ERNST & ERNST v. HOCHFELDER
Legal provision: Securities Act of 1933, the Securities and Exchange Act of 1934, or the Williams Act
Argument of Robert L. Berner, Jr.
Chief Justice Warren E. Burger: We will hear arguments first this morning in Ernst and Ernst against Hochfelder.
Mr. Berner you may proceed whenever you are ready.
Mr. Robert L. Berner, Jr.: Mr. Chief Justice and may it please the Court.
The basic issue in these cases is whether Rule 10b-5 is to be turned into a National Negligence Statute, affecting all conduct in any way touching on the purchase or sale of a security.
This issue is presented in the petition for certiorari as whether respondents may predicate a cause of action against petitioners for aiding and abetting a violation of Section 10b of the Securities Exchange Act of 1934 and Rule 10b-5 there under, an allegation and proof of negligence alone of whether they must be alleged and proved something more than negligence, some fraud, some knowledge of the fraud or some reckless or willful conduct tantamount to fraud.
There are three other issues in this case which are important to the petitioners and the respondents as a disposition of anyone of them can dispose of this litigation and they are whether.
Ernst and Ernst as a matter of law ordered the first securities with all diligence whether the respondent’s conduct is such as to estop them from bringing their claims against Ernst and Ernst and whether the respondents can avoid the bar of the statute limitations.
These issues of course are best under understood in the context of the facts which briefly are that First Securities was a small broker dealer in Chicago.
It was owned by Leston B. Nay.
The respondents for many years were regular securities customers of First Securities and as such in their regular securities transactions received all of the documentary paraphernalia that a securities customer ordinarily receives.
They will receive purchase and sale forms, confirmation of sales, accountings, all the documents that emanate from a broker dealer.
Most or all of the respondents were also friends or had some personal or social relationship with Nay or with Mrs. Nay and as a result Nay was able to persuade the respondents to invest in what he called an escrow.
He told them that he had befriended a small loan company that was required by law to maintain a cash escrow.
Their investments would be perfectly safe and it paid 12% interest in some cases, 9% in the other.
Of course, the escrow was fictitious and there was no small loan company, but these people paid their funds to Nay by personal check made payable to him personally and he evidenced the investments, the escrow investments by personal notes of his or by -- by letters, all however the correspondence coming from on the letterhead of First Securities Company.
None of the transactions involving this escrow ever were reflected on the books and the records of First Securities.
The respondents conducted all of their transactions with respect to the escrow with Nay personally as compared with the transactions they had when dealing with First Securities as regular securities customers.
The petitioner, Ernst and Ernst was the auditor of First Securities from sometime in the middle 40s until 1967.
The respondents’ relationship with First Securities as regular securities customers and as escrow investors began in the early 40s in some cases and continued up until 1968.
In June of 1968, Nay’s fancy scheme caught up with them and he shot and killed himself.
Chief Justice Warren E. Burger: Killed his wife first?
Mr. Robert L. Berner, Jr.: Yes sir.
He shot and killed his wife and then killed himself.
That was, I believe, June 6, 1968.
The SEC within a day or two initiated the receivership proceeding which is still pending and the respondents have made their claims in that receivership proceeding, but in 1971, they sued Ernst and Ernst under Section 10b and Rule 10b-5, claiming that Ernst and Ernst caused their loss.
Chief Justice Warren E. Burger: Does the record show that in every transaction for the escrow account, the checks were paid to Nay personally and not to First Trust?
Mr. Robert L. Berner, Jr.: Yes sir.
In the litigation against Ernst and Ernst, there were a number of depositions taken of all of the people connected with Ernst and Ernst audit, with the audit by Ernst and Ernst.
The documents in Ernst and Ernst's possession relating to the -- their audits over 25 years such as they still had were examined by the respondents and then a motion for summary judgment was filed and granted in favor of Ernst and Ernst in the District Court and the grounds that Ernst and Ernst's conduct in the audits was blameless.
The District Court also found that the statute limitations barred these claims and found that the respondents own conduct acted as estoppel.
That summary judgment was appealed to the Court of Appeals for the Seventh Circuit which reversed, finding that there could be a genuine issue of material fact as to whether or not Ernst and Ernst's conduct in connection with the audit might have been negligent and they pointed to two -- two transactions, two types of conduct.
One, it was the existence of a mailed procedure for securities and the other one was an allegation that they did not take regular vacations.
With respect to the what is referred to as the mail rule, I should explain that there was simply an office procedure for securities which provided that all mail delivered to First Securities, addressed to an individual to his attention or to him personally would be delivered to him, put on his desk.
Nay, being the owner and president of --
Unknown Speaker: Unopened?
Mr. Robert L. Berner, Jr.: Unopened, yes sir.
According to the record in the affidavit of John Walsh of Haskins & Sells, that procedure existed at substantially all the brokerage houses, well most of the brokerage houses in Chicago at that time and probably most of them in the county.
Nay, however, had an additional -- additional provision which restricted anyone else at the office from opening his mail.
As a result when he was not in the office, his mail was not opened.
The Court of Appeals found that this could create an issue of fact as to whether or not Ernst and Ernst audited diligently and they reversed and in doing so, the Court of Appeals announced a standard for aiding and abetting liability under 10b-5 --
Justice William H. Rehnquist: Mr. Berner, is the term aiding and abetting a familiar one to members of the security bar?
Mr. Robert L. Berner, Jr.: It is becoming familiar.
Justice William H. Rehnquist: Where did it come from?
Mr. Robert L. Berner, Jr.: It comes from, I think it comes from the criminal law originally.
Justice William H. Rehnquist: How did it get over into the civil law?
Mr. Robert L. Berner, Jr.: Well, I think it first came over in -- in Fischer versus Klotz, a case in the -- in the Southern District in the late 60s and in the Seventh Circuit, in Brennan versus Midwestern Insurance, the Seventh Circuit adapted the analogy.
