquiry is inherently comparative.” Id. A court must compare
the malicious and innocent inferences cognizable from the
facts pled in the complaint, and only allow the complaint to
survive a motion to dismiss if the malicious inference is at
least as compelling as any opposing innocent inference. See
id. at 324; see also Metzler Inv., 540 F.3d at 1066.
[2] Under Tellabs and Ninth Circuit law, we conduct a
two-part inquiry for scienter: first, we determine whether any
of the allegations, standing alone, are sufficient to create a
strong inference of scienter; second, if no individual allegation is sufficient, we conduct a “holistic” review of the same
allegations to determine whether the insufficient allegations
combine to create a strong inference of intentional conduct or
deliberate recklessness. Zucco, 552 F.3d at 991-92. Arguing
that EY was, or should have been, aware of significant
accounting problems within audit years covered by its 2005
Opinion, Plaintiffs allege scienter based on three specific
points when EY was faced with circumstances that would
compel a reasonable auditor to further investigate and disclose
Broadcom’s backdating of options: (1) a large grant of
options on May 26, 2000 for which EY was given no documentation; (2) options granted in 2001 during a period when
Broadcom’s compensation committee did not have a quorum
due to the death of one of its members; and (3) EY’s direct

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involvement in 2003 with corrective reforms to Broadcom’s
prior options practices.
We hold that these factual allegations were each sufficient
to support an inference of scienter by EY. While a holistic
review is therefore unnecessary, these primary allegations certainly support an inference of scienter when viewed collectively with other claims that EY received no documentation
for many option grants, knew Broadcom’s internal controls
were weak, and ignored other red flags.
EY’s Knowledge of the May 2000 Backdated Option
Grant
Plaintiffs’ most detailed allegations of scienter involve a
series of events surrounding a large stock option grant on May
26, 2000, when Broadcom’s Compensation and Options Committee allegedly granted over seven million options to various
senior officers. At the time, this was the single largest grant
of stock options in Broadcom’s history. The choice of the
May date for the option grant was suspect because, on that
day, not only was the price of Broadcom’s stock at its lowest
point for the entire month of May, but also the lowest closing
price since October 1999 and, as it turns out, until October
2000.
By July 2000, EY started to question the timing of the May
2000 grant, as Broadcom’s stock price had risen from $118
per share on May 26, 2000 to a high of $261 per share in July
2000. Plaintiffs allege that EY knew by July 2000 that Broadcom had not yet allocated the grants to its employees, as
required under GAAS, but failed to investigate. Accordingly,
EY’s issuance of the unqualified 2005 Opinion (including the
accuracy of Broadcom’s 2003-05 financials) represented a
material misstatement.
The Complaint points to emails sent on July 20, 2000.
Broadcom’s Manager of Financial Reporting informed Broad-

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com’s CFO that she was “experiencing resistance from [EY]”
and that “[t]he basic concern is the measurement date of these
grants (5/26/00).” The Manager of Financial Reporting also
informed the CFO that “[the auditors] could require us to
record compensation expenses . . . [that] could be over $700
million based on the 5/26/00 price and the current price!”
Later that day, Broadcom’s CFO informed the CEO that EY
was requesting documentation, which did not exist, for the
May 2000 grant, and that EY was “making noise” that the
company will have to take a $700 million compensation
charge.
Concern over the measurement date of the grant was based
on a specific GAAP standard. The reporting of expenses associated with stock options is governed by an opinion by the
Accounting Principles Board entitled “Accounting for Stock
Issued to Employees.” ACCOUNTING PRINCIPLES BOARD,
OPINION NO. 25 (1972) (“APB 25”).3 Under APB 25, if the
options had an exercise price lower than the fair market value
of the stock as of the “measurement date,” the company
would have to recognize a compensation expense over the
option’s vesting period or the period of time the employee
performed services for the company. The expense would be
equal to the difference between fair market value as of the
grant date and the exercise price. APB 25 §§ 12-14.
Critical to this rule is the option’s “measurement date.”
This term refers to the date on which the fair market value of
the option is determined. The measurement date is the first
date on which both of the following are known: (1) the number of options that each individual employee is entitled to
3

The Financial Accounting Standards Board promulgated Rule FAS123
in 1995 with the intent of replacing APB 25 for the accounting of stock
options. However, companies were permitted to continue using APB 25 in
reporting their financial statements. Broadcom chose to continue using
APB 25 as reflected in its financial statements during the relevant time
period.

