A good example is the recent case of Burstyn v. Worldwide Xceed Group, Inc. (S.D.N.Y.), published in the New York Law Journal October 11, 2002 (www.nylj.com). Xceed was a classic dotcom that provided consulting services and digital solutions to enable corporations and businesses to compete more effectively in the network economy and to accelerate the development of eBusiness solutions. One of the defendants was the CFO. The complaint alleged that Xceed knowingly and recklessly understated its losses in seven SEC filings.

There were four types of alleged accounting violations. First, Xceed made inadequate allowances for doubtful accounts. When Xceed issued its correction it showed an extraordinary increase in the allowance for uncollectible accounts receivable. Plaintiffs alleged that this correction was proof of the understatement of the collectible accounts receivable in prior reports.

The second type of alleged accounting violation was that Xceed had violated its stated goodwill amortization policy. Its published policy stated that it would amortize the excess purchase price over the fair value of the assets over a 7- to 12-year period, while its other intangible assets would be amortized over a 7-year period. However, in making an acquisition in 1998, Xceed amortized the excess goodwill over a 12-year period rather than a 7-year period, which resulted in an understatement of its losses by approximately $1.8 million per year.

The third alleged accounting violation was that in the fourth quarter of 2000, Xceed wrote off approximately $87 million in unamortized goodwill due to a significant decrease in the work force and customer base. The plaintiffs alleged that the defendants knew or should have known of the impairment of these intangible assets before the 4th quarter, and it should have been reflected in the earlier quarterly statements.

Lastly, the plaintiffs alleged that Xceed  improperly used the percentage of completion method for its fixed price contracts from the company's Internet professional services and performance enhancement business for its other contracts, which, in turn, led to a material understatement of the net losses. Plaintiffs then alleged that these accounting violations were coupled with a series of improperly optimistic press releases.

Plaintiffs alleged that the motives for the accounting violations were that it enabled Xceed to acquire seven Internet-related companies during fiscal year 2000, using an inflated stock price. In this case, the court held that this was a sufficient allegation of motive to satisfy the PSLRA standard of a strong inference of motive to accomplish the fraud. The court also held that this particular pleading alternatively alleged sufficient recklessness and rejected the defendants' claim that the stock purchasers' arguments were fraud by hindsight. In this connection, the court noted that violations of GAAP standing by themselves are insufficient to make out a securities fraud claim.

However, the magnitude of the adjustments in the subsequent periodic reports raised questions about the defendants' credibility, thus making the press statements increasingly suspect, which in turn supported a strong inference of scienter. Causation under the federal securities laws has two prongs: (i) transaction causation; and (ii) loss causation. In Burstyn, the court held that the misrepresentations, rather than the market forces behind the dotcom collapse, were the proximate cause of the person's injuries who purchased stock during the period in which the company's false financial information was available to the marketplace.

The court also held that the loss causation prong was satisfied by this complaint. Xceed was portrayed as a healthy and viable company while, in fact, the company was already failing. Accordingly, investors were encouraged to purchase the stock, creating a disparity between the transaction price and the true value of the securities. The court held that when the alleged accounting violations were ultimately revealed to the market with the foreseeable consequences, the share price declined. Although a jury might blame market forces rather than accounting violations for the decline in the stock's price, the allegations in the complaint were deemed sufficient to enable the plaintiff to overcome the motion to dismiss and conduct discovery.

This case is an example of a more liberal approach to permitting litigation to proceed against financial professionals. It also illustrates that each case of alleged accounting fraud must be looked at on a case-by-case basis to see whether claims are sufficient to permit discovery and possible trial of the case. Of course, the best way to avoid litigation relating to the financial statements is to ensure that the financial statements initially published accurately reflect the current state of affairs of the enterprise.

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CHARLES HECHT has been a principal of his own law firm specializing in securities law since 1971. He was previously on the staff of the Division of Corporate Finance of the Securities and Exchange Commission at its headquarters in Washington, DC. Mr. Hecht would appreciate any input on subject matters within the SEC accounting area which you believe would be appropriate for a future article.