Louisiana School Employees' Retirement System v. Ernst & Young, LLP

RECOMMENDED FOR FULL-TEXT PUBLICATION
Pursuant to Sixth Circuit Rule 206
File Name: 10a0308p.06

UNITED STATES COURT OF APPEALS
FOR THE SIXTH CIRCUIT
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LOUISIANA SCHOOL EMPLOYEES’
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RETIREMENT SYSTEM; DEBRA SWIMAN,
individually and on Behalf of All Others -
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No. 08-6194
Similarly Situated,
Plaintiffs-Appellants, ,>
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v.
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Defendant-Appellee. -
ERNST & YOUNG, LLP,

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N
Appeal from the United States District Court
for the Western District of Tennessee at Memphis.
No. 06-02214—Samuel H. Mays, Jr., District Judge.
Argued: October 15, 2009
Decided and Filed: September 22, 2010
Before: BOGGS, MOORE, and GIBSON, Circuit Judges.*

_________________

COUNSEL

ARGUED: Joseph D. Daley, COUGHLIN STOIA GELLER RUDMAN & ROBBINS
LLP, San Diego, California, for Appellants. L. Joseph Loveland, KING & SPALDING
LLP, Atlanta, Georgia, for Appellee. ON BRIEF: Joseph D. Daley, Mark Solomon,
COUGHLIN STOIA GELLER RUDMAN & ROBBINS LLP, San Diego, California,
for Appellants. L. Joseph Loveland, John P. Brumbaugh, Tracy C. Braintwain, Shelby
S. Guilbert, Jr., KING & SPALDING LLP, Atlanta, Georgia, Paul D. Clement, KING
& SPALDING LLP, Washington, D.C., for Appellee.

*
The Honorable John R. Gibson, Circuit Judge of the United States Court of Appeals for the
Eighth Circuit, sitting by designation.

1
No. 08-6194 Louisiana School Employees’ Retirement Page 2
Sys., et al. v. Ernst & Young, LLP

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OPINION
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JOHN R. GIBSON, Circuit Judge. This appeal is from a dismissal on the
pleadings of a securities fraud class action pursuant to Federal Rules of Civil Procedure
9(b) and 12(b)(6) and the pleading requirements of the Private Securities Litigation
Reform Act of 1995 (“PSLRA”). This lawsuit against public accounting firm Ernst &
Young is brought on behalf of all persons who and entities which purchased the publicly
traded securities of Accredo Health, Inc. (“Accredo”) between June 16, 2002 and
April 7, 2003 (the “Class Period”). Accredo is a pharmaceutical distribution company.

The class contends that the district court misinterpreted and misapplied the
Supreme Court’s scienter-pleading standard from Tellabs, Inc. v. Makor Issues & Rights,
Ltd., 551 U.S. 308 (2007), and instead used the higher pre-Tellabs pleading standard set
forth in Helwig v. Vencor, Inc., 251 F.3d 540 (6th Cir. 2001) (en banc). Plaintiffs further
allege that the district court erred when it rejected facts that, when considered
collectively, raise a strong inference of defendant’s scienter. Finally, the class asserts
that the district court abused its discretion by ignoring plaintiffs’ request to be allowed
to move for amendment should the court dismiss any part of the complaint.

For the reasons set forth below, we AFFIRM the judgment of the district court.

I. Background

The Louisiana School Employees’ Retirement System and Debra Swiman (the
“Lead Plaintiffs”), individually and on behalf of all others similarly situated, filed a
complaint against Defendant Ernst & Young for alleged violations of federal securities
laws. Each member of the Plaintiff Class purchased or otherwise acquired Accredo
securities during the Class Period. Ernst & Young provided services to Accredo during
the Class Period until Accredo terminated Ernst & Young as its auditor because of
alleged professional malpractice.
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Sys., et al. v. Ernst & Young, LLP

Ernst & Young’s involvement began well before the Class Period. Gentiva
Health Services Inc. (“Gentiva”), a company Accredo was interested in acquiring,
retained Cap Gemini/Ernst & Young (Ernst & Young’s consulting arm) between May
and September 2000. Gentiva needed assistance in the collection of hundreds of
millions of dollars of outstanding receivables owed to one of its divisions, the Speciality
Pharmaceutical Services division (“Gentiva Division”). In September 2000, Cap
Gemini/Ernst & Young recommended that Gentiva write off a substantial portion of its
accounts receivable and redirect its focus on more current accounts receivable. As a
result of Cap Gemini/Ernst & Young’s audits of Gentiva’s financials, in 2000 Gentiva
wrote off approximately $92 million in uncollectible accounts receivable attributable to
the Gentiva Division.

In the summer of 2001, Accredo sought to expand its business through acquiring
from Gentiva substantially all of the assets of the Gentiva Division, which was
composed of two kinds of pharmacies: the “acute” and “chronic” health care products
and services segments. In September 2001, Accredo’s senior officers and Ernst &
Young began conducting due diligence in connection with the potential acquisition.
Plaintiffs allege that between September 2001 and June 2002, during its audit of the
Gentiva Division, Ernst & Young learned that nearly $58.5 million of acute segment
receivables were uncollectible. They further allege that Ernst & Young recognized that
the Gentiva Division’s allowance for doubtful accounts was understated, causing
Accredo’s net income and earnings per share to be materially overstated during the Class
Period. Despite Ernst & Young’s knowledge of the uncollectible accounts on Accredo’s
balance sheet, Ernst & Young issued an unqualified audit opinion on Accredo’s 2002
fiscal year financial results and approved the quarterly reports in Accredo’s 10-Qs for
the first and second quarters of fiscal year 2003. On January 2, 2002, Gentiva and
Accredo entered into an Asset Purchase Agreement. Accredo then acquired the Gentiva
Division on June 13, 2002.