I believe it comes over because usually an aid and abettor is very little if anything to do with the fraud, and very little knowledge if any, usually no knowledge of the fraud, but it is a term where someone has given substantial assistance and knowing assistance in connection with some wrong and it has been imported from both the criminal law and there is some old SEC administrative decisions which use the concept, but it is -- it is not a well-known concept yet in the securities law.
The standard that the Seventh Circuit adapted as a negligence standard, it leaves no room or at least it does not require any element of scienter, that is any element of knowledge of the fraud of reckless conduct tantamount to fraud.
It is a pure negligence standard and as such --
Justice Byron R. White: Negligent aiding and abetting?
Mr. Robert L. Berner, Jr.: Yes sir, negligent aiding and abetting.
I believe the first case in the federal jurisprudence, I am certain it is the first case in the securities laws that adapts that standard that a person can negligently aid and abet a securities violation under 10b-5 or other violations.
The Ninth Circuit has adapted a standard which does not require the element of scienter although the case in which they adapted it, clearly had that element, but the majority of the Circuits, the Second, Fifth, Sixth, and Tenth circuits at least, who have specifically addressed themselves to the question have required something more than negligence in terms of culpability for a liability in a private money damage action under Rule 10b-5.
Those circuits are correct I believe, if the statute and the legislative history and the reasoning behind those as looked at deep as Mr. Justice Powell pointed out in his concurring opinion in Blue Chip when a language -- when a statute is being construed the place to start is the language of the statute.
10b-5 speaks of manipulative and deceptive devices.
Now, it is not clear what that is, but that certainly is fraud language.
That is not blameless language or negligent language that talks of fraud.
The rule also is replete with words of fraud and in fact, Professor Lass has commented Judge Friendly in the Second Circuit have each stated that if Rule 10b-5 is held to encompass merely negligent conduct it goes beyond the mandated Section from which it draws its life.
Justice Byron R. White: Where did the B-2 come from, B-2 in this case?
Mr. Robert L. Berner, Jr.: Clause B-2 in Rule 10b-5?
I believe that all of Rule 10b-5 was draft at the same time in the early 1940s by the SEC.
Now there is similar language in the Investment Company Act.
The SEC points to some New York Corporation law as perhaps suggesting the language.
Justice Byron R. White: Well, the B-2 does not refer -- It does not have that fraud language?
Mr. Robert L. Berner, Jr.: No, it does not and it --
Justice Byron R. White: It is so worded that --
Mr. Robert L. Berner, Jr.: It does not have language as to fault at all.
It simply speaks of a misrepresentation or an omission, but I believe the proper view of the three clauses of 10b-5 is that they get to this basically the same kind of behavior.
In this court’s case in Capital Gains Research --
Justice Byron R. White: Well, is part of your submission then that B-2 just is not within the reach of -- if it is construed this way, not to require scienter of any kind that it just not authorized by the statute?
Mr. Robert L. Berner, Jr.: Yes sir.
The legislative history of course is not conclusive.
Nowhere does it conclusively say that Section 10b requires something more than negligent, but it gets near to that because a reading of the legislative history makes it clear that these provisions in the securities laws are designed to get to dishonest behavior.
The phrase is honesty in the marketplace, high ethical standards, these phrases permeate the legislative history.
I think it is absolutely clear from the legislative history that these acts are not designed to get to the competence of somebody, but his honesty and the certain abuses that we get in capital gains research that Mr. Justice Goldberg’s points are abuses of honesty.
Chief Justice Warren E. Burger: Do you suggest that the statute deals in terms of affirmative action rather than commissions?
Mr. Robert L. Berner, Jr.: I believe it deals in terms of both affirmative actions and of omissions and an omission can be as a culpable as an affirmative action.
The standard which the majority of the circuits urge and which we support would not constitute a retreat to 1934 when the Act was drafted.
It would not require a retreat to all common-law elements of fraud as we understood them at that time.
We are speaking only of the level of culpability and this would not affect the direction that this Court and other courts that have taken and the other elements which constituted a 10b-5 action, elements of reliance, materiality, causation and the like.
We submit that requiring something more than negligence in terms of culpability would simply be a continuation of the direction that Rule 10b-5 and Section 10b has been taking and would prevent an abrupt change in direction which endorsement of the Seventh Circuit’s opinion would constitute.
With respect to Ernst and Ernst's conduct, even if a simple negligence standard were permitted for Rule 10b-5, it is clear we submit on the record that as a matter of law, Ernst and Ernst conducted its audit of First Securities with all due diligence.
Ernst and Ernst's duty to audit First Securities was to audit in accordance with the general accepted auditing standards.
In the uncontroverted evidence, the affirmative evidence in this case is unequivocal.
It is to the effect that Ernst and Ernst conducted its audits in accordance with generally accepted auditing standards.
The evidence submitted by the respondents is evidenced that goes to the question of whether or not First Securities Company maintained high internal accounting controls, strong internal accounting controls.
But of course that is not the issue whether or not the a company has strong or weak internal accounting controls is not determinative of whether or not an auditor audits in accordance with generally accepted auditing standards.
Internal accounting controls arrangements are controls, arrangements, procedures within a company that are designed to ensure that company, that its assets and liabilities are correctly reflected on the books and records.
And if a company has strong controls, the auditor then has more confidence in them and need not extend his procedures unduly to confirm that.
If the controls are weak, he has to engage in more procedures, but whether or not they are strong or weak is not determinative of whether the auditor audits correctly.
Justice William H. Rehnquist: Well, the respondents had a couple affidavits of that, I thought that the mail rule would have sure alerted auditors to do more than Ernst and Ernst did here?
Mr. Robert L. Berner, Jr.: Well, I think that the respondent has submitted three affidavits.
One is by a man named Michael Garst who was a retired national bank examiner.
Justice William H. Rehnquist: Okay.
Can we really parse this kind of a thing on when it is simply a reversed level motion for summary judgment in the Seventh Circuit as to whether the affidavits did or did not make out a conflict on the question of proper audit or it is not that more logical to concentrate on the negligence versus something more issue?
