Ernst & Young (EY), an accounting firm, audited the financial statements of semiconductor company Broadcom Corporation. In


Ernst & Young (EY), an accounting firm, audited the financial statements of semiconductor company Broadcom Corporation. In 2005, EY issued an unqualified opinion that Broadcom's financial statements from 2003 to 2005 fairly presented Broadcom's finances.
Broadcom offered stock options as part of its compensation package for officers, directors, and key employees and secretly backdated certain option grants so that option recipients received the largest possible gain.
For example, if the market price increased from $10 on January 1 to $12 on January 15, then options granted on January 15 might be dated January 1 and have an exercise price of $10. Because issuers are required to take a charge against earnings for the value of options, including the difference between the strike price and the fair market value on the date of grant, backdating had the effect of understating the compensation expense and thereby overstating the company's reported net income in each of the years in which the options vested.
In 2007, Broadcom issued a restatement for 1998 to 2005 in which it acknowledged that it had improperly accounted for $2.2 billion in income, mostly due to improper option backdating. As a result, every financial statement issued during this time period was false and misleading. After Broadcom agreed to pay $12 million to settle civil charges brought by the SEC, the New Mexico State Investment Council led a civil suit against EY for knowing, or being deliberately reckless in not knowing, that its 2005 opinion was materially false and misleading due to Broadcom's stock option backdating scheme. The plaintiffs alleged that:
● 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, in violation of generally accepted auditing standards (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 was deliberately reckless in ignoring a number of "red flags" that should have alerted it to the potential for material misstatements related to stock-based compensation.
Did EY violate section 10(b) or Rule 10b-5? Would it matter if the EY employees who participated in the 2005 audit were unaware of the earlier alleged backdating, given that EY continuously served as Broadcom's auditor during that time period?

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