CASE 7.8

FIRST SECURITIES COMPANY OF CHICAGO (HOCHFELDER)

Synopsis

Prior to the Supreme Court’s ruling in the Hochfelder case, it was unclear exactly what degree of malfeasance on the part of auditors had to be proven for them to be held civilly liable under the Securities Exchange Act of 1934. For many years, plaintiff legal counsel had maintained that if an audit firm was found to have been negligent in auditing financial statements included in a registration statement filed under the 1934 Act, third parties who relied on those statements to their detriment were entitled to recover damages from the audit firm. Conversely, attorneys representing audit firms in such cases maintained that plaintiffs should be allowed to recover damages only if they could prove that an audit firm had engaged in fraudulent conduct. The 1978 Hochfelder (First Securities) ruling by the U.S. Supreme Court addressed this important issue.

The Supreme Court ruled in the Hochfelder case that plaintiffs seeking recovery of damages under the 1934 Act from an audit firm were required to establish “scienter” or intent to deceive on the part of the audit firm rather than simply negligence. However, the court also noted that in certain cases “reckless disregard for the truth” might be construed as equivalent to scienter. That is, a plaintiff unable to establish explicit fraud on the part of an audit firm might be allowed to recover damages by proving that the audit firm had engaged in reckless behavior. In summary, although the Hochfelder case established that audit firms were not liable under the 1934 Act for negligence, the case left open the question of whether they could be held liable for “recklessness” under that statute. In addition to discussing the central legal issues in the First Securities lawsuit, this case provides background information regarding the fraud from which this important lawsuit stemmed.

Case 7.8 First Securities Company of Chicago

First Securities Company of Chicago—Key Facts

1. Leston Nay was well respected and trusted by his customers.

2. Despite his reputation as a prudent and conservative stockbroker, Nay had a well concealed history of unscrupulous business practices.

3. The alleged escrow syndicate was an investment fund personally managed by Nay and not an asset of First Securities.

4. Nay’s “mail rule” allowed him to conceal the existence of the escrow syndicate from his subordinates at First Securities.

5. After failing to recover their losses from the Midwest Stock Exchange and First Securities, the escrow investors filed a lawsuit against Ernst & Ernst, the longtime audit firm of First Securities.

6. The escrow investors alleged that negligence on the part of Ernst & Ernst had prevented the audit firm from discovering Nay’s mail rule and, as a result, the escrow syndicate fraud.

7. The lawsuit against Ernst & Ernst by the investors was filed under Rule 10b-5 of the Securities Exchange Act of 1934.

8. At the time of the First Securities scandal it was unclear whether plaintiffs had to prove fraudulent conduct on the part of auditors in a lawsuit filed under the 1934 Act or whether negligence was a sufficient basis for such a suit.

9. The Supreme Court ruled that negligence was not a sufficient basis for a civil lawsuit filed against an audit firm under the 1934 Act; instead, a plaintiff must prove either intent to deceive (scienter) or possibly reckless disregard for the truth on the part of an audit firm to recover damages.

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Instructional Objectives

1. To define auditors’ legal liability under the Securities Exchange Act of 1934.

2. To demonstrate that auditors must be skeptical of even well respected and apparently trustworthy client executives.

Suggestions for Use

This case is best suited for coverage during discussion of auditors’ legal liability, specifically auditors’ liability under the federal securities laws. The key learning points in this case focus on what I like to refer to as auditors’ “culpability standard” under the Securities Exchange Act of 1934. Although the Hochfelder ruling clearly established that negligence is an insufficient basis for a civil lawsuit filed against an auditor under the 1934 Act, it was much less definitive regarding when “reckless disregard for the truth” or, more simply, recklessness, qualifies as sufficient grounds for such a suit. Almost certainly, future litigation related to the 1934 Act will resolve this latter issue.

This is another case that instructors can use to impress upon students the importance of maintaining a healthy degree of skepticism during every audit engagement. Leston Nay was well known and respected in both the Chicago business and civic communities and had a seemingly spotless reputation as a prudent investment advisor. Despite this reputation, Leston Nay was, to put it mildly, dishonest. As pointed out in the case, Ernst & Ernst served as First Securities’ audit firm for more than two decades. Audit engagement personnel may become complacent when assigned to a long-term client that has never presented any major problems for the audit firm. Whether such complacency was a factor in this case is impossible to determine. Nevertheless, I believe that possibility is certainly a valid point for instructors to raise when discussing this case.

Suggested Solutions to Case Questions

1. The mail rule would likely qualify as a “material weakness” under AU Section 325, “Communicating Internal Control Related Matters Identified in an Audit:” “A material weakness is a significant [control] deficiency, or combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the financial statements will not be prevented or detected” (AU 325.06). In turn, a “significant deficiency” is a “control deficiency, or combination of control deficiencies, that adversely affects the entity’s ability to initiate, authorize, record, process, or report financial data reliably in accordance with generally accepted accounting principles such that there is more than a remote likelihood that a misstatement of the entity’s financial statements that is more than inconsequential will not be prevented or detected” (325.06). AU Section 325 requires auditors to communicate material weaknesses that they discover to “management and those charged with governance as a part of each audit” (325.20).