Mr. Robert L. Berner, Jr.: Well, that is an issue that as I mentioned in the beginning, the question of negligence or not can also win this case for Ernst and Ernst and as a result at least in those terms that is quite important for Ernst and Ernst and I believe that a reading of the three affidavits submitted by the respondents makes it fairly clear that the respondents, two of the three are auditors, one is not an auditor, of the two auditors, one has never audited a brokerage house, but he is leased as an auditor and they say that as a -- it is a matter of personal opinion that they expressed that they would do, one says would employ additional audit procedures if you found this rule.
Well, of course he has not reviewed the system at First Securities like the affiance whose affidavits are submitted on behalf of Ernst and Ernst did and they know what the system was and they know what procedures were there and as a result they say, even taking into account the mail rule, the audit was conducted with all due diligence in accordance with generally accepted auditing standards.
The respondent’s affidavits simply say, taking the mail rule by itself, they would consider that a possible weakness and they may do something.
They may employ additional procedures or not, but they do not get to the question and the question is did Ernst and Ernst audit in accordance with generally accepted auditing standards.
Now, even more than that, the respondents have charged, particularly in their briefs submitted to this Court that Ernst and Ernst's conduct could be considered as reckless or fraudulent.
They charge that even if the proper standard is followed by this Court, the case should be remanded and we submit that this is incorrect because the conduct of Ernst and Ernst was fully disclosed, fully discovered, is fully out in the open and on the record.
It was on the record for the District Court.
It was on the record before the Court of Appeals and it is here and it is not just a record that was developed during this case.
In the other litigation, related litigation in which the respondents were involved which resulted in a full trial under merits, on at least three other appeals, a lot of information was developed.
In fact, all of the items, the three or four items about which the respondents complain in their brief, I mean it is there in their brief, were all outlined in the complaint itself.
So, this is nothing new.
Justice William H. Rehnquist: Did they allege reckless or willful misconduct in their complaint?
Mr. Robert L. Berner, Jr.: No, they allege that Ernst and Ernst knew or should have known but as the brief of the Hochfelder, the respondents points out, they never characterized that conduct.
They simply -- they did not say it was simply negligent.
They submitted it the facts to the Court and it is our view that it should not be permitted at this stage on the basis of the same record to apply a few more adjectives and thus send the case back for another view of the same facts simply with different adjectives in mind.
This is not a new theory they are proposing.
They are simply proposing that they are continuing to propose that Ernst and Ernst conduct was wrong.
Justice William H. Rehnquist: Did they argue on this Seventh Circuit that there was sufficient evidence or would be a trial to support a finding of recklessness or willfulness?
Mr. Robert L. Berner, Jr.: It was not that clear in the Seventh Circuit.
They did not emphasize that, but the Seventh Circuit opinion I believe is quite clear that no finding of recklessness or fraud could be found in the Seventh Circuit opinion and the Seventh Circuit had stretched some to find the possibility of negligence.
Justice William H. Rehnquist: Well, the Seventh Circuit said in fact that at common law, Ernst and Ernst could not be held --
Mr. Robert L. Berner, Jr.: That is correct.
Justice William H. Rehnquist: -- under the Ultramares?
Mr. Robert L. Berner, Jr.: That is correct which would eliminate a finding of fraudulent of reckless conduct.
That is correct.
Chief Justice Warren E. Burger: Was there a claim here in the pleadings of reliance on the Ernst and Ernst certificate?
Mr. Robert L. Berner, Jr.: No sir, not direct reliance.
In fact, the record is clear that the plaintiffs did not rely on Ernst and Ernst and on their audit.
They have never seen the audit.
They did not know Ernst and Ernst.
They did not know of them.
The theory as best I can make it out is that if Ernst and Ernst had audited properly, it would have told the Midwest Stock Exchange and the SEC that there were weak internal accounting controls at First Securities.
Chief Justice Warren E. Burger: Would it derive from the mail, the opening of his mail?
Mr. Robert L. Berner, Jr.: Opening of the mail.
Chief Justice Warren E. Burger: And the fact that he did not take the vacations?
Mr. Robert L. Berner, Jr.: Well, the record does not support he did not take vacations, but for the record is clear to contrary, but vacations, weak internal accounting controls and there are two other elements.
One was the fact that Nay borrowed from this company and the other was that there was tampering in net capital violation in 1967.
Both of those were litigated in part of this suit below that was directed against the Midwest Stock Exchange and both of those were found to be by the Seventh Circuit and the District Court as not instances of negligence and a part of the Midwest.
Now, Ernst and Ernst was simply to report those to the Midwest.
The gist of the complaint as I understand it is that Ernst and Ernst reported those informally rather than formally.
I am not sure the legal distinction, but that appears to be what it is and those are not audit problems.
For instance, the excessive borrowings are called by Nay, they were always less than the earned surplus.
Nay owned the company and the amounts he borrowed were always less than the earned surplus of the company, considerably less.
They were all reported on the financial statements just as the requisite SEC instructions require.
The respondents claim that the debt should have been reserved because they said Nay was hopelessly insolvent.
Well, they overlooked the fact that the debts were reserved, reserved to 100% under net capital computations.
Debts from an officer or partner or director of a broker dealer must be carried as a zero asset in determining that capital and that was done in these instances.
So those are the other instances Mr. Chief Justice.
So we submit that a remand on the issue of recklessness or fraud would be particularly inappropriate.
There is not a new theory that is being urged by the respondents.
They are merely new adjectives that are being applied to Ernst and Ernst conduct, the same conduct that has been fully before all of the courts.
I would like briefly to touch upon the two other issues --
Unknown Speaker: May I ask Mr. Berner, I think the commission suggests that they should have an opportunity to amend their complaint to affect the theory of reckless and the intentional rather than negligent conduct?
Mr. Robert L. Berner, Jr.: Yes sir.
Unknown Speaker: What do you think?
What do you say to that?
Mr. Robert L. Berner, Jr.: I think the commission’s suggestion is improper.
