Audit

CASE 7.9

First Securities Company of Chicago (Ernst & Ernst u Hochfelder et al)

Ladislas Nay immigrated to the United States from Hungary in 1921 at the age of 18.

The opportunities offered by his new land excited the industrious young immigrant and he promised himself that he would make the most of them. Shortly after arriving in the United States. Nay made his way to Chicago and landed a job in the booming securities industry with a small brokerage firm. For the next several years, Nay worked long and hard hours learning the brokerage business.

Unfortunately for Nay, the Great Depression hit the securities industry particularly hard. Young stockbrokers like himself were the first to be released by their firms when personnel cuts were necessary. During the bleak 1930s, Nay, who by this time had Americanized his first name to Leston, endured several job changes and two failed marriages. In 1942, as World War ll began to pull the United States out of the Depression, Nay landed a permanent job with the brokerage firm of Ryan-Nichols & Company.

Within two years of joining Ryan-Nichols, Nay was promoted to president. He eventually became the firm's principal stockholder, accumulating more than 90 percent of its outstanding common stock. In 1945, Nay renamed his firm First Securities Company of Chicago. Nay's firm also successfully applied for membership in the Midwest Stock Exchange that year. Over the next two decades, Nay's career and personal life flourished. His family settled into the upper-class neighborhood of Hyde Park, near the University of Chicago. Nay and his wife, Elizabeth, participated in a wide range of community affairs, including serving on several prominent civic boards. Nay made numerous friends among the faculty and staff of the University of Chicago. In fact, many of his best customers were associated with the prestigious school.

Nay's personal attention to the financial needs of his customers earned him their respect and admiration. One of his customers described him as a kind and considerate man, much "like an old-fashioned English solicitor who took care of a family's affairs." His conservative investment strategies particularly appealed to his retired clients and those nearing retirement. Nay offered many of these customers an opportunity to invest in a lucrative fund that he personally managed. This fund was not an asset of First Securities, nor were any other First Securities personnel aware it existed. Nay referred to this fund as the "escrow syndicate.”

Nay loaned funds invested in the escrow syndicate to blue chip companies that developed sudden and unexpected working capital shortages. These companies paid interest rates well above the prevailing market rates. Individuals who invested in the escrow syndicate earned 7 to 12 percent on their investments, considerably more than the interest rates paid at the time by banks on savings accounts.

One of Nay's closest friends, Arnold Schueren, entrusted him with more than 400,000 over three decades and granted him a power of attorney to make investment decisions regarding those funds. Nay invested a large portion in the escrow syndicate. Another individual who relied heavily on Nay for investment advice was the widow of a close associate of the famed University of Chicago scientist Enrico Fermi. This woman later testified that Nay had managed her family's investments for many years but did not offer her the opportunity to invest in the escrow syndicate until after her husband's death. Nay told her that he only offered this investment opportunity to his "nearest and dearest friends." Following the death of another of his customers, Norman Moyer, Nay convinced Moyer's widow to invest her husband's estate of $90,000 in the escrow syndicate. In total, 17 of Nay's friends and/or their widows invested substantial sums in the escrow syndicate.

Dr. Jekyll and Mr. Hyde: A Tragic Ending.

On the morning of June 4, 1968, Leston Nay drove to St. Luke's Hospital in Chicago to pick up his wife, who had fallen and broken her hip the previous week. Earlier that morning, Nay had telephoned his secretary to tell her that he would not be in the office that day because he had a stomach virus. Shortly before noon, as his wife, who was still on crutches, made her way to the kitchen of their apartment, Nay retrieved his 12-gauge shotgun and shot her in the upper back from close range. Nay then laid a suicide note on a dressing table in his bedroom, sat down on his bed, put the muzzle of the gun in his mouth, and pulled the trigger.

News of the murder-suicide shocked the Nays' friends and associates. These same people were shocked again when the Chicago police released the contents of Nay's suicide note. The note revealed that the kindly stockbroker had led a Dr. Jekyll- Mr. Hyde existence for decades. In the note, addressed "To whom it may concern,” Nay admitted stealing from his customers for more than 30 years. The escrow syndicate in which his closest friends had invested did not exist-police speculated that Nay had lost the investors funds in the stock market. Nay had successfully concealed the missing funds for as long as he did because he periodically mailed the investors checks for interest supposedly earned by the escrow syndicate. These periodic interest payments deterred the victims of the scam from questioning the safety of their investments.

In the suicide note, Nay displayed some remorse when he referred to the 80-year-old Mrs. Moyer, who was penniless as a result of his actions. He also explained why d decided to take his life. After Arnold Schueren died in 1967, the executor of his estate had demanded that Nay return Schueren's investment in the escrow syndicate. Nay indicated in the suicide note that he had "stalled" as long as he could but that the executor would not be put off any longer. So he took his life. Most likely, Nay murdered his wife to "save" her from the shame she would feel when his fraudulent scheme, of which she was apparently unaware, was disclosed.