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receive, and (2) the option or purchase price. APB 25.10(b).
Frequently, the measurement date is the date the option is
granted to the employee. Id. There are instances where the
measurement date can be more complicated to measure, such
as an option grant conditioned on some other event occurring,
such as a promotion or assuming a new position. See In re
CNET Networks, Inc., 483 F. Supp. 2d 947, 955 (N.D. Cal.
2007). When a company, under proper guidance of the board
of directors and executives, chooses to award a block of
options to various employees, the measurement date cannot
be established until the exact recipients and their respective
number of options are identified. Id. at 955-56 (citing APB
25.10(b)).
Plaintiffs allege that EY violated GAAS by failing to verify
whether Broadcom’s May 2000 option grant was in violation
of GAAP and APB 25. GAAS standards provide, in part:
[T]he accountant may become aware of matters that
cause him or her to believe that interim financial
information, filed or to be filed with a specified regulatory agency, is probably materially misstated as a
result of a departure from generally accepted
accounting principles. In such circumstances, the
accountant should discuss the matters with the
appropriate level of management as soon as practicable. . . . If, in the accountant’s judgment, management does not respond appropriately to the
accountant’s communication within a reasonable
period of time, the accountant should inform the
audit committee, or others with equivalent authority
and responsibility . . . of the matters as soon as practicable.
PUBLIC COMPANY ACCOUNTING OVERSIGHT BOARD (“PCAOB”),
INTERIM AUDITING STANDARDS (“AU”) § 722A.20-.21. GAAS
also requires an auditor to maintain independence in mental
attitude during an audit, to obtain sufficient evidence to afford

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a reasonable basis for its opinion, and for financial statements
subject to audit to be presented in accordance with GAAP.
See AU §§ 220, 410; PCAOB, AUDITING STANDARDS (“AS”)
§ 15.04.
The EY audit team, led by partners Blythe and Stump,
allegedly engaged in an “intense discussion” but no follow up
with Broadcom’s executives, and eventually “capitulated” to
Broadcom’s CFO on July 24, 2000, ultimately relying on a
single conversation with him that the option grant was properly accounted. Plaintiffs claim that the CFO told EY that, on
May 26, 2000, the Options Committee had (1) authorized a
fixed number of options to be granted; and (2) approved a
“program” establishing a set “Guideline Matrix” for calculating the number of options awarded to each employee. Plaintiffs allege that the CFO’s oral representation was not
sufficient to satisfy GAAP, and that EY neither received nor
relied on any documents from Broadcom before EY signedoff on the May 2000 grant, thereby violating GAAS.
In further support of EY’s wrongdoing, Plaintiffs point to
another email, sent on September 11, 2000 by Broadcom’s
Manager of Financial Reporting to its CFO, acknowledging
that EY granted Broadcom “flexibility” with respect to the
May 2000 grant, and that “[g]oing forward, we can expect
much greater scrutiny by [the auditors] on our option granting
process.”
As a result of these events, Plaintiffs argue: (1) EY had
actual knowledge that the May 2000 option grant did not
comply with GAAP and that EY’s own audit did not comply
with GAAS; and (2) because the Broadcom options had a
four-year vesting period, the consequences of the May 2000
grant caused material misstatements in Broadcom’s audited
financial statements in fiscal years 2001-04, years expressly
covered in the 2005 Opinion.
Typically, pleading sufficient facts to support a strong
inference of scienter by an outside auditor is difficult because