The commission’s brief was filed several weeks after the brief of the Hochfelder, the respondents where the use of the words reckless and fraudulent first occurred and the SEC, that the commission refers to that brief and says perhaps the case should be remanded.
However, the SEC bases that apparently on the fact they believe a new theory is being -- maybe argued.
We do not consider this a new theory.
Unknown Speaker: Incidentally was there suggestion involve as to the statute limitations questions?
Mr. Robert L. Berner, Jr.: Well, the statute limitations questions exist now and the statute would be the same.
It would not affect the applicable statute.
If I may, I would --
Justice William H. Rehnquist: Mr. Berner, if the general rule is that even an intervenor is not allowed to raise a new theory in the case, would the SEC simply as an amicus have any right to raise a new theory at this stage?
Mr. Robert L. Berner, Jr.: We felt that the suggestion was gratuitous and it is not supported by any case authority as to their standing.
It appears on the last page of their brief.
Chief Justice Warren E. Burger: Does it not suggest something like the common law action?
Mr. Robert L. Berner, Jr.: A common law action, a 10b-5 is not the only statute or the only theory upon which a plaintiff can proceed in this case, can a common law --
Chief Justice Warren E. Burger: On what theory, did they proceed, on 10b?
Mr. Robert L. Berner, Jr.: No, only on 10b-5.
Chief Justice Warren E. Burger: But now, if the SEC suggestion is construed to be a suggestion for a common law claim then it is a different theory, is it not?
I put that if.
Mr. Robert L. Berner, Jr.: Well, I would not call it a different theory.
I think they would still be alleging fraud.
They may have found to know another way to get at Ernst and Ernst, but I would not consider that different theory.
I would like to reserve a few minutes if I may.
Chief Justice Warren E. Burger: Very well, Mr. Berner.
Argument of Willard L. King
Mr. Willard L. King: Mr. Chief Justice and may it please the Court.
In 1968, a man calling himself Leston B. Nay, a member of the Midwest Stock Exchange and President of First Securities Company of Chicago murdered his wife and killed himself.
He left a suicide note in which he said that his company was bankrupt because of his debts committed over a period of 30 years.
His suicide note also said that a certain escrow in which he had sold investments to the customers of First Securities Company was spurious.
Nay had persuaded these plaintiffs, long time customers of First Securities Company to let that company sell their standard securities and invest the proceeds in this fictitious escrow.
There was no escrow.
Nay converted their money to his own use immediately upon its receipt.
Nay’s suicide note also asked that Ernst and Ernst be notified.
What part did Ernst take it in Nay’s horrid story?
For 20 years, Ernst had certified each year to Midwest Stock Exchange that First Securities Company, a balance sheet of First Securities Company showing it to be solvent when in fact it was utterly insolvent.
In each of those 30 years, Ernst had certified to Midwest Stock Exchange that it had revealed the internal accounting control of Nay’s company as it was required to do by the standards of its profession.
Actually, the company had no internal accounting control because they had Nay had adamant office rule that all mail received by the company, addressed to him or to the company for his attention could only be opened, seen or read by him.
When he was away for a few days, the mail by his command piled up unopened on his desk.
Nay secreted the incoming mail on his debts.
A great mass of his correspondents with his escrow victims was found locked in his desk.
Ernst never reviewed the internal accounting control.
If they had done so it would have uncovered Nay’s fraud.
Now what is internal accounting control?
Chief Justice Warren E. Burger: Do you say it would have necessarily uncovered the mail rule that you just described?
Mr. Willard L. King: Yes, Mr. Chief Justice.
What is internal accounting control?
In 1939, the SEC published a volume on that subject which established the very simple definition of that term.
Internal accounting control means that the work of each officer and employee must be counter checked by the work of another.
It means that no fraud or crime can exist without collusion between two or more persons.
It means that no one person can profit by fraud because his fraud will be discovered by another person.
Chief Justice Warren E. Burger: With whom do you suggest there was collusion here?
You say it takes two, at least two to accomplish collusion?
Mr. Willard L. King: There was no collusion here that I suggest.
I was giving the definition of internal accounting control as stated by the SEC on the basis of the testimony of 12 leading American Public Accountants in 1939.
I did not suggest collusion.
The essence of the internal accounting control is required duality.
In 1939, the SEC published the complete transcripts of the testimony of 12 leading American Publican Accountants, each of whom testified to this definition of required duality as internal accounting control.
One of those experts was the senior partner of Ernst and Ernst.
This occurred in the SEC’s investigation of the colossal frauds that McKesson and Robbins, a multi million dollar drug concern; no securities were listed on the New York Stock Exchange.
The President of that company was an ex-convict under a fictitious name who operated the company with the aid of his three brothers also under various fictitious names.
They inflated the sales and inventories by many millions.
Like Nay, the President shot himself when his fraud was discovered.
McKesson had been audited by a nationally known public accounting firm and the SEC condemned its failure to check the internal accounting control.
One of the McKesson criminals required that all of the incoming mail be put unopened on his desk.
He never took a vacation.
Under these circumstances, the SEC questioned each of the twelve leading American Public Accountants on the duty of a public accountant with respect to checking the incoming mail.
It showed each of them a bulletin of the American Institute of Certified Public Accountants under a caption “safeguards surrounding the handling of incoming mail.”
Each of the twelve leading public accountants testified that a public accountant must not fail to check the routine of examining, handling the incoming mail and find it to be controlled so that no one could secrete that mail.
Justice William H. Rehnquist: Well, Mr. King supposing they do fail to check into that, that would still be no more than negligence, would it?
Mr. Willard L. King: I suggest that it would be the grossest sort of negligence and gross negligence of the public accountant as evidence of fraud.
Justice William H. Rehnquist: Well, that is just a lot of words, negligence, gross negligence, evidence of fraud, but those are three fairly separate things and I do not think it helps analysis to simply garble them all together?
Mr. Willard L. King: I did not mean to garble them, Mr. Justice.