Defrauded Customers Sue to Recover Their Investments.

The investors in Nay's escrow syndicate filed civil lawsuits against several parties in an effort to recover their collective investments of more than $1 million. Initially, the investors sued the Midwest Stock Exchange. In that suit, the investors alleged that the stock exchange failed to adequately investigate Nay's background before admitting firm to membership. According to the investors, a more thorough investigation might have revealed that Nay had a history, although well concealed, of unscrupulous business practices. The investors suggested that the discovery of Nay's past unethical conduct would have forced the exchange to deny his firm's membership application and possibly prevented him from engaging in the escrow syndicate fraud. The court hearing the suit quickly dismissed the investors' claims, concluding that the stock exchange sufficiently investigation Nay's background before approving his firm’s membership application.

Nay's 17 escrow participants or their estates also sued First Securities Company of Chicago. The court ruled that the brokerage firm had clearly facilitated Nay's fraudulent activities. But, since the brokerage firm was bankrupt, the escrow investors found themselves thwarted again.

Finally, Nay’s former customers filed suit against Ernst’s & Ernst's the accounting firm that audited First Securities Company for more than two decades. The lawsuit alleged that Ersnt & Ernst’s negligence had prevented the firm from detecting what became known throughout the lengthy judicial history of the firm from detecting what became known thought the lengthy judicial history of the First Securities case as Nay’s mail rule. According to the plaintiffs' legal counsel, “Nay had forbidden anyone other than himself to open mail addressed to him and in his absence all such mail was simply allowed to pile up on his desk, even if it was addressed to First Securities for his attention. Nay’s mail rule allowed him to conceal the escrow syndicate scam from his subordinates at First Securities and from the brokerage’s independent auditors. Had Ernst & Ernst discovered the mail rule, the plaintiffs alleged, an investigation would have been warranted. Such an investigation would very likely have led to the discovery of Nay's escrow investment scam.

Ernst & Ernst v. Hochfelder et al

The defrauded investors filed their lawsuit against Ernst & Ernst under the Securities Exchange Act of 1934. That federal statute does not expressly provide civil remedies to stockholders of companies registered with the Securities and Exchange Commison (SEC). However, since the adoption of the 1934 Act, federal courts have allowed stockholders to use the statute as a basis for civil suits against company officers, investment brokers, auditors, and other parties associated with false financial statement filed with the SEC. Most of these suits allege one or more violations of Rule Ob-5 of the 1934 Act, shown in Exhibit 1. (Rule 10b-5 of The Securities Exchange Act of 1934)

In the First Securities case, the plaintiffs charged that Ernst& Ernst's alleged negligence in failing to discover Nay's mail rule constituted a violation of Rule 10b-5.

The premise (of the investors' suit) was that Ernst & Ernst had failed to utilize "appropriate auditing procedures" in its audits of First Securities. ... Respondents (vectors) contended that if Ernst & Ernst had conducted a proper audit, it would have discovered this "mail rule." The existence of the rule then would have been disclosed to the Exchange (Midwest Stock Exchange] and to the Commission (SEC) by Ernst & Ernst as an irregular procedure that prevented an effective audit.

Employment of manipulative and deceptive devices. It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,

a) To employ any device, scheme, or artifice to defraud

(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or

(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

To support their claim that the mail rule qualified as a critical internal control weakness having important audit implications, the escrow investors submitted affidavits from three expert witnesses with impressive credentials in the accounting profession. Exhibit 2 ( Except from Expert Witness testimony regarding Nay’s mail rule) lists a portion of one of these affidavits.

The federal district court that initially presided over the Hochfelder et al. v. Ernst & Ernst case quickly dismissed the lawsuit. This court deemed that there was no substantive evidence to support the allegation that Ernst & Ernst had negligently audited First Securities. When the investors appealed this decision, the U.S. Court of Appeals reversed the lower court decision and ordered that the case go to trial. In its decision, the appeals court ruled that sufficient doubt existed regarding the negligence claim against Ernst& Ernst to have the case heard. The appeals court also suggested that if the plaintiffs established negligence on the part of Ernst & Ernst, the accounting firm could be held civilly liable to the defrauded investors under Rule 10b5 of the 1934 Act.

Before the Hochfelder case went to trial in federal district court, Ernst & Ernst appealed the ruling of the US. Court of Appeals to the U.S. Supreme Court. Ernst & Ernst argued before the Supreme Court that the negligence allegation of the escrow investors was insufficient, even if proved, to constitute a violation of Rule 10b-5. This issue had surfaced in many previous civil cases filed under the Securities Exchange Act of 1934. In these earlier cases, the federal courts had generally ruled or suggested that negligence constituted a violation of Rule 10b-5. That is, fraud or gross negligence, either of which is much more difficult for a plaintiff to prove than ordinary negligence, did not have to be established for a defendant to be held civilly liable to a plaintiff under Rule 10b-5.

