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investigations indicated that audit committees could serve very effectively to reduce
the incidence of fraud.39


Livent, Inc.
This case relates to securities class actions brought by investors against Livent and
associated individuals and entities. In addition to other defendants, three directors
who served on Livent™s audit committee were named as defendants. The audit
committee members were charged with violating federal securities laws, namely
Section 10(b), and Section 20(a) claims of the 1934 act. The case involved fraud-
ulent revenue-generating transactions and manipulation of books and records. The
shareholders alleged that the audit committee failed to discover the aforemen-
tioned schemes. In the decision, the judge dismissed the Section 10(a) and Section
20(a) violations since the audit committee was not a culpable participant in the
fraud schemes. Likewise, the Section 10(a) and Section 20(a) violations were not
sufficient to plead scienter as well as the criteria for control person liability.40

Manzo v. Rite Aid Corporation
The plaintiffs brought a class action lawsuit against the officers, directors, and out-
side accounting firm. With respect to the audit committee, they alleged a breach of
fiduciary duty with respect to fraudulent financial statements during the class pe-
riod. The defendants asserted that they deny any wrongdoing with regard to mis-
leading financial statements. They contend good faith reliance on the officers™
reports. The court ruled for the defendants, saying that the complaint failed to ad-
equately allege reliance and damages and failed to establish a direct claim and a
derivative claim. 41

37
Thomas Petziner, Jr., “Heinz Senior Officials Didn™t Participate in Profit-Juggling Practices, Panel
Says,” Wall Street Journal (May 9, 1980), p. 2.
38
Ibid.
39
Hugh L. Marsh and Thomas E. Powell, “The Audit Committee Charter: Rx for Fraud Prevention,”
Journal of Accountancy 167, No. 2 (February 1989), p. 56.
40
In Re Livent, Inc. Securities Litigation, 148 F. Supp. 2d 331 (S.D.N.Y. 2001). For additional court
cases, see Haltman, et al. v. Aura Systems, Inc., et al., 844 F. Supp. 544 (C.D. C.A. 1993); and Bo-
marko, Inc. v. Hemodynamics, Inc., 848 F. Supp. 1335 (W.D. M.I. 1993).
41
Manzo v. Rite Aid Corporation, C.A. No. 18451-NC (Del. Ch. 2002)
Legal Cases Involving the Audit Committee 159


Guttman v. Nvidia Corporation
In this case, the plaintiffs alleged that the defendants issued materially misstated
financial statements. They contend the defendants used “cookie jar reserves” to
smooth earnings in bad times. The court ruled in favor of the defendants because
the audit committee did not commit any culpable failure of oversight under the
Caremark standard. 42
As William T. Allen, chancellor of the Court of Chancery of Delaware stated
in his decision:

In order to show that the Caremark directors breached their duty of care by failing ad-
equately to control Caremark™s employees, plaintiffs would have to show either (1)
that the directors knew or (2) should have known that violations of law were occur-
ring and, in either event, (3) that the directors took no steps in a good faith effort to
prevent or remedy that situation, and (4) that such failure proximately resulted in the
losses complained of, although under Cede & Co. v. Technicolor, Inc., Del. Supr., 636
A.2d 956 (1994) this last element may be thought to constitute n affirmative defense.
1. Knowing violation for statute: Concerning the possibility that the Caremark di-
rectors knew of violations of law, none of the documents submitted for review, nor
any of the position transcripts appear to provide evidence of it. Certainly the board
understood that the company had entered into a variety of contracts with physicians,
researchers, and health care providers and it was understood that some of these con-
tracts were with persons who had prescribed treatments that Caremark participated
in providing. The board was informed that the Company™s reimbursement for patient
care was frequently from government funded sources and that such services were
subject to the ARPL. But the Board appears to have been informed by experts that
the company™s practices while contestable, were lawful. There is no evidence that re-
liance on such reports was not reasonable. Thus, this case presents no occasion to
apply a principle to the effect that knowingly causing the corporation to violate a
criminal statute constitutes a breach of a director™s fudiciary duty. See Roth v.
Robertson, N.Y. Sup. Ct., 64 Misc. 343, 18 N.Y. 351 (1909); Miller v. American Tel.
& Tel. Co., 507 F.2d 759 (3rd ci. 1974). It is not clear that the Board knew the detail
found, for example, in the indictments arising from the Company™s payments. But,
of course, the duty to act in good faith to be informed cannot be thought to require
directors to possess detailed infomation about all aspects of the operation of the en-
terprise. Such a requirement would simply be inconsistent with the scale and scope
of efficient organization size in this technological age.
2. Failure to monitor: Since it does appears that the Board was to some extent un-
aware of the activities that led to liability, I turn to a consideration of the potential av-
enue to director liability that the pleadings take: director inattention or “negligence.”
Generally where a claim of directorial liability for corporate loss is predicated upon
ignorance of liability creating activities within the corporation, as in Graham or in
this case, in my opinion only a sustained or systematic failure of the board to exer-
cise oversight”such as an utter failure to attempt to assure a reasonable information
and reporting system exists”will establish the lack of good faith that is a necessary
condition to liability. Such a test of liability”lack of good faith as evidenced by sus-
tained or systematic failure of a director to exercise reasonable oversight”is quite