Plaintiffs further allege that following its June 2002 acquisition of the Gentiva
Division, Accredo tried to sell the acute segment of the Gentiva Division but was not
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Sys., et al. v. Ernst & Young, LLP

able to do so because of the uncollectible receivables. Accredo was forced to write off
$58.5 million in uncollectible receivables.

Plaintiffs aver that Ernst & Young was involved in the alleged accounting fraud
from the beginning of the due diligence preceding the acquisition of the Gentiva
Division and that Ernst & Young knew of the uncollectible receivables as early as 2001.
Plaintiffs allege that Accredo’s acquisition of the Gentiva Division depended on Ernst
& Young’s issuance of unqualified audit opinions on the Gentiva Division’s financial
statements, that Accredo retained Ernst & Young to analyze the adequacy of the
allowance for the Gentiva Division’s doubtful accounts, and that accounts receivable
comprised seventy-five percent of the $415 million purchase price. Ernst & Young’s
unqualified audit opinions were incorporated into the 2002 proxy statement filed with
the Securities & Exchange Commission (“SEC”).

Gentiva was intent on selling both the acute and chronic segments of the Gentiva
Division to Accredo; Accredo needed the chronic segment to enable Accredo to become
the billion-dollar company it aspired to be. Plaintiffs allege that Accredo and Ernst &
Young hid the acute segment’s accounts receivable problems from investors so that
Accredo could proceed with the transaction. Accredo intended to rid itself of the acute
segment soon after the transaction was completed. The 2002 proxy statement stated that
Accredo would sell the acute segment by December 31, 2002.

On April 7, 2003, William Drummond, an Ernst & Young partner and the lead
auditor during the Class Period, admitted to Joel Kimbrough, Accredo’s Senior Vice
President and CFO, that “there was a problem.” A day later, an Accredo press release
disclosed that, due to the understated allowance for doubtful accounts, the Gentiva
Division’s receivables had been overstated. This announcement caused a one-day
forty-four percent drop in Accredo’s stock price.

On May 2, 2003, Accredo consulted with Ernst & Young about its intention to
present information about the write-off in an upcoming press release. Three days later,
Accredo issued a press release, stating that it had taken a current period charge to
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Sys., et al. v. Ernst & Young, LLP

earnings to write off $58.5 million of acute accounts receivable that it had acquired from
Gentiva. On May 5, 2003, Accredo issued its fiscal year 2003 third quarter Form 10-Q,
which included a note to the consolidated financial statements that if the collection rates
had been evaluated based on data as of January 1, 2003, a $58.5 million charge would
have been recorded as of that date. Plaintiffs allege that this change in the language was
made to avoid having to restate Accredo’s Class Period financial statements. That same
day, Accredo terminated Ernst & Young as its auditor and filed a civil suit against Ernst
& Young charging professional malpractice. (Cir. Ct. Tenn. No. CT-002556-03).1

On September 15, 2004, plaintiffs filed a consolidated complaint against Accredo
and two of its executives in a related class action (the “Accredo Action”), which settled
four years later. In re Accredo Health, Inc. Sec. Litig., Civ. No. 03-2216-BBD (W.D.
Tenn.). Lead Plaintiffs were also appointed as lead plaintiffs in the Accredo Action. On
April 13, 2006, plaintiffs filed this separate single-count lawsuit against Ernst & Young,
and in June 2006, Ernst & Young moved to dismiss the complaint pursuant to Federal
Rules of Civil Procedure 9(b) and 12(b)(6) and the pleading requirements of the PSLRA.
The motion to dismiss the complaint was pending when the Supreme Court decided
Tellabs, resolving a circuit split regarding the relevance of competing inferences in
evaluating whether a complaint satisfies the “strong inference” of scienter requirement
of the PSLRA.

On August 14, 2008, the district court entered its order granting Ernst & Young’s
motion to dismiss. The district court held that Ernst & Young is not liable under Rule
10b-5 for statements that it did not make. With respect to Ernst & Young’s audit report
on Accredo’s 2002 financial statements, which was included in Accredo’s fiscal year
form filed with the SEC, the district court held that “[a] review of the complaint as a
whole shows that plaintiffs have failed to meet the PSLRA’s requirement of pleading
with particularity facts that give rise to a strong inference of scienter.” The district court
thus dismissed the complaint. In its discussion of scienter, the district court correctly

1
On September 26, 2003, Accredo voluntarily dismissed the lawsuit and agreed to proceed with
formal arbitration.
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Sys., et al. v. Ernst & Young, LLP

paraphrased the Tellabs standard but also repeated this Court’s pre-Tellabs holding,
which articulates a higher pleading standard:

[P]laintiffs are only entitled to the most plausible of competing
inferences. Helwig, 251 F.3d at 553. The “strong inference” requirement
means that a plaintiff is entitled only to the most plausible of competing
potential inferences. Id. at 553.