Unknown Speaker: Mr. King, do you understand you are now arguing that was fraud, a fraud of Ernst and Ernst?
Mr. Willard L. King: Our complaint does not allege either negligence or fraud.
Unknown Speaker: But in your interrogatory as you expressly disclaim that is fraud?
Mr. Willard L. King: Yes.
Unknown Speaker: Are you standing on that interrogatory, are you now changing the course?
Mr. Willard L. King: Of course I stand upon it Mr. Justice.
Unknown Speaker: Well then you are not charging forward?
Mr. Willard L. King: Well, I asked, if necessary leave to amend the complaint to charge gross negligence equivalent to fraud.
Unknown Speaker: In this court?
Mr. Willard L. King: Yes.
Well, this Court has previously in cases involving summary judgment permitted case to be reversed for amendment of the complaint.
Unknown Speaker: So, you are asking that the case be remanded to allow you to amend your complaint to chargeable?
Mr. Willard L. King: That is correct.
Unknown Speaker: When was this suit instituted?
Mr. Willard L. King: In 1971.
Unknown Speaker: And this is the first time that this it has occurred to you, four years?
Mr. Willard L. King: Well, it only occurred to me when this Court allowed certiorari on the opinion of the Seventh Circuit.
I had been describing the McKesson report of the SEC.
Since that report, since 1939, the SEC in two cases has suspended a broker from the exchanges for tolerating Nay’s mail rule.
The advisory committee of broker dealers to the SEC in its volume entitled “Guide to Broker Dealer Compliance” has stated no personal mail should be permitted in an office or any mail distributed unopened to any salesman or other employees and our position to Ernst's motion for summary judgment, the plaintiffs filed the affidavit of Fred J. Duncan, a former President of the Illinois Society of Certified Public Accountants and a former member of the Board for certifying them.
Mr. Duncan’s affidavit stated that he would not have certified the balance sheet of a company employing Nay’s mail rule because such a company had no internal accounting control.
To the same effect, the plaintiff’s filed in opposition to the summary judgment the affidavit of Gerhard Meyer, a distinguished public accountant of 30 years experience.
Ernst filed in support of its motion for summer judgment, the affidavit of its partner Jerry Hooker who had been in-charge of the First Securities Company audit.
Hooker’s affidavit stated that Nay’s mail rule was not relevant to internal accounting control.
On his deposition, Hooker testified that he would had not have objected to Nay’s mail rule if he had known about it.
He was clearly unacquainted with the elementary rules of his profession.
His affidavit is contrary to the affidavits of the two distinguished public accountants that the plaintiffs filed.
It is contrary to the testimony of the twelve leading American Public Accountants published by the SEC in 1939.
It is in the teeth of the two cases where the SEC has suspended a broker from the exchanges for tolerating Nay’s mail rule.
I submit that no summary judgment may be issued on that affidavit.
I turn now to privity or as Judge Cardozo called it near privity between the plaintiffs and Ernst.
These plaintiffs had been long time customers of First Securities Company.
Nay made the proposal of the escrow to them in the office of the company.
Nay made the proposal of the escrow to them under this plaque.
This plaque was Nay’s principal tool for perpetrating his fraud.
By this plaque, Nay defrauded these people of their life savings, aggregating approximately $1 million.
It reads, “Midwest Stock Exchange organized 1882, where highest standards have commercial honor and integrity are maintained and just an equitable principles of trade and business prevail.”
This certificate of membership is issued to Leston B. Nay of First Securities Company of Chicago.
That plaque was kept there for 20 years by Ernst’s false certification of the balance sheet of First Securities Company.
That plaque would have come down if Ernst had ever delivered a correct balance sheet.
That plaque would have come down if Ernst had ever told Midwest Stock Exchange that First Securities Company had no internal accounting control.
That plaque would have come down if Ernst had ever told Midwest that Nay secreted the incoming mail.
Twice the SEC has suspended brokers from the exchanges for tolerating that rule.
Unknown Speaker: Mr. King, neither you nor Mr. Lassers has cited in your briefs the Blue Chip opinion.
Although your opposition cites it repeatedly, is there a reason for this?
Do you feel that that Blue Chip case has no bearing on this one?
Mr. Willard L. King: I think there is a footnote in the Blue Chip case that might have a bearing on 17a-5, but our complaint did not mention 17a-5 and I would avoid it.
Nay represented this escrow to these plaintiffs as the First Securities Company project.
The evidence of that in the Court of Appeals, first Nay decision in the 463rd Federal Second is overwhelming.
When one of the plaintiffs asked to withdraw his escrow investment, Nay said to him, your money is safe at First Securities.
And Ernst certificate was given wholly for the benefit of these customers of the company and not at all for the benefit of Midwest Stock Exchange.
It is only in the name was the protection of the customer’s of the company.
I suggest that we thus have a situation approaching privity as Judge Cardozo said between Ernst and these plaintiffs.
Unknown Speaker: The Court of Appeals stated that plaintiffs admitted lack of reliance on the financial statements prepared by Ernst and Ernst?
Mr. Willard L. King: We never saw the financial statement.
What we did see this plaque which was kept there by that certificate.
Unknown Speaker: But you never saw the financial statement?
Mr. Willard L. King: We never saw it.
Unknown Speaker: And you agree of the clients therefore, did not rely on what you contend are the failures of Ernst and Ernst correctly to audit the accounts of this company?
Mr. Willard L. King: I agree that we never saw the financial statement, but I think our loss was a direct result of Ernst’s failure to properly audit the company.
There failure to discover Nay’s mail rule which would have terminated Nay’s operations.
He could not continue those operations if an auditor reported that he has secreted the incoming mail.
Chief Justice Warren E. Burger: What if all the factual situation was the same and Mr. Nay had a sideline dealing in second mortgages and did that through the private mail rule and that the whole scheme involved forgeries of the second mortgages, would you think that the same kind of liability would follow in that kind of a case?
Mr. Willard L. King: I would think you could assume an isolated transaction by Nay --
Chief Justice Warren E. Burger: Well, I mean a series.