42
Guttman v. Jen-Hsun Huang et al. Nvidia Corporation, C.A. No. 19571-N.C. (Del. Ch. 2003).
160 The Legal Position of the Audit Committee



Exhibit 4.1 Securities Litigation and Preventing Fraudulent Reporting

When Kirschner Medical Corp., a Baltimore-based manufacturer of orthopedic equip-
ment, went public in 1986, President Bruce Hegstad planned to go from $6.5 million to
$100 million in revenues. They did indeed skyrocket, reaching $55 million in 1989. Nat-
urally, stock prices soared as well.
But the investors who flocked to Kirschner now claim that the company duped them.
During the third quarter of 1989, the company lost $488,000. Despite its assurances of a
quick rebound, Kirschner lost $2.5 million in the next quarter and wrote off an additional
$13.2 million in losses.
During this time, the company allegedly failed to disclose information about defective
products, obsolete inventories and an unprofitable European plant. When the bad news fi-
nally came out, stock prices dove $17 a share, causing a lost market value of $35.7 million.
Claiming fraudulent financial reporting, over 1,000 investors have filed a class-action suit
against Kirschner and three of its executives in the U.S. District Court in Baltimore.
In recent years, corporate boards of directors and their audit committees have faced
great vulnerability to such litigation.
According to William R. McLucas, the Security and Exchange Commission™s en-
forcement director, “The agency has a hefty backlog of cases, many focusing on financial
fraud and accounting problems.”
In 1989, the SEC filed enforcement actions against the officers and directors of 30 pub-
lic companies and 12 public accounting firms, alleging improper financial reporting practices.a
Two years earlier, the National Commission on Fraudulent Financial Reporting, estab-
lished by accounting associations and chaired by former SEC Commissioner James Tread-
way, reported that it had “reviewed 119 enforcement actions against public companies and
42 cases against independent public accounting firms by the SEC from 1981“1986.”
The commission asserted that “public companies should maintain internal controls
that provide reasonable assurance that fraudulent financial reporting will be prevented or
subject to early detection.”
What is fraudulent financial reporting? The commission defines it “as intentional or
reckless conduct, whether act or omission, that results in materially misleading financial
statements.”
Generally speaking, fraudulent reporting occurs when management intentionally over-
states assets and improperly recognizes revenue. These actions clearly differ from unin-
tentional errors.
The irregularities are shown by the misapplication of generally accepted accounting
principles, inappropriate valuations, and/or omissions of material information from finan-
cial statements. For example, the deliberate distortion of accounting records to overstate
inventory, along with falsified transactions to increase sales and overstate earnings, is
clearly fraudulent financial reporting.
These activities, often referred to as “cooked books” and “cute accounting,” cause
management to restate the financial statements, which, in turn, causes a decrease in the
market price of the stock. Such misleading representations in the company™s annual and
quarterly figures can be the basis of a class-action lawsuit.
Typically in this type of litigation, a class of stockholders alleges that the board of di-
rectors, the officers and the independent auditing firm have prepared and distributed ma-
terially false and misleading financial statements and reports to existing stockholders and
potential investors.
Plaintiffs accuse defendants of violating Section 10(b) of the Securities Exchange Act,
SEC Rule 10(b)-5 and common law. Relief claims are based on fraud, deceit and negli-
gence by the directors, officers, employees and the independent auditors.
Legal Cases Involving the Audit Committee 161



Questions of law and fact commonly arising in these cases are:

• Whether defendants knowingly or recklessly disseminated untrue statements of ma-
terial fact and/or omitted material facts relating to the sales and earnings during the
class period;
• Whether the market prices of securities were artificially inflated by reason of the de-
fendants™ conduct, constituting a fraud on the market;
• Whether defendants violated Section 10(b) of the 1934 Act and Rule 10(b)-5 and/or
perpetrated common law fraud or negligent misrepresentations upon the members
of the class;
• Whether the defendant™s SEC Form 10-Q, 10K, annual and quarterly reports, and
public announcements of expected earnings and growth during the class period
were materially false and misleading.