(quoting Helwig v. Vencor, Inc., 251 F.3d 540 (6th Cir. 2001) (en banc)). Plaintiffs did
not amend their complaint while the motion to dismiss was pending and did not seek
leave to do so after the district court entered its order. However, a reference to amending
was in a footnote on the last page of plaintiffs’ brief in response to Ernst & Young’s
motion to dismiss, stating, “[s]hould the Court grant any portion of E&Y’s motion to
dismiss, Lead Plaintiffs respectfully request an opportunity to move to amend the
pleadings and demonstrate that an amendment would cure any deficiencies.”

Based on the allegations in their complaint, plaintiffs contend that Ernst &
Young is liable as a primary participant in a fraudulent scheme and course of business
that defrauded the plaintiffs, deceived the investing public about Accredo’s financial
results, artificially inflated the price of Accredo’s publicly traded securities, caused
plaintiffs to be damaged when Accredo’s share price fell as a result of the revelations of
accounting fraud, enabled Ernst & Young to collect accounting fees from Accredo, and
allowed Accredo to complete its acquisition of the Gentiva Division. Plaintiffs contend
that all of these actions were accomplished by disseminating false and misleading
statements and concealing materially adverse facts on numerous occasions.

Ernst & Young argues that it tested the substantial reserve for accounts
receivable that Accredo management had established and found that reserve to be
reasonable. Two other accounting firms, Price Waterhouse Coopers LLP and Deloitte
& Touche LLP, issued unqualified audit opinions on financial statements that included
the Gentiva Division. Price Waterhouse Coopers audited Gentiva’s financial statements
(including the Gentiva Division) on February 6, 2002, and Deloitte & Touche audited
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Sys., et al. v. Ernst & Young, LLP

Accredo’s financial statements for the year ending June 30, 2003.2 Neither auditor
found evidence of an inadequate allowance for doubtful accounts of the Gentiva
Division.

On appeal, plaintiffs argue that the district court erred in granting Ernst &
Young’s motion to dismiss the complaint because the complaint was pleaded with the
requisite particularity, giving rise to a strong inference that Ernst & Young acted with
scienter when it allegedly issued a false or misleading audit opinion on Accredo’s
financial statements. Specifically, plaintiffs argue that the district court utilized the
improper pre-Tellabs evidentiary inferences in concluding that their allegations do not
raise a strong inference of scienter. Additionally, plaintiffs assert that the court erred in
dismissing the complaint with prejudice rather than granting leave to amend.

II. Discussion

A. Dismissal in Securities Fraud Cases

We review the district court’s decision to dismiss the complaint de novo. Ley v.
Visteon Corp., 543 F.3d 801, 805 (6th Cir. 2008). In doing so, we may affirm the
judgment of the district court on any ground supported by the record. Hoffman v.
Comshare, Inc. (In re Comshare, Inc. Sec. Litig.), 183 F.3d 542, 548 (6th Cir. 1999)
(citations omitted). We must construe the complaint in the light most favorable to the
plaintiff, accept all well-pleaded factual allegations as true, and determine whether the
plaintiff undoubtedly can prove no set of facts consistent with its allegations that would
entitle it to relief. League of United Latin Am. Citizens v. Bredesen, 500 F.3d 523, 527
(6th Cir. 2007).

Section 10(b) of the Securities Exchange Act and Rule 10b-5 promulgated
thereunder prohibit “fraudulent, material misstatements or omissions in connection with
the sale or purchase of a security.” Frank v. Dana Corp., 547 F.3d 564, 569 (6th Cir.
2008) (citation omitted). To state a securities fraud claim under Section 10(b), a plaintiff

2
Accredo acquired the Gentiva Division on June 13, 2002.
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Sys., et al. v. Ernst & Young, LLP

“‘must allege, in connection with the purchase or sale of securities, the misstatement or
omission of a material fact, made with scienter, upon which the plaintiff justifiably relied
and which proximately caused the plaintiff’s injury.’” Id. (quoting Comshare, 183 F.3d
at 548). Scienter is “a mental state embracing intent to deceive, manipulate, or defraud.”
PR Diamonds, Inc. v. Chandler, 364 F.3d 671, 681 (6th Cir. 2004) (quoting Ernst &
Ernst v. Hochfelder, 425 U.S. 185, 193 n.12 (1976)).

Securities fraud claims arising under Section 10(b) must satisfy the particularity
pleading requirements of Federal Rule of Civil Procedure 9(b). PR Diamonds, Inc., 364
F.3d at 681. A plaintiff’s complaint must “(1) specify the statements that the plaintiff
contends were fraudulent, (2) identify the speaker, (3) state where and when the
statements were made, and (4) explain why the statements were fraudulent.” Frank, 547
F.3d at 570 (citation omitted). In addition, the PSLRA imposes additional and more
“[e]xacting pleading requirements” for pleading scienter in a securities fraud case.
Tellabs, 551 U.S. at 313. Under the PSLRA’s heightened pleading requirements, any
private securities complaint alleging that the defendant made a false or misleading
statement must:

