Ernst & Ernst v. Hochfelder

Summary

Ernst & Ernst, an accounting firm, audited First Securities Company of Chicago, a small brokerage house, from 1946 through 1967 and prepared the annual reports the firm filed with the Securities and Exchange Commission. Leston B. Nay, the brokerage's president and owner of 92 percent of its stock, persuaded certain customers to put money into special escrow accounts that he said would pay a high return. No such accounts existed; Nay took the funds for himself, and the transactions never appeared on the firm's books. The scheme came to light in 1968, after Nay's death, when he left a note calling the accounts spurious. The defrauded customers sued Ernst & Ernst under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5, claiming that a proper audit would have uncovered Nay's rule that only he could open mail addressed to him, and that disclosure of this irregular practice would have exposed the fraud. They expressly disclaimed any charge that the accountants acted intentionally; their claim rested on negligence. The District Court granted summary judgment for Ernst & Ernst, and the Seventh Circuit reversed. The question was whether a private suit for damages under Section 10(b) and Rule 10b-5 can succeed without proof of scienter, an intent to deceive, manipulate or defraud. The customers, supported by the SEC as amicus curiae, argued that the statute is remedial, that Rule 10b-5's language reaches any act that operates as a fraud, and that investors suffer the same loss from careless conduct as from deliberate deceit. Ernst & Ernst answered that the words of the statute describe intentional wrongdoing and that Congress set out negligence liability only in specific, limited provisions. On 30 March 1976 the Court reversed, six to two, with Justice Stevens not participating. Justice Powell reasoned that the words manipulative, device and contrivance are the vocabulary of knowing or intentional misconduct; that the legislative history described Section 10(b) as a catchall against new manipulative practices; that where Congress allowed recovery for negligence in the 1933 and 1934 Acts it did so expressly and with procedural limits; and that a Commission rule cannot reach further than the statute it implements. He declined to remand for trial on a new theory because the plaintiffs had always proceeded on negligence alone. Justice Blackmun, joined by Justice Brennan, dissented. He doubted the majority's reading, argued that an investor is injured as much by negligence as by deception, stressed the public role of the certifying accountant, and suggested Congress would have to act if such investors were to recover. The library text contains both opinions; most notes are left out, though several explanatory notes from the source appear after the dissent. Powell reserved in a footnote whether recklessness might satisfy the scienter requirement, and the courts of appeals later generally held that it can. Aaron v. SEC (1980) applied the same scienter rule to SEC enforcement suits under Section 10(b).

Top Lessons

• Intent as an element of securities fraud

  The Court held that a private plaintiff suing under Section 10(b) must prove scienter, an intent to deceive, manipulate or defraud. Careless auditing, however costly to investors, is not by itself the kind of deceptive device the statute forbids.

• Reading a statute through its words, history and structure

  Powell's opinion uses three tools in turn: the ordinary and technical meaning of the statute's words, the drafting history of the 1934 Act, and a comparison with sections where Congress expressly allowed negligence claims. The opinion is a model of building an interpretive argument from several independent supports.

• The auditor's public duty

  Blackmun's dissent stresses that an accountant certifying a broker's financial statements serves the investing public, not only the client. The majority did not deny the importance of audits; it held that the remedy for negligent auditing lies elsewhere than in Section 10(b).

• Who should change the law?

  Blackmun closed by saying that it rested with Congress to rephrase the statute if investors like the respondents were to recover. The majority, for its part, refused to extend the statute beyond its words. Both opinions thus point to Congress, from opposite directions.

Verified Quotes

Medical Lens

A dispute over an accounting firm's liability for a broker's escrow fraud; the opinions concern the mental element of securities fraud in the legal sense and contain no medical subject matter.