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outsider auditors have more limited information than, for
example, the company executives who oversee the audit. Further, an auditor exercises “complex and subjective professional judgments that courts are not ideally positioned to
second guess.” In re Countrywide Fin. Corp. Sec. Litig., 588
F. Supp. 2d 1132, 1197 (C.D. Cal. 2008). In examining allegations of scienter, courts have looked at a range of factors for
potential “red flags,” including the interaction of auditors with
company executives and the breadth and scope of the auditor’s deviation from GAAP or GAAS. See In re Enron Corp.
Sec., Derivative & ERISA Litig., 235 F. Supp. 2d 549, 673-85
(S.D. Tex. 2002).
The “red flag” doctrine guides the GAAP and GAAS inquiries: the more facts alleged that should cause a reasonable
auditor to investigate further before making a representation,
the more cogent and compelling a scienter inference becomes.
In re Countrywide, 588 F. Supp. 2d at 1197; see also DSAM
Global Value Fund v. Altris Software, Inc., 288 F.3d 385, 389
(9th Cir. 2002). “Scienter requires more than a misapplication
of accounting principles. The plaintiff must prove that the
accounting practices were so deficient that the audit amounted
to no audit at all, or an egregious refusal to see the obvious,
or to investigate the doubtful, or that the accounting judgments which were made were such that no reasonable accountant would have made the same decisions if confronted with
the same facts.” In re Software Toolworks Inc., 50 F.3d 615,
628 (9th Cir. 1994) (quoting Miller v. Pezzani (In re Worlds
of Wonder Sec. Litig.), 35 F.3d 1407, 1426 (9th Cir. 1994)).
When assessing GAAP violations in connection with auditor scienter, the violations should generally be more than
“minor or technical in nature” and “constitute [ ] widespread
and significant inflation” to contribute to a strong inference of
scienter. In re Daou Systems, Inc., 411 F.3d 1006, 1017 (9th
Cir. 2005). While a violation of GAAP, standing alone, is not
sufficient, allegations of recklessness have been sufficient
where defendants “failed to review or check information that

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they had a duty to monitor, or ignored obvious signs of
fraud.” Novak v. Kasaks, 216 F.3d 300, 308-09 (2nd Cir.
2000).
With respect to allegations of GAAS violations and how an
audit is conducted, “[a]lleging a poor audit is not equivalent
to alleging an intent to deceive.” Ezra Charitable Trust v.
Tyco Int’l Ltd., 466 F.3d 1, 12 n.10 (1st Cir. 2006). Rather,
just as with GAAP, the more likely an auditor would have discovered the truth if a reasonable audit had been conducted,
the stronger the scienter inference. In re Countrywide, 588 F.
Supp. 2d at 1198.
[3] Against this backdrop, we consider the factual allegations that EY failed to further investigate the May 2000 option
grant. EY had knowledge that the grant was, at a minimum,
suspicious in not only its timing but its relative size. It was the
largest option grant in the company’s young history and the
potential $700 million impact on Broadcom’s earnings was
material. Despite this knowledge as reflected in the specific
email exchanges recited in the Complaint, EY apparently did
not take steps to verify the accuracy of the grant, then or later.
This failure to investigate such a large grant was not minor or
technical in nature, and it is hard to imagine how a reasonable
auditor, confronted with the same set of circumstances, would
fail to obtain some documentation to verify Broadcom’s executive claim of a “Guideline Matrix program” being put in
place on that very day. EY apparently accepted management
at its word, never received requested documentation, and
issued an unqualified Opinion on the accuracy of Broadcom’s
financial statements. These circumstances are sufficient to
support an inference that EY knew, or should have known, the
May 2000 options were not legitimate. See In re Homestore.com, Inc. Sec. Litig., 252 F. Supp. 2d 1018, 1044 (C.D.
Cal. 2003), vacated on other grounds by Simpson v. Homestore.com, Inc., 519 F.3d 1041 (9th Cir. 2008) (finding necessary scienter in denying a motion to dismiss, stating that it
was a “logical inference that because [the auditor] objected to