(1) . . . specify each statement alleged to have been misleading, the
reason or reasons why the statement is misleading, and, if an allegation
regarding the statement or omission is made on information and belief,
the complaint shall state with particularity all facts on which that belief
is formed [and]
(2) . . . 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)(1), (2) (emphasis added). The PSLRA “requires plaintiffs to state
with particularity both the facts constituting the alleged violation, and the facts
evidencing scienter, i.e., the defendant’s intention to deceive, manipulate, or defraud.”
Tellabs, 551 U.S. at 313 (quotation and citation omitted). The Supreme Court explained
in Tellabs that Congress adopted the “strong inference” standard because it intended to
raise the bar for pleading scienter, id. at 323-24, but the PSLRA did not change the state
of mind required to prove securities fraud. Comshare, 183 F.3d at 548-49.
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In the securities fraud context, we have long premised liability on at least
“reckless” behavior. Mansbach v. Prescott, Ball & Turben, 598 F.2d 1017, 1025 (6th
Cir. 1979). We have held that, following passage of the PSLRA, a plaintiff may plead
scienter in a securities fraud complaint by alleging facts that give rise to a strong
inference of recklessness. Comshare, 183 F.3d at 549. Recklessness sufficient to satisfy
10b-5 is “a mental state apart from negligence and akin to conscious disregard.” Id. at
550. It is “highly unreasonable conduct which is an extreme departure from the
standards of ordinary care. While the danger need not be known, it must at least be so
obvious that any reasonable man would have known of it.” PR Diamonds, Inc., 364
F.3d at 681 (citing Mansbach, 598 F.2d at 1025). A plaintiff may survive a motion to
dismiss only by pleading with particularity facts that give rise to a strong inference that
the defendant acted with knowledge or conscious disregard of the fraud being
committed. Id. at 682 (citing Comshare, 183 F.3d at 548-49).

The standard of recklessness is more stringent when the defendant is an outside
auditor. In that instance, recklessness requires a mental state “so culpable that it
approximate[s] an actual intent to aid in the fraud being perpetrated by the audited
company.” PR Diamonds, Inc., 364 F.3d at 693 (citations omitted).

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.

Id. at 693-94 (quotation marks and citations omitted). “To allege that an independent
accountant or auditor acted with scienter, the complaint must identify specific, highly
suspicious facts and circumstances available to the auditor at the time of the audit and
allege that these facts were ignored, either deliberately or recklessly.” Id. at 694
(quotations and citations omitted).

The well-pleaded facts must give rise not merely to an inference of scienter, but
to a strong inference of scienter. “[T]he court must take into account plausible opposing
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Sys., et al. v. Ernst & Young, LLP

inferences.” Tellabs, 551 U.S. at 323. The district court must conduct a “comparative
inquiry” and assess the possible competing inferences that could be drawn from the
allegations, including “plausible nonculpable explanations for the defendant’s conduct,
as well as inferences favoring the plaintiff.” Id. at 323-24. A complaint will survive a
motion to dismiss only if “a reasonable person would deem the inference of scienter
cogent and at least as compelling as any opposing inference one could draw from the
facts alleged.” Id. at 324 (emphasis added). When two equally compelling inferences
can be drawn, one demonstrating scienter and the other supporting a nonculpable
explanation, Tellabs instructs that the complaint should be permitted to move forward.
Frank, 547 F.3d at 571. This formulation rejects that previously used in the Sixth
Circuit, when a plaintiff could survive a motion to dismiss only if the inference of
scienter was “the most plausible of competing inferences.” Helwig, 251 F.3d at 553.

Lastly, the Sixth Circuit subjects the scienter test to the “totality of
circumstances” analysis, whereby the alleged facts collectively must give rise to a strong
inference of actual knowledge or recklessness. See PR Diamonds, Inc., 364 F.3d at 690
(citation omitted). The court must “consider the complaint in its entirety.” Tellabs, 551
U.S. at 322.

1. Tellabs v. Pre-Tellabs Standard Analysis

It is well established that we review the district court’s dismissal de novo, and
we “may affirm on any grounds supported by the record, even though they may be
different from the grounds relied on by the district court.” Ley, 543 F.3d at 805-06
(citation omitted). Nonetheless, plaintiffs argue that the district court applied the
incorrect scienter-pleading standard, citing Frank, 547 F.3d at 571, which held that the
pleading standard of Helwig had been rejected by Tellabs.

Frank does not support plaintiffs’ argument. In Frank, the district court
incorrectly cited Tellabs as requiring the court “to accept plaintiff’s inferences of
scienter only if those inferences are the most plausible of competing inferences.” Id. at
571. The “most plausible” standard comes from Helwig, which “plainly is at odds with
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Sys., et al. v. Ernst & Young, LLP

the Supreme Court’s holding in Tellabs.” Id. Accordingly, this court vacated the district
court’s order and remanded.

In this case, in articulating the controlling pleading standard, the district court’s
parenthetical description of Tellabs stated: “plaintiffs must plead facts rendering
inference of scienter at least as likely as any plausible opposing inference.” This
statement correctly describes the Tellabs standard. See Tellabs, 551 U.S. at 324.
However, the district court also repeated this court’s pre-Tellabs holding, which
enunciated the following standard:

[P]laintiffs are only entitled to the most plausible of competing
inferences. Helwig, 251 F.3d at 553. The “strong inference” requirement
means that a plaintiff is entitled only to the most plausible of competing
potential inferences. Id. at 553.

The district court correctly applied the law to the facts using the Tellabs standard, and
the Helwig quote was dicta that had no impact on the district court’s analysis. See
Konkol v. Diebold, Inc., 590 F.3d 390, 397 (6th Cir. 2009) (stating that although the
district court opinion contained scattered references to the “most plausible” standard, the
court ultimately applied the correct standard). Nonetheless, we review the district
court’s dismissal de novo, using the correct Tellabs standard.