Mr. Willard L. King: A series of isolated transactions?
But that is not this situation.
Here, he represented that this escrow was a First Securities project.
Unknown Speaker: And he was using the money for what?
Mr. Willard L. King: That I am not sure.
Justice Byron R. White: Well, why was the company bankrupt?
Mr. Willard L. King: Oh! That was an originally back in 1938, a tremendous theft of some $474,000.00.
Justice Byron R. White: Why was the company -- what was he doing to the company that led its failure?
This escrow arrangement, how did that contribute to the failure of the company?
Mr. Willard L. King: His failure was a suicide when he no longer could put all the bank out in Colorado to whom he was short some $475 -- the company was short some $474,000.00 and mind you this is incorporated for 35,000.
The company was utterly, hopelessly insolvent from the instant Ernst started to audit.
Chief Justice Warren E. Burger: I think you are cutting onto your colleague’s time.
Mr. Willard L. King: Thank you.
Chief Justice Warren E. Burger: Mr. Lassers.
Argument of Willard J. Lassers
Mr. Willard J. Lassers: Mr. Chief Justice and may it please the Court.
I would like to start off by responding to Mr. Justice Powell’s comment or question as whether we are for the first time in this Court now arguing that the conduct of Ernst and Ernst was reckless.
Our answer to that question is that we are not arguing it for the first time because what happened was we tried the case below on the theory that all we have to show was a failure of Ernst and Ernst to observe proper auditing standards and that case was tried on that basis in the District Court and in the Seventh Circuit.
Justice William H. Rehnquist: Have you tried -- you are talking about the case against Ernst and Ernst?
Mr. Willard J. Lassers: Yes sir.
Justice William H. Rehnquist: I thought it went off on a summary judgment?
Mr. Willard J. Lassers: It was.
Yes, I am sorry I did not -- yes, right.
And then in this Court in the certiorari petition, Ernst and Ernst for the first time raised the issue that something more was needed and we said, well, now that something more is needed, we are prepared to prove something more.
Second, I would like to respond to Mr. Justice Blackmun’s comment --
Unknown Speaker: Before you carry on, our attempt to the response to interrogatories on page 86 of the appendix in which you say, we do not contend that Ernst and Ernst employed any scheme or auditors to defraud.
Do you now repudiate that?
Mr. Willard J. Lassers: No sir because what we are saying there was we do not contend that Ernst and Ernst was in league with Nay.
What we do say is that if this Court holds that Ernst and Ernst, if that recklessness is the standard, then we are prepared to prove recklessness after all you can commit a fraud, if you disregard, you close your eyes to the obvious, that too is a fraud and coming to Mr. Justice Blackmun’s comment about the Blue Chip case.
As I read Blue Chip I do not think that is applicable because as I read Blue Chip, there has to be a purchase and a sale.
We grounded our case on Section 10b and there was clearly a purchase and a sale.
Unknown Speaker: On the negligence basis, would there be a cause of action under state law against Ernst and Ernst?
Mr. Willard J. Lassers: Under state law?
I do not know, I cannot answer that.
I have not researched Illinois on that question.
Now, I would like to comment on the mail rule.
Justice Thurgood Marshall: In this case, four years, you took for discovery?
Mr. Willard J. Lassers: Yes sir.
Justice Thurgood Marshall: Extensive discover?
Mr. Willard J. Lassers: Well, yes.
Justice Thurgood Marshall: And did you find enough of fraud?
Mr. Willard J. Lassers: I think we found enough to prove it.
Justice Thurgood Marshall: Why did you not allege it?
Mr. Willard J. Lassers: What?
Mr. Willard J. Lassers: Well, we did our discovery after we filed our complaint.
Justice Thurgood Marshall: Well, you still could have amended your complaint, could you not?
Mr. Willard J. Lassers: No, but --
Justice Thurgood Marshall: Could you not?
Mr. Willard J. Lassers: Well, we could have asked, but if --
Justice Thurgood Marshall: Well, did you ask?
Mr. Willard J. Lassers: No sir, because Ernst and Ernst never raised this issue that we have to prove recklessness until we got here.
Unknown Speaker: But it was your lawsuit.
Unknown Speaker: It is your lawsuit.[Laughter]
Mr. Willard J. Lassers: Well, that certainly is true, but we felt that we had alleged enough.
Justice William H. Rehnquist: But if you got a claim for negligence and a claim for fraud, certainly you will allege both of them, do you not, you do not say negligence is good enough to get by and so we will not worry about fraud even though we cannot rule (Voice Overlap)?
Mr. Willard J. Lassers: Well, because fraud is a much more difficult thing to prove, but and I like to say this about the mail rule because I do not think the full flavor of the mail rule has come through to the Court and that is this.
It was not just that there was rule on the abstract that the auditor failed to find.
What happened was that he went in, the auditors went in every year, at the beginning of every audit, they would spend two and three days, they would come in the morning at nine o’clock, but before the mail was untied from the bundles and their duty was to examine the mail as it came in and they watch the mail being untied from the bundles and they saw the clerk then abstract the letters that were for Mr. Nay and put them off to one side and the auditors never raised a question about that for 15 years and it went through two or three auditors.
Now, then the other matter that Mr. Berner alluded to and very late in the game.
Unknown Speaker: Mr. Lassers?
Mr. Willard J. Lassers: Yes.
Unknown Speaker: What do you suggest the auditors should have done, should have said why he do that and the answer would have been, well, because Mr. Nay likes to open his own mail?
Mr. Willard J. Lassers: Well, I say that at that point, and Mr. Meyer, our expert CPA says that that would have been enough to trigger a warning to him that further investigation was --
Unknown Speaker: Well, that would be the further investigation.
Why do you hold that mail for Mr. Nay while he is away on vacation?
Mr. Willard J. Lassers: Right.
Unknown Speaker: Well, because he likes to open his own mail.