Failure on the part of the audit committee to review and evaluate the financial state-
ments and related accounting policies in accordance with generally accepted accounting
principles is clearly malfeasance.
A case in point is Crazy Eddie Inc., which, like many public companies, had audit
committees. According to the SEC, Eddie Antar, founder and former chairman of the East
Coast electronics chain, directed activities that resulted in overstating the company™s 1985
pretax income by $2 million, or 18.9 percent; by approximately $6.7 million, or 33.8 per-
cent, in 1986; and by “tens of millions of dollars” in 1987.
Peter Martosella, who was brought in to run Crazy Eddie after the fraudulent reporting
was discovered, told Forbes magazine, “You have to be careful how much you expect of the
audit committee. You™re talking about people brought in by the CEO, and you™re telling
them they shouldn™t necessarily listen to him. It™s not realistic, especially when the chief ex-
ecutive is a charismatic person, a darling of the securities world, like Eddie Antar was.”
Antar allegedly made $60 million from the sale of his Crazy Eddie stock; investors al-
legedly lost $200 million. In 1989 the SEC filed a complaint against Antar and other com-
pany officials and employees. Last summer the U.S. District Court for New Jersey entered
a $73.5 million judgment against Antar, who is currently a fugitive. (It should be noted that
Antar was recently apprehended by the authorities.)
Moreover, a group of about 10,000 shareholders have filed a lawsuit in the federal dis-
trict court in New York against Crazy Eddie™s former officers and directors, as well as its
external auditor and several Wall Street brokerage firms.
In another case, Sundstrand Corp. pleaded guilty to a criminal defense procurement
fraud of overbilling the Defense Department. Sundstrand agreed to pay a $115 million set-
tlement to the federal government. In addition, the liability insurance carrier for Sund-
strand™s board of directors and officers agreed to pay $15 million to settle shareholder
litigation.
An academic research study found that Sundstrand™s audit committee was ineffective
since it had too few meetings and too many changes in membership.b
As a result of the committee™s performance, there were management-imposed scope
limitations on the internal audit department, which ultimately caused the company to de-
fraud the federal government.
As the Crazy Eddie and Sundstrand cases demonstrate, merely having an audit com-
mittee isn™t always enough. So what exactly is this committee supposed to do?
The major impetus for establishing and maintaining audit committees occurred in
1978 when the New York Stock Exchange adopted a policy requiring all of its listed com-
panies to have such a committee, composed solely of independent outside directors. Of
course, the NYSE™s intent was to increase the investing public™s confidence in the quality
of financial reporting.


(continued)
162 The Legal Position of the Audit Committee



Exhibit 4.1 (Continued)

Before the NYSE™s mandate, the SEC required companies to establish and maintain
independent audit committees.
Thus, a consent injunction and ancillary relief against respondents charged with fraud-
ulent financial reporting issues”for example, in cases against Lum™s Inc. and Mattel Inc.
in 1974”provided a framework for defining the duties and functions of audit committees.
Lum™s agreed not to commit any proxy fraud in connection with future acquisitions of
businesses or business assets. Mattel was charged with overstating sales by $14 million.
These sales were subject to customer cancellation.
The question of what constitutes proper standards and practices for the audit commit-
tee has emerged through settlements, with the courts dictating the audit committee™s re-
sponsibilities. In particular, the courts in Lum™s and Mattel required the following general
responsibilities:
• Recommend or approve appointment or independent auditors.
• Review internal accounting control policies and procedures.
• Oversee the duties and results of the internal audit department.
• Review with the independent auditors the proposed scope and general extent of their
audit.
• Review, prior to issuance, financial statements and significant press releases con-
cerning financial results.
• Act as a mediator between management and the independent auditors for any dis-
agreements over accounting issues.
Recognizing the SEC enforcement actions, court decisions and the national stock ex-
change listing requirements for audit committees, the National Commission on Fraudulent
Financial Reporting has fully supported and endorsed implementation of audit committees.
In particular, the commission recommended that “the boards of directors of all public
companies should be required by SEC rule to establish audit committees composed solely
of independent directors. Such committees should be informed, vigilant, and effective
overseers of the financial reporting process and the company™s internal controls.”
Today, both the American Stock Exchange and the National Association of Securities
Dealers have listing requirements for audit committees that are modeled after the NYSE™s
requirements. The U.S. House of Representatives is currently considering legislation,
sponsored by Rep. John Dingell, D-Mich., requiring all public companies to create audit
committees.
Given that the audit committee is a part-time operation, the commission™s call for vig-
ilance requires committee members to be willing to make a significant commitment of
their time.
The audit committee should be informed about the financial and operational aspects
of the company and, therefore, should receive sufficient and timely information. If the
audit committee meeting is scheduled to coincide with the regular full board meetings,
then the committee must receive written information well in advance of the meetings.
To be vigilant, the audit committee should ask probing questions about the propriety
of the company™s financial reporting process and the quality of its internal controls. This
task requires the committee to keep abreast of financial reporting developments affecting
the company.
To be an effective independent overseer, the audit committee must be positioned be-
tween senior management and the external auditors. This organizational structure allows
the audit committee to question management™s judgments about financial reporting matters
and to suggest improvements in the internal control systems. Finally, the committee should
Legal Cases Involving the Audit Committee 163



develop a charter that defines its mission, duties and responsibilities; plans its annual
agenda; and documents its findings and conclusions.
Through audit committees, boards of directors can meet their oversight responsibili-
ties in the internal and external auditing processes and the financial reporting process.

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