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some transactions, it knew that the transactions and the
accounting of them were improper” and “[t]he fact that it also
allowed some of them to be reported [improperly] shows that
[the auditor] acted with deliberate recklessness in failing to
properly audit [the] transactions”).
EY fails to suggest a more compelling innocent inference
from the circumstances alleged in the Complaint. While it
may be true that Broadcom lied to EY’s audit partners about
the creation of the “Guideline Matrix,” and Broadcom may
have even drafted fraudulent documents in support of the
Guideline Matrix, nonetheless EY never received or reviewed
any documents, real or fraudulent.
EY would lead this Court to believe that its failure to further investigate amounts to, at most, negligence. However, an
auditor, in fulfilling duties of public trust, should take a long
hard look at a transaction of $700 million, roughly a quarter
of Broadcom’s reported revenue in 2006 of $2.5 billion. This
Complaint alleges more than negligence. EY, as Broadcom’s
auditor, owes its ultimate allegiance to the company creditors
and stockholders, as well as to the investing public. See
United States v. Arthur Young & Co., 465 U.S. 805, 817-18
(1984). By offering an “unqualified” or “clean” audit opinion,
as EY did in its 2005 Opinion, EY provided the “highest level
of assurance.” In re Ikon Office Solutions, Inc., 277 F.3d 658,
663 n.4 (3rd Cir. 2002). “Accountants will ‘qualify’ their
opinion where discrepancies are identified in a client’s financial statements.” Id.
EY relies on Public Employees’ Retirement Ass’n of Colo.
v. Deloitte & Touche, 551 F.3d 305, 314 (4th Cir. 2009),
where the court held generally that failing to review documentation may not be enough to support a strong inference of
scienter. However, the facts at issue in that case are distinctly
different from this case. In Public Employees’, the documents
were secret side letters that contradicted joint venture agreements. The auditors were, however, provided letters attesting

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(wrongly) otherwise. The court noted, “[w]ith perfect hindsight, one might posit that defendants should have required
stronger evidence of control from [the company].” Id. But the
point remains that the auditors had already asked for and
received some documentation—they could not be blamed for
failing to see secret side letters purposely kept hidden. Furthermore, when the auditor discovered the company had been
lying, the company, two days later, announced it had misstated its revenues. Id. at 309. Here, there were no secret letters; EY noticed there could be a significant issue with the
option grant; EY asked for documentation, but when none
was received, EY still signed off.
Finally, EY wrongly claims that the 2005 Opinion has no
connection to the May 2000 option. As noted previously, the
2005 Opinion expressly covered the 2003-05 financial statements. Because Broadcom’s options vested over a four-year
period, the 2000 option grant would have been accounted for
in the 2001-04 fiscal years, resulting in two years of overlap
between the fraudulent options grant and EY’s audited financial statements.
EY argues Plaintiffs cannot show a concrete connection
between the auditors who performed the audit in 2000 and
those who issued the 2005 Opinion; in other words, that
Plaintiffs cannot rely on a “roving scienter” across the relevant time period. However, EY cannot insulate itself from
accountability for multiple years of approved financial statements with a “right hand, left hand” defense. Clearly, with
any doubts, EY could limit its Opinion to the years for which
it is confident in the audit. EY, despite serving continuously
as Broadcom’s auditor from 1998 until 2008, during which it
attested to the accuracy of Broadcom’s financial statements
for the multiple years noted in the 2005 Opinion, cannot now
disclaim those prior opinions simply because the same individuals were not involved.

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Option Grants Approved When Compensation
Committee Was Not Legally Constituted
Plaintiffs’ second argument is that the Complaint pleads
sufficient facts to support a strong inference of scienter based
on EY’s failure to audit option grants allegedly awarded on
dates when Broadcom’s compensation committee lacked
authority to act because the committee was not legally constituted due to the death of one of the committee members.
Under Broadcom’s bylaws, the board of directors compensation committee possessed sole authority to issue stock
option grants to Broadcom officers. The compensation committee was required to have a minimum of two members for
a quorum. As of July 2001, the committee was composed of
just two members. One of those members died, leaving the
committee without its required two-member quorum to issue
options. A replacement was not appointed until February
2002 when a resolution, appointing the new committee member, was backdated effective as of October 2001.
During the period between June 2001 through December
2001, Broadcom’s compensation committee allegedly
approved stock option grants on June 24, October 19, and
December 24. During the same time period, Broadcom was
also using unanimous written consent (“UWC”) resolutions to
approve options on dates after the actual date the grant supposedly was approved.
The Complaint alleges that, with respect to the June 24,
2001 grant, EY was presented with unsigned draft minutes
that had been fabricated to approve the June option grant; the
UWC ‘approving’ the June grant was signed after the death
of the compensation committee member, meaning the grant
was not validly executed; and Broadcom specifically consulted with EY on the June 24, 2001 option grant to determine
whether a compensation charge was necessary. Thus, not only
did EY allegedly accept unsigned draft minutes, but also