Testimony in the various lawsuits triggered by the First Securities fraud did not reveal whether that firm had an audit committee or an equivalent committee. If the organization had such a committee or a comparable committee, Ernst & Ernst would have been required to disclose the mail rule to that committee under the present requirements of AU Section 325 (obviously, this is assuming that Ernst & Ernst had discovered the mail rule). Such disclosure

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may very well have resulted in the discontinuance of the mail rule and, possibly, to the discovery of Nay’s fraud. If First Securities did not have such an oversight committee, then Ernst & Ernst would apparently have been required to report the mail rule to Nay, himself. No doubt, Nay would have resisted any suggestion that he alter or eliminate the mail rule, making it unlikely that the material weakness disclosure would have resulted in the escrow syndicate fraud being discontinued.

Note: For a more in-depth discussion of significant internal control deficiencies and material weaknesses in internal control and auditors’ related responsibilities, see the solution to case question No. 3 for Case 1.11, “New Century Financial Corporation.”

2. The mail rule clearly had important financial implications for First Securities. In one of the legal cases prompted by the First Securities fraud, the court pointed out that while engaging in the fraud Nay was acting as an agent of First Securities.

“ . . . First Securities also provided Nay with the printed letterhead, printed safekeeping receipts, rubber stamps, and other supplies and other accoutrements which enabled him to perpetrate and perpetuate his frauds.” [Securities and Exchange Commission vs. First Securities Company of Chicago, 466 F.2d 1035 (1972), p. 1040.]

In fact, in another court case, First Securities was found liable for the investment losses suffered by the participants in the escrow syndicate. This finding was essentially a moot point, however, since First Securities was insolvent.

The mail rule also had significant implications for the brokerage firm’s internal controls. If Ernst & Ernst had discovered the mail rule, it would have vigorously questioned Nay as to its purpose. In this vein, Ernst & Ernst apparently did not contest the testimony of expert witnesses who suggested that had the mail rule been discovered, the Ernst & Ernst auditors should have considered its existence to be a very serious control deficiency. [See Exhibit 2 for portions of the expert testimony on this issue.]

3. The definitions of negligence, recklessness, and fraud presented here are found in the following source: D.M. Guy, C.W. Alderman, and A.J. Winters, Auditing, Fifth Edition (San Diego: Dryden, 1999), 85–86.

Negligence. “The failure of the CPA to perform or report on an engagement with the due professional care and competence of a prudent auditor.” Example: An auditor fails to test a client’s reconciliation of the general ledger controlling account for receivables to the subsidiary ledger for receivables and, as a result, fails to detect a material overstatement of the general ledger controlling account.

Recklessness (a term typically used interchangeably with gross negligence and constructive fraud). “A serious occurrence of negligence tantamount to a flagrant or reckless departure from the standard of due care.” Example: Evidence collected by an auditor suggests that a client’s year-end inventory balance is materially overstated. Because the auditor is in a hurry to complete the engagement, he fails to investigate the potential inventory overstatement and instead simply accepts the account balance as reported by the client.

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Fraud. “Fraud differs from gross negligence [recklessness] in that the auditor does not merely lack reasonable support for belief but has both knowledge of the falsity and intent to deceive a client or third party.” Example: An auditor accepts a bribe from a client executive to remain silent regarding material errors in the client’s financial statements.

4. Most likely, the escrow investors would have been successful in recovering their losses from Ernst & Ernst if they had been entitled to file their suit under the Securities Act of 1933. Auditors are faced with much more litigation risk when they audit financial statements included in a registration statement filed under the 1933 Act compared with financial statements included in a registration statement filed under the 1934 Act. A “qualified” plaintiff who files suit under the 1933 Act is not required to establish any type or degree of malfeasance on the part of the given audit firm. In fact, when filing suit against an audit firm under the 1933 Act, a plaintiff must establish only two general elements of proof to make a prima facie case. The plaintiff must prove that he or she suffered damages and that the financial statements in question contain one or more material errors. (In this case, the material error in First Securities’ financial statements was the lack of disclosure regarding the firm’s contingent liability for Nay’s fraudulent actions.)

5. In a jurisdiction that invokes the legal precedent established by the Restatement of Torts, both “primary” and “foreseen” beneficiaries are allowed to recover damages resulting from the actions of a negligent audit firm. Foreseen beneficiaries include a reasonably small or limited group of individuals or other parties that the given audit firm was aware would be relying on the financial statements in question. [Key point: The auditor is aware of the given group of intended financial statement users but is not necessarily aware of the specific individuals or other parties that belong to that group.] If the escrow investors could have established that they qualified as foreseen beneficiaries, they likely would have been able to recover their losses in a “Restatement of Torts” jurisdiction.

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