2. Pleading a Strong Inference of Scienter

Plaintiffs allege that Ernst & Young’s material misrepresentation, which
subjected it to liability under Section 10(b) and Rule 10b-5, was the Accredo audit report
dated August 16, 2002. The report, which contained Ernst & Young’s unqualified
opinion on Accredo’s 2002 financial statements, was included in Accredo’s fiscal year
2002 Form 10-K that was filed with the SEC on September 30, 2002. The district court
held that the allegations contained in plaintiffs’ complaint “do not raise a strong
inference that [Ernst & Young] acted with scienter” with regard to the audit report.

On appeal, the class members rely on a number of allegations to establish that
Ernst & Young acted with scienter. They assert that Ernst & Young knowingly used
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stale and incorrect data in preparing its audit opinion and that there were numerous “red
flags” that should have placed Ernst & Young on notice about financial improprieties.
Further, they contend that the magnitude of the accounting violations by Ernst & Young
creates the inference that Ernst & Young acted knowingly or recklessly in ignoring the
company’s financial misstatements. Plaintiffs also argue that having Ernst & Young in
a position to have its fees increase tremendously if Accredo acquired the Gentiva
Division, Ernst & Young’s post-Class Period statements, and Accredo’s firing of Ernst
& Young support the inference that Ernst & Young acted with the requisite scienter.
Finally, the class members contend that even if the individual allegations in the
complaint are by themselves insufficient, when viewed in their entirety they establish
that Ernst & Young acted with scienter. We accept the class’s allegations as true and
address each of their arguments in turn.

a.

Plaintiffs argue that Ernst & Young rendered audit opinions on Accredo’s
financial statements contrary to the requirements of Generally Accepted Auditing
Standards and Generally Accepted Accounting Principles, approving reports that
misstated Accredo’s true financial condition by millions of dollars. More specifically,
plaintiffs allege that Accredo’s and Gentiva’s estimates and methodologies were
available to Ernst & Young at the time of the audits and that Ernst & Young deliberately
or recklessly ignored and failed to investigate them.

As noted above, in the context of securities fraud, recklessness requires proof that
the defendant’s conduct was highly unreasonable and involved an extreme departure
from the standards of ordinary care, meaning that the danger was either known to the
defendant or so obvious that any reasonable person would have been aware of it. PR
Diamonds, Inc., 364 F.3d at 681. The standard for proof of recklessness in securities
fraud cases is especially stringent when the claim is brought against an outside auditor.
Id. at 693.
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The PSLRA requires plaintiffs to plead the elements of fraud in detail. A
“complaint alleging accounting irregularities fails to raise a strong inference of scienter
if it allege[s] no facts to show that Defendants knew or could have known of the errors,
or that their regular procedures should have alerted them to the errors sooner than they
actually did.” PR Diamonds, Inc., 364 F.3d at 684 (internal quotations omitted).
General allegations regarding an auditor’s access to information do not raise an inference
of fraud. See id. at 695-96; cf. Kennilworth Partners L.P. v. Cendant Corp., 59 F. Supp.
2d 417, 429 (D.N.J. 1999) (“[S]tatement[s that] could be made in relation to the auditor
of every corporation” are not sufficient to raise the inference of scienter, because “[i]f
[they] were sufficient . . . , it might make every auditor liable in cases of securities
fraud.”). We have also held that a failure to follow Generally Accepted Accounting
Principles is, by itself, insufficient to establish scienter for a securities fraud claim.
Comshare, 183 F.3d at 553 (citations omitted). Improper accounting alone does not
establish scienter whereby “mere allegations that statements in one report should have
been made in earlier reports do not make out a claim of securities fraud.” Id. (citation
omitted).

The crux of plaintiffs’ complaint against the accounting firm is that Ernst &
Young failed to follow the professional standards that govern the auditor’s testing of
management’s accounting estimates, such as the allowance for doubtful accounts.
Plaintiffs claim that Ernst & Young’s testing of the allowance attributable to the Gentiva
Division receivables was deficient because Ernst & Young “used old and stale data . . .
to test the reasonableness” of the allowance. The “old and stale” data to which the
plaintiffs refer is the model for determining the allowance as of June 30, 2002. Plaintiffs
cite a note written on an April 2003 fax from an Ernst & Young partner to another
outside auditor as circumstantial evidence of scienter. The fax includes two worksheets
Ernst & Young used to determine the Gentiva Division’s accounts receivable reserve
requirement. Plaintiffs point to a handwritten note on the first worksheet stating that the
“worksheet was in a file with the previous schedule. This was labeled as ‘Q4,’ which
we assume was 12/00. I do not believe it was ever used even though the [percentages]
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Sys., et al. v. Ernst & Young, LLP

are much higher. This amount more in line with reality.” The “previous schedule” to
which the worksheet is referring is the actual worksheet that Ernst & Young used to
determine the reserve requirement. It is the second worksheet included in the fax. On
the second worksheet, a note states the amount “appears low.”