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accepted later documentation that could not possibly have
been valid. Similarly, EY allegedly accepted a falsified UWC
in March 2002 as support for the October and December 2001
option grants, and a UWC nearly two months after EY had
already signed the unqualified audit Opinion for 2001.
[4] Taking these allegations as true, as required at this
stage, Plaintiffs provide an inference of scienter at least as
compelling as any opposing innocent inference offered by
EY. While the Complaint indicates that Broadcom executives
may have attempted to deceive EY, there is an equal inference
that EY overlooked significant events without further questioning or investigation. The failure of EY to follow up on the
grant approvals, and to sign off on these options months later
after reviewing false documentation, sufficiently pleads an
audit so deficient that the audit amounted to no audit at all.
See In re Software Toolworks Inc., 50 F.3d at 628.
Moreover, these questionable option grants ultimately
required a compensation expense of $569 million in Broadcom’s Restatement. While EY is correct that magnitude alone
is not sufficient to support a finding of scienter, large GAAP
and GAAS violations can play a role in finding scienter. See
Carley Capital Group v. Deloitte & Touche, 27 F. Supp. 2d
1324, 1339-40 (N.D. Ga. 1998) (“[w]hile alleging a misapplication of [GAAP] standing alone is insufficient, such allegation when combined with a drastic overstatement of financial
results can give rise to a strong inference of scienter . . . .
[and] the totality and magnitude of the . . . accounting violations [may] constitute strong circumstantial evidence of reckless or conscious misbehavior”); see also In re Baan Co. Sec.
Litig., 103 F. Supp. 2d 1, 21 (D.D.C. 2000) (stating the magnitude of the GAAP error can play a role in inferring
scienter).
Involvement in Broadcom’s 2003 Corrective Reforms
The Complaint alleges that EY had direct knowledge of the
irregularities in Broadcom’s option granting process due to

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EY’s participation in “corrective” reforms undertaken in 2003
to ensure future option grants were treated properly.
In June 2003, the Broadcom board of directors “significantly strengthened [its] options granting practices and put
into place rigorous processes to prevent and detect any future
instances of improper accounting for equity awards.” Press
Release, Broadcom Corp., Broadcom Completes Restatement
of Financial Statements (Jan. 23, 2007). This announcement
was made by the Broadcom CEO in January 2007 in connection with the Restatement of Broadcom’s financial statements.
The Restatement declared the board “made significant corrective changes to its options granting and documenting processes.”
Plaintiffs allege that EY, as Broadcom’s auditor, presided
over or participated in the 2003 reforms and, by doing so, EY
had knowledge that prior option grants caused previously
reported financials to be false and could not be relied upon.
Despite this knowledge, EY did not investigate the prior
grants and did not encourage Broadcom to submit to a restatement of its financial statements. Instead, EY continued to
issue unqualified audit opinions, including the 2005 Opinion
that validated several earlier years in which the improperly
accounted option grants would have materially impacted
Broadcom’s financial results. Not until the 2007 Restatement
did the 2003 corrective reforms become public knowledge.
EY, citing Zucco, claims the 2003 corrective reforms cannot be indicative of scienter because Broadcom was simply
making changes based on the 2002 congressional mandate of
the Sarbanes Oxley Act (“SOX”). Not so.
First, EY participated in, perhaps presided over, the 2003
corrective reforms. Second, these changes were not simply
part of Broadcom’s SOX compliance because Broadcom’s
2003 proxy statement shows the SOX reforms were completed before the implementation of the corrective reforms