Ernst & Ernst contested these earlier rulings by arguing that Rule 10b-5, as worded could not be construed to encompass negligent behavior. Given the longstanding controversy surrounding this issue, the Supreme Court decided to rule on the issue in the Hochfelder case. This ruling would then establish a precedent for future lawsuits filed under Rule 10b-5.

Expert Witness No. 3:

If I had discovered in making an audit of a security brokerage business that its president had established an office rule that mail addressed to him at the business address, or to the company for his attention should not be opened by anyone but him, even in his absence; and that whenever he was away from the office such mail would remain unopened and pile up on his desk I would have to raise the question whether such rule or practice could possibly have been instituted for the purpose of preventing discovery of irregularities of whatever nature; would, at a minimum, have to undertake additional audit procedures to independently establish a negative answer to the latter question; also failing such an answer either withdraw from the engagement or decline to express an opinion on the financial statements of the enterprise.

Before the Supreme Court heard Ernst & Ernst's appeal, the SEC filed a legal brief with the Court. This brief supported the defrauded investors' argument that Rule 10b-5 encompassed both fraudulent and negligent conduct. The SEC pointed out that the end result of investors acting on false financial statement is the same whether the errors in the statements result from fraud or negligence. Because a central purpose of the federal securities laws is to ensure laws is to ensure that investors receive reliable information, the SEC'S argued that the ambiguity in Rule 10b-5 should be resolved in favor of investors.

Surprisingly, the bulk of the Supreme Court's opinion in the Hochfelder case responded to the SEC's legal brief rather than the arguments of the defrauded investors or those of Ernst & Ernst. The Court rejected the SEC’s largely philosophical argument and instead focused on the question of whether the authors of Rule 10b-5 intended it to encompass both negligent and fraudulent behavior. In addressing this issue, the Court reviewed the legislative history of the 1934 Act and did a painstaking analysis of the semantics of Rule 10b-5.

The Supreme Court eventually concluded that the kay signal to the underlying meaning of Rule 10b-5 was the term manipulative. As shown in Exhibit 1, the heading of the clearly indicates that it pertains to "manipulative and deceptive" devices. According to the Court, negligence on the part of independent auditors or other parties associated with false financial statement could not be construed as manipulative behavior. The Court suggested that in most cases for behavior to qualify as manipulative, intent to deceive-the legal term being scienter-had to be present.

When a statute speaks so specifically in terms of manipulation and deception, and of implementing devices and contrivances-the commonly understood terminology of intentional wrongdoing-and when its history reflects no more expansive intent, we are quite unwilling to extend the scope of the statute to negligent conduct.

Two of the nine Supreme Court justices dissented to the Hochfelder decision, while one justice abstained. In disagreeing with the majority decision, Justice Harry Blackmun sided with the view expressed by the SEC. He noted that although the decision was probably consistent with the semantics of the Securities Exchange Act of 1934, the decision clashed with the underlying intent of that important federal statute. He wrote, "It seems to me that an investor can be victimized just as much by negligent conduct as by positive deception, and that it is not logical to drive a wedge between the two, saying that Congress clearly intended the one but certainly not the other." Justice Blackmun went on to comment on the "critical importance" of the independent auditor’s role and the ultimate responsibility of the auditor to serve the "public interest." Given this societal mandate, Justice Blackmun argued, negligent auditors should be held accountable to investors who rely to their detriment on false financial statements.

An Unresolved Issue.

At first reading, the Supreme Courts Hochfelder opinion appeared to establish once and for all, the culpability standard for determining Rule 10b- violations. Unfortunately, the opinion is not as precise or definitive as it first appeared. A footnote to the opinion suggests that in certain cases, scienter, or intent to deceive, may not be necessary element of proof for a plaintiff to establish in a civil suit alleging a Rule 10b-5 violation. The Court noted that some jurisdictions equate scienter with willful or reckless disregard for the truth or, more simply, "recklessness." When engaging in reckless behavior, a party does not actually possess conscious intent to deceive; that is, scienter is not present. For whatever reason, the Court specifically refused to rule on the question of whether reckless behavior would be considered equivalent to scienter and thus constitute a violation of Rule 10b-5. This omission caused subsequent plaintiffs to predicate alleged Rule 10b-5 violations by independent auditors on reckless behavior, since that type of professional misconduct is much easier to prove than actual scienter.

EPILOGUE

Congressional critics of the Supreme Court's decision in the Hochfelder case insisted that the alleged "flaw" in Rule 10b-5 should be corrected legislatively In late 1978, legislators introduced a bill in the U.S. House of Representatives to hold negligent auditors civilly liable to investors who relied on false financial statements filed with the SEC. Fortunately for independent auditors, Congress rejected that bill.