Mr. Willard J. Lassers: Right, then our expert said, if he had not been allowed in effect to look at that mail and if that practice had not been stopped as an extreme, he would have withdrawn from the audit.
He would have withdrawn from the engagement.
Justice Byron R. White: Why does that your colleague do have said that an accounting firm is not to certify unless another person in the organization sees the mail?
Mr. Willard J. Lassers: Well, I do not know if I could go that far?
Justice Byron R. White: But you would go that far if the auditor were not permitted to look at it?
Mr. Willard J. Lassers: Well, I think that our auditor says that he would have not certify and now I want to stress to the Court, Section 17a of the 1934 Act which I think is essential to this action here because that is the Section which says the brokers have to keep books and records and it says that the auditor must have a certified audit once a year so that the audits that Ernst and Ernst was performing were not audits.
They were being undertaken voluntarily.
These were audits pursuant to the SEC’s command and the audit had to be filed and certified with the SEC.
And our point is that the failure to observe the mail practices indicated to the auditors, they should have indicated that there was violation of internal accounting control.
Under the SEC regulations, the auditors were required to check internal accounting controls, and therefore, they failed in their statutory and regulatory duties.
Unknown Speaker: Mr. Lassers is 17a before us on this petition for certiorari?
Mr. Willard J. Lassers: Yes sir.
Unknown Speaker: Did you file any cross-petition?
Mr. Willard J. Lassers: No sir, but as I understand the rule that we relied on 17a in the Seventh Circuit and the Seventh Circuit decided the case on the basis of 17a and we are a respondent, and therefore, we are in a position to assert anything that is in support of the judgment below.
Justice Byron R. White: Mr. Lassers, let me ask you.
Do you mean that if we reversed the Court of Appeals on the 10b, that we could affirm the judgment on 17a?
Mr. Willard J. Lassers: Well, our position --
Justice Byron R. White: I did not know that, is there a private cause of action under 17a?
Mr. Willard J. Lassers: Well, there may be.
Now, that is not -- it has not been decided by this Court.
It has not been decided --
Justice Byron R. White: Well, the Court of Appeals did not say so, did it?
Mr. Willard J. Lassers: No, it did not.
Justice Byron R. White: Well, then we could not affirm on 17a?
Mr. Willard J. Lassers: Our position on 17a as we are suing under Section 10b and our position on 17a --
Justice Byron R. White: Well, if we reversed the Court of Appeals on 10 and decide against you on the 10b, you have lost the case, have you not?
Mr. Willard J. Lassers: No sir, your Honor.
Justice Byron R. White: What about 17a then?
Mr. Willard J. Lassers: Our position on 17a as we are suing under 10b, and our position is that Section17a sets up the duty and it also sets up the standard that has to be adhered to under 10b.
Justice Byron R. White: Yes, but you do not whether you could stay in court under 17?
Mr. Willard J. Lassers: Well, that would be an issue before this Court whether there is an implied cause of action under Section 17 as such.
Justice Byron R. White: Well, the Court of Appeals certainly did not decide there was?
Mr. Willard J. Lassers: No, they reserved the question.
Justice Byron R. White: Well.
Mr. Willard J. Lassers: And as I read the Seventh Circuit, they held that there was a -- that the Section 17 set-up a duty and the standard.
Justice Byron R. White: Only if we wanted to decide an issue, the Court of Appeals did not decide is 17 here?
Mr. Willard J. Lassers: Well, I think 17 is here in the sense of a setting up the standard and that we are suing under 10b about the standard of care that the auditor is responsible for is laid out for and very precisely under 17.
Now, the final point I want to make has to do with another violation and that has to do with the net capital violation that occurred very late in the game.
What happened there was this and here I think that Ernst and Ernst did in effect file of a false audit certificate.
They came in and as part of their auditing they were required to examine the question whether the net capital rule of a company had been violated and they found that there was a violation.
They called it to the attention of Midwest, Midwest said do not say anything about it.
They did not say anything about it and they went ahead and they filed -- gave First Securities a clean bill of health with the SEC.
Justice William H. Rehnquist: Mr. Lassers, could I ask you a question which I should have asked your colleague Mr. King.
Is he the author of the leading biography on Chief Justice Fuller?
Mr. Willard J. Lassers: Yes, he is.
Justice William H. Rehnquist: Thank you.
Chief Justice Warren E. Burger: Mr. Gonson?
Argument of Paul Gonson
Mr. Paul Gonson: Mr. Chief Justice and may it please the Court.
The basic position of the SEC in this case, assuming that the auditor's conduct below was not more than negligent, is that the judgment should be rendered for Ernst and Ernst and this is so on a very simple basis because the plaintiffs in this case, respondents here in their capacity as escrow investors were not reasonably foreseeable by Ernst and Ernst and as they concede, they did not rely on any order prepared by Ernst and Ernst.
We share with Ernst and Ernst then with the amicus, American Institute of Certified Public Accountants, a reluctance to expose accounting firms to potential damages in vast amounts for negligence in cases where it strikes one's basic sense of fairness that such damages should not be imposed.
But Ernst and Ernst comes to this Court in this quite unusual case actually, quite an untypical case and asks that the baby be thrown out with the bath water.
It asks this Court to enunciate a rule that if accepted, would also bar recovery in meritorious cases, the more typical cases; the cases were a sense of fairness would say to one that perhaps damage judgment should be awarded.
Now, if this Court wishes to develop such a broad rule, respecting the liability of auditors for negligence then we have offered in our brief in which I will speak to you briefly today, what we think is a sound approach in doing so.
But in developing such a broad rule in this case, this Court would then be called upon to strike an appropriate balance between two important competing policies.
On the one hand there is the necessity of maintaining high professional standards of accounts because of their extremely important role with respect to the Federal Securities Laws.
This country system of such laws is dependent on the disclosure, the integrity of disclosures which are made to investors.
In order recognized as having a public duty in that respect to safeguard the interest of the public who reads their reports, more so than an interest to safeguard the auditor’s client.
Auditors are called upon to certify financial statements containing the wide variety of documents required to be given to investors by public companies and to be filed with the SEC.