The district court noted that the first schedule bears a date after the events at
issue and surmised that it had been misfiled. However, plaintiffs note that the two
schedules were in the same file. They attach another copy of the second worksheet
bearing a print date of “11/02/2000”, which shows that Ernst & Young possessed the
worksheet during the events at issue. Given our standard of review, we must assume that
the first and second worksheets were created in 2000 and that the copies attached to the
fax bear a later date because that is the date they were reprinted. Nonetheless, even if
we make this inference and plaintiffs can show that the second schedule existed in 2000,
they still have not met the high threshold for scienter by establishing only that Ernst &
Young had the data in hand. See PR Diamonds, Inc. 364 F.3d at 695-96 (stating that
general allegations regarding an auditor’s access to information do not raise an inference
of fraud). Moreover, because “mere allegations that statements in one report should
have been made in earlier reports do not make out a claim of securities fraud,”
Comshare, 183 F.3d at 553 (quotation and citation omitted), it follows that even if Ernst
& Young should have included the appropriate data in its audit, its failure to do so does
not create an inference that it acted with the requisite scienter. See Ley, 543 F.3d at 817.

b.

Plaintiffs also argue that Ernst & Young disregarded numerous red flags that
should have triggered a higher degree of scrutiny and that collectively these red flags
support a strong inference of scienter. As the district court discussed, and as mentioned
above, for a red flag to create a strong inference of scienter in securities fraud claims
against an outside auditor, it must consist of an “egregious refusal to see the obvious, or
to investigate the doubtful.” PR Diamonds, Inc., 364 F.3d at 693 (citation omitted).
“Courts typically look for multiple, obvious red flags before drawing an inference that
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Sys., et al. v. Ernst & Young, LLP

a defendant acted intentionally or recklessly.” Id. at 686-87 (citations omitted). Mere
allegations that an accountant negligently failed to closely review files or follow
Generally Accepted Auditing Standards cannot raise a strong inference of scienter. See
Ley, 543 F.3d at 817 (alleged “red flags” known to auditor, including Generally
Accepted Auditing Standard violations and statement by an anonymous witness, did not
give rise to scienter).

The district court compared this case to the facts in Fidel v. Farley, 392 F.3d 220
(6th Cir. 2004), overruled on other grounds, Tellabs, 551 U.S. 308 (2007), where we
found that alleged red flags did not create the inference that the auditor acted with
scienter in preparing its audit report. Id. at 229. In Fidel, plaintiffs alleged that its
outside auditor should have been placed on notice by red flags that included (i) having
unfettered access to the documents and employees at all offices; (ii) knowing of a
securities fraud lawsuit filed against the company before it completed its audit;
(iii) knowing of the company’s propensity to disobey financial rules; (iv) receiving an
anonymous letter that detailed some of the company’s financial mistatements; and
(v) noting in its audit papers that the company demonstrated significant “book to
physical losses” and was understating its reserve for close-out inventory. Id. at 228-29.
The court in Fidel found no inference of scienter because the red flags occurred before
or after the audit period or because there was no indication that the auditors knew or
could have known that the red flags affected the financial results for the audit year. Id.
at 229.

In this case, plaintiffs’ list of red flags is not as compelling as that found in Fidel.
For example, plaintiffs claim that Ernst & Young ignored that Gentiva had reduced the
reserve percentages by pointing to a memorandum. The memorandum appears to be an
internal Accredo report, which stated:

For the first item, [Ernst & Young] had used the percentages calculated
for CY00 as the basis for the required reserve as of September 2001 as
this was the latest information presented to them. [Gentiva] had tweaked
the percentages down for September as a result of current collection
trends; however, [Ernst & Young] has not seen the basis for doing so.
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Sys., et al. v. Ernst & Young, LLP

This change in percentages used results in approximately $2,400,000 of
the change.

While the plaintiffs suggest that this memorandum shows that Ernst & Young discovered
that Gentiva had been “tweak[ing] the percentages down,” the competing inference is
that Ernst & Young required Gentiva to show why management did so. We conclude
that the more compelling inference is that Ernst & Young was resisting a lower reserve.

Plaintiffs also allege that investment banker Thomas Weisel Partners’ alleged
refusal to consummate the purchase of Gentiva’s acute care business was another red
flag that should have focused Ernst & Young on the accounts receivable. Plaintiffs do
not plead facts to support their contention that Ernst & Young knew that this acquisition
was a condition of Accredo’s purchase of the Gentiva Division or that Thomas Weisel
Partners backed out of it. Here, plaintiffs do not allege highly particularized facts
demonstrating a connection between the failed acquisition and the accounts receivable.

Plaintiffs also emphasize the Gentiva Division’s “history of serious accounts
receivable problems” as revealed in the 2000 Cap Gemini/Ernst & Young consulting
engagement, which recommended that Gentiva write off millions in uncollectible
receivables. However, no one disputes that a substantial portion of the Gentiva Division
accounts receivable was indeed thought to be uncollectible. Plaintiffs seek to use this
allegation to show that Ernst & Young was aware of the prior receivables collection
problems in 2000, which, presumably, should have alerted them to similar problems in
2002. As the district court points out, however, “[t]he timing of this awareness would
not support a finding of scienter” because the complaint does not allege facts suggesting
that Ernst & Young was on notice that the accounts receivable problems were in excess
of the substantial allowance recorded in 2002.