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described in the Complaint. Third, Broadcom’s description of
the 2003 corrective reforms makes it clear the changes were
made specifically to address improper option procedures.
Indeed, all option grants after the 2003 reforms were
accounted for properly. Fourth, and finally, despite these
reforms taking place in 2003, EY apparently took no action
to revisit the audits of earlier grants or to inform creditors,
stockholders, or the investing public as EY was required to
do. See e.g., United States v. Arthur Young & Co., 465 U.S.
at 817-18.
[5] Here, the allegations strongly suggest EY knew of and
participated in the corrective reforms to address improper
stock option grants, but made no communication and took no
action until Broadcom announced its Restatement several
years later. This scenario survives a motion to dismiss.
Plaintiffs’ Remaining Scienter Allegations
Plaintiffs also allege several other grounds that would support finding the necessary scienter with respect to EY. The
Complaint claims EY knew there was insufficient documentation for nearly half of the $2.2 billion in backdated option
grants in violation of GAAS; EY knew Broadcom’s internal
controls were weak and failed to expand the scope of its audit
procedures as required under GAAS; and EY recklessly
ignored a number of “red flags” that should have alerted it to
the potential for material misstatements related to stock-based
compensation. Each of these grounds include additional facts
but also somewhat overlaps with the three major claims presented above. These remaining allegations support an inference that EY’s actions fell far short of the standard expected
of a public company auditor.
For example, the Complaint recites that nearly half of the
$2.2 billion Restatement resulted from option awards for
which there was no contemporaneous documentation. While
not explicitly required under GAAP and GAAS, the auditing

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standards do give strong guidance to auditors to dig deeper
once there are questionable circumstances surrounding such
material transactions. See e.g., PCAOB AU §§ 319.69,
333.02. While EY argues there was nothing technically incorrect at the time each of the questionable grants was audited
individually, EY fails to explain how it could innocently overlook the number and magnitude of the aggregate amount of
undocumented grants, particularly in light of GAAS and its
knowledge of the 2003 corrective reforms. Considering the
number, magnitude, and multi-year financial impacts of these
grants, it is certainly reasonable to infer scienter just as
strongly as an innocent inference.
Finally, the Complaint lists a number of “red flags” that
arguably should have alerted EY to Broadcom’s wrongdoing
and that EY allegedly would have had to purposely or recklessly overlook. These include elements of the 2000 option
grants and the deceased member of the compensation committee, option grant dates that were sporadic, suspiciously long
delays between the award of stock options and the UWC
approving the grant, and option grant dates set at or near the
low stock price for the quarter in which the options were
granted followed by a typical price surge soon after the dates
of the option awards.
As other courts have noted, “[a]t the pleading stage, courts
have recognized that allegations of GAAS violations, coupled
with allegations that significant ‘red flags’ were ignored, can
suffice to withstand a motion to dismiss.” In re Suprema Specialties, Inc. Sec. Litig., 438 F.3d 256, 279-80 (3d Cir. 2006)
(citing cases). However, “[s]uch allegations . . . must be pled
with particularity. It is insufficient, for example, for a plaintiff
to cite GAAS standards without an explanation of how the
defendant knowingly or recklessly violated those standards.”
Id. at 280 (citations omitted).
[6] Here, Plaintiffs have not simply cited GAAS standards
in connection with vague claims that EY failed to comply

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with the standards. The Complaint is loaded with specific
allegations of how and why EY should have investigated deficient or missing documentation. Even after being alerted to
potential problems during the 2003 corrective reforms, EY’s
behavior, and perhaps more importantly, its unqualified audit
opinions, did not change. These red flags further support a
strong inference of scienter.
Holistic Review of Plaintiffs’ Allegations
In addition to reviewing the allegations of scienter individually, this Court has also viewed the claims “holistically.”
When viewed in totality, there is no doubt the allegations, at
this early phase of the proceedings, present at least as strong
an inference of scienter as any competing innocent inference.
As stated by the court in In re Oxford Health Plans Inc.
Sec. Litig., 51 F. Supp. 2d 290, 294 (S.D.N.Y. 1999), the
“[P]laintiffs allege ‘in your face facts,’ that cry out, ‘how
could [defendants] not have known that the financial statements were false.’ ” (citation omitted). 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.” 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, under Tellabs, is simply to test whether the Complaint provides a sufficient inference of scienter for the case
to proceed against EY. It does.

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CONCLUSION
For the reasons set forth above, we REVERSE the ruling
granting Defendant EY’s Motion to Dismiss, and REMAND
the case for further proceedings consistent with this Opinion.