Plaintiffs next claim that during its audits, Ernst & Young saw the days-sales-
outstanding for the acute business “approaching nearly 300 days,” allegedly an
indication that “a material portion of the receivables were uncollectible and worthless.”
Again, Ernst & Young does not dispute that a portion of the Gentiva Division’s accounts
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Sys., et al. v. Ernst & Young, LLP

receivable were uncollectible. Moreover, plaintiffs do not plead facts that support their
contention that Ernst & Young not only knew of the information before issuing its audit
report, but also that knowing so would amount to “no audit at all.” See PR Diamonds,
Inc., 364 F.3d 693-94 (quotation marks and citations omitted); see also Konkol, 590 F.3d
at 398 (stating that even monitoring the high day sales outstanding is a general allegation
not sufficient to support scienter). Accordingly, because plaintiffs’ red flags rest on
conclusory allegations and are devoid of facts, we hold that they do not create an
inference that Ernst & Young acted with scienter.

c.

Plaintiffs next argue that the magnitude of the fraud supports the inference that
Ernst & Young acted with scienter. Plaintiffs state that they “are aware of this Court’s
holding in Fidel v. Farley, 392 F.3d 220 (6th Cir. 2004), that the magnitude of an
accounting fraud cannot be used to bolster a scienter inference.” Plaintiffs suggest,
however, that the “prominent nature of the [Gentiva Divisions’] accounts receivable
allowance and the error’s $58.5 million magnitude, in combination with the other facts
alleged, provides an additional, scienter-bolstering inference.”

We have addressed similar allegations of scienter based on the magnitude of
fraud with respect to an outside auditor. “We decline to follow the cases that hold that
the magnitude of the financial fraud contributes to an inference of scienter on the part
of the defendant.” Fidel, 392 F.3d at 231. Allowing such an inference would eviscerate
the principle that accounting errors alone cannot support a finding of scienter. Id.;
Stambaugh v. Corrpro Cos., 116 F. App’x 592, 597 (6th Cir. 2004) (declining to find a
strong inference of scienter where, among other things, the plaintiff referenced the
magnitude of the fraud and the fact that the fraud involved a “material component” of
the defendant’s business). Furthermore, as reasoned by the court in Reiger v. Price
Waterhouse Coopers LLP, to infer scienter solely from the magnitude of the fraud would
require hindsight, speculation, and conjecture. 117 F. Supp. 2d 1003, 1013 (S.D. Cal.
No. 08-6194 Louisiana School Employees’ Retirement Page 18
Sys., et al. v. Ernst & Young, LLP

2000). We are bound by our holding in Fidel, and we thus reject plaintiffs argument that
the magnitude of the alleged error was indicative of Ernst & Young’s scienter.

d.

Plaintiffs accuse Ernst & Young of being motivated to commit fraud by the
promise of future professional fees. Indeed, Ernst & Young’s Memphis Office earned
$1.1 million in auditing fees from Accredo during fiscal year 2002. Plaintiffs’ motive
and opportunity allegations, however, do not raise an inference of scienter.
“[A]llegations that the auditor earned and wished to continue earning fees from a client
do not raise an inference that the auditor acted with the requisite scienter.” Fidel, 392
F.3d at 232. Even a specific account that was one of the auditor’s most lucrative would
not imply scienter on the part of the auditor. See In re Cardinal Health Inc. Sec. Litig.,
426 F. Supp. 2d 688, 778 (S.D. Ohio 2006).

The complaint contains no allegations that Ernst & Young’s fees from Accredo
were more significant than its fees from other clients or that Accredo’s business
represented a significant portion of Ernst & Young’s revenue. See Fidel, 392 F.3d at
232-33. Plaintiffs allege no facts to support an allegation that Ernst & Young’s motive
to retain Accredo as a client was any different than its general desire to retain business.

Plaintiffs also point to post-Class Period events to help bolster a strong scienter
inference, such as post-Class Period statements and charges leveled in Accredo’s lawsuit
against Ernst & Young. Specifically, plaintiffs look to an April 2003 statement, which
is after the Class Period. William Drummond, an Ernst & Young partner and the lead
audit partner for Accredo during the Class Period, admitted to Joel Kimbrough,
Accredo’s Senior Vice President and CFO, that “there was a problem.” Moreover, the
facts alleged in the May 5, 2003 professional negligence complaint that Accredo filed
against Ernst & Young may support a contention that, at least in Accredo’s opinion at
the time, the allowance was understated as of June 30, 2002 when Accredo acquired the
Gentiva Division.
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Sys., et al. v. Ernst & Young, LLP

Finding scienter based on such allegations would be equivalent to “the classic
fraud by hindsight case where a plaintiff alleges that the fact that something turned out
badly must mean defendant knew earlier that it would turn out badly.” Konkol, 590 F.3d
at 403 (citation omitted). A statement such as “there was a problem” does not tell us
whether Ernst & Young fraudulently refused to see the obvious with regard to the
allowance at the time of its audit of the 2002 financial statements. In addition,
Accredo’s malpractice complaint against Ernst & Young does not support an inference
that Ernst & Young engaged in fraud. Without specific allegations showing that Ernst
& Young either knew or recklessly disregarded the falsity of its own statements at the
time the statements were made, the fact that the statements later turned out to be false
is irrelevant to a cause of action under PSLRA. Id.

e.

Finally, plaintiffs argue that the allegations contained in the complaint combine
to create a strong inference of scienter. In their brief, they argue that the district court
was “[e]rroneous . . . [in its] rejection of myriad facts that, considered collectively and
holistically . . . raise a strong inference of defendants’ scienter.” It is true that this court
employs a “totality of the circumstances analysis whereby the facts argued collectively
must give rise to a strong inference of at least recklessness.” PR Diamonds, Inc., 364
F.3d at 683 (citation omitted). However, even taken as a whole, the complaint does not
establish that plaintiffs met the PSLRA’s requirement of pleading “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). Taking plaintiff’s allegations as true, as we must,
Ernst & Young’s alleged failures were not so grievous as to suggest that their work was
“no audit at all.” See PR Diamonds, Inc., 364 F.3d at 693.

In the end, plaintiffs’ allegations do not raise a strong inference that Ernst &
Young acted with scienter in affirming Accredo’s allegedly fraudulent accounting.
Conclusory allegations about what Ernst & Young must or should have known while
auditing Accredo do not amount to specific allegations that show material misstatements
No. 08-6194 Louisiana School Employees’ Retirement Page 20
Sys., et al. v. Ernst & Young, LLP

or omissions committed with recklessness. Plaintiffs thus fail to adequately allege all
of the elements of their Section 10(b) and Rule 10b-5 claim.

B. Leave to Amend

Because we determined that the district court properly dismissed plaintiffs’
complaint against Ernst & Young, we now consider whether the district court erred in
doing so without affording them an opportunity to amend their complaint. Plaintiffs
never sought leave to amend. In their opposition to Ernst & Young’s motion to dismiss,
plaintiffs asked the district court to allow them the opportunity to move for amendment
should the court “grant any portion” of the motion to dismiss. In its dismissal order, the
district court made no mention of amendment. Although in certain instances district
courts may permit the losing party leave to amend when ruling on a motion to dismiss,
under the circumstances of this case, the district court did not err by failing to do so. See
PR Diamonds, Inc., 364 F.3d at 698.

As explained in PR Diamonds, Inc., the review of a district court’s denial of a
motion for leave to amend a complaint generally is governed by an abuse of discretion
standard. Id. at 698. Review, however, is de novo where the reason for the district
court’s denial is based on a legal conclusion that the amended pleading would not
withstand a motion to dismiss. Ziegler v. IBP Hog Market, Inc., 249 F.3d 509, 518 (6th
Cir. 2001). In this case, the district court did not state why it declined to offer plaintiffs
an opportunity to amend their complaint. There was no “motion” to deny. Accordingly,
we will review the district court’s actions for abuse of discretion. See PR Diamonds,
Inc., 364 F.3d at 698.

Federal Rule of Civil Procedure 15(a) provides that a district court should freely
grant leave when justice so requires. However, we have held that the PSLRA restricts
the scope of Rule 15(a) in the context of securities litigation such that plaintiffs have
more limited ability to amend their complaints. Miller v. Champion Enters., Inc., 346
F.3d 660, 692 (6th Cir. 2003). And while Rule 15 plainly embodies a liberal amendment
policy, in the post-judgment setting we must also take into consideration the competing
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Sys., et al. v. Ernst & Young, LLP

interest of protecting the finality of judgments. See PR Diamonds, Inc., 364 F.3d at
698-99. “Thus, in the post-judgment context, we must be particularly mindful of not
only potential prejudice to the non-movant, but also the movant’s explanation for failing
to seek leave to amend prior to the entry of judgment.” Id. at 699 (citation omitted).

As stated in PR Diamonds, Inc., “a bare request in an opposition to a motion to
dismiss -- without any indication of the particular grounds on which amendment is
sought . . . does not constitute a motion within the contemplation of Rule 15(a).” Id.
(citation omitted). A request for leave to amend “almost as an aside, to the district court
in a memorandum in opposition to the defendant’s motion to dismiss is . . . not a motion
to amend.” Begala v. PNC Bank, Ohio, Nat’l Ass’n, 214 F.3d 776, 784 (6th Cir. 2000);
see PR Diamonds, Inc., 364 F.3d at 699. As the Begala decision stated in affirming the
district court’s dismissal of the plaintiffs’ complaint with prejudice:

Had plaintiffs filed a motion to amend the complaint prior to th[e]
Court’s consideration of the motions to dismiss and accompanied that
motion with a memorandum identifying the proposed amendments, the
Court would have considered the motions to dismiss in light of the
proposed amendments to the complaint . . . . Absent such a motion,
however, Defendant was entitled to a review of the complaint as filed
pursuant to Rule 12(b)(6). Plaintiffs were not entitled to an advisory
opinion from the Court informing them of the deficiencies of the
complaint and then an opportunity to cure those deficiencies.

214 F.3d at 784.

In this case, plaintiffs failed to follow the proper procedure for requesting leave
to amend. They did not actually file a motion to amend; instead, they included the
following request in their brief opposing the defendants’ motions to dismiss: “Should
the Court grant any portion of Ernst & Young’s motion to dismiss, Plaintiffs respectfully
request an opportunity to move to amend the pleadings and demonstrate that an
amendment would cure any deficiencies.” In light of plaintiffs’ procedural shortcomings
and in the context of the PSLRA, we hold that the district court did not abuse its
discretion by denying plaintiffs an opportunity to amend their complaint, and we affirm
the district court’s judgment.
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Sys., et al. v. Ernst & Young, LLP

III. Conclusion

For the reasons stated above, the district court properly dismissed Plaintiffs’
Section 10(b) and Rule 10b-5 claims against Ernst & Young. The district court also did
not abuse its discretion in failing to invite Plaintiffs to amend their complaint.

For the foregoing reasons, the judgment of the district court is AFFIRMED.