In many instances, the opinion of the auditing firm is essential before securities may be offered to the public or placed privately, Thus, the continued confidence of the public in the securities laws of this country has to rest to some great extent on the shoulders of the accounting profession.
Now, when I say this I do not mean to suggest that auditors are insurers of the honesty of their clients.
Certainly, they are not and they have no obligation affirmatively, but to seek out fraud, nor should they have any liability of any kind for honest professional judgments which turned out on hindsight to have been erroneous, but the auditor is, in a peculiarly advantageous position to detect and to stop fraud in its incipiency.
The question here is what if he fails to that through negligence and investors are injured.
Now, we doubt that this Court would wish to say that there never could be a case under any circumstances under 10b-5 where an injured investor might recover damages against an auditor whose professional conduct fell below the standards of his profession.
Justice Thurgood Marshall: Mr. Gonson, is there anything that Securities Exchange Commission itself can do to a fraudulent auditor?
Mr. Paul Gonson: Well, certainly there are remedies that are available to the Securities and Exchange Commission.
It could sue an auditor for an injunction pursuant to the provisions of the Securities and Exchange Act and under appropriate circumstances they could bring disciplinary proceedings under Rule 2E of its Rules of practice.
This Court has recognized in several cases that private causes of action are an effective supplement to the SEC’s own enforcement --
Justice Thurgood Marshall: You seem to anticipate my next question, have they taken any action against Ernst and Ernst?
Mr. Paul Gonson: In this case, not to my knowledge Your Honor.
Justice Potter Stewart: But what role if any, do you think Section 17a of the Exchange Act plays or ought to play?
Mr. Paul Gonson: Well, this raises a question to which of course Justice White eluded earlier and that is that it does not appear to have been ruled out in the court below and the question --
Justice Potter Stewart: Well, it is discussed in part two or part three of its opinion -- part two of its opinion?
Mr. Paul Gonson: Yes, there is a question as to whether --
Justice Potter Stewart: It is just saying that it was a statutory --
Mr. Paul Gonson: Yes, it implied that right of action could be created and beyond there of course there would be the question whether in this case the requirements of Section 17a as it existed at the time of this action that were met which is a separate factual --
Justice Potter Stewart: But you are going as I understand you, you are a little beyond meats and bones of this case and talking generally about what the rule ought to be and it was in that connection that I asked you a question what role if any, do you think, what function if any do you think that Section 17a ought to play in deciding the question of civil liability of accountants to investors under 10b?
Mr. Paul Gonson: That rule of course, I am speaking much more broadly in respect as to the order to broker dealers in that rule is of course the rule that relates to the order of broker dealers and the commission has not prepared a position your Honor today with respect to what Rule Section 17a should be playing this case rather we are addressing ourselves to the role of Section 10b and 10b-5.
Now, we think that in appropriate balance there must be struck between a sufficiently broad standard of culpability to reinforce this important right of investors to receive accurate information and the need to avoid unfairness to particular accountants by subjecting him for damages to negligence to persons who do not rely on his conduct.
Now, the question is how is this balance to be struck?
Where should the Court look to for guidance to structure the contours of an appropriate damage remedy?
Before I do get to that, I want to make two brief points.
First, in this case, we do agree with the respondents that negligent conduct is sufficient to establish a violation of Section 10 and Rule 10b-5, but it does not follow that every negligent violation should give rise to a money damages remedy, thus we separate ours into two questions.
The first, is there a violation of the Section and second, what should the remedy be?
I agree with Mr. Berner, Ernst and Ernst counsel that the legislative history on 10b is far from conclusive, but I offered to this Court that there is nothing in the phrase “any manipulative or deceptive device or contrivance” which limits conduct only to that which is done intentionally.
Indeed, when Congress wanted to limit the Act to willful conduct, both with respect to violations and with respect to civil liability for this violation, it specifically said so.
Justice William H. Rehnquist: But do the terms not manipulative and deceptive both at least to the common mind convey a sense of intent as well as the objective result of the actions?
Can you negligently manipulate something?
Mr. Paul Gonson: Well I would respectfully disagree, Your Honor.
I think that the phrase manipulative and deceptive refers not to any particular state of mind, but rather to the conduct or to the affective conduct.
If one looks at the phrases that Congress used in the various civil liability provisions which are set forth in our brief and in the other briefs, and when they wish to connote conscious or intentional wrongdoing, they use phrases like this they said “did not know” --
Justice William H. Rehnquist: What is the manipulative practice that could be negligently carried on?
Mr. Paul Gonson: I am not sure what a manipulative practice that could be negligently carried on is, but I think I know what a deceptive practice that could be negligently carried on and that is the kind of a practice where a person, through failure to it adhere to the standards of his profession like an accountant causes financial statements to be deceptive and to mislead persons.
Unknown Speaker: The statute does not use the word practice.
It uses a device or contrivance.
Nouns that are derived from verbs, from the verbs device or contrive, and those are affirmative verbs, those are not negligent verbs?
Mr. Paul Gonson: That is true Your Honor.
I would not disagree with that, but I would point out that in Section 9 of the Securities Exchange Act in the subdivisions, in that Section, this is the Section that deals with the prohibition against affecting transaction on the securities exchange for the purpose of influencing the price and that Section and several sub sections prohibit these practices “for the purpose of doing such and such.”
And the civil liability Section which is Section 9e, imposes liability on the person who “willfully violate” so at least we are having some sections an indication of the state of culpability required.
We have in 10b at least an ambiguous phrase and I would suggest that in this situation, we look to the admonition that this Court has emphasized again and again that when the Court is construing the federal securities laws, in particular Rule 10b-5, since they are remedial legislation, these laws should be construed not technically and not restrictively, but flexibly in order to effectuate the remedial purposes.
Justice Byron R. White: For the cause of action that has been implied and the problem is how to construe the law and with respect to the standard of performance is to be required, now why should we not look to some other provisions in the Act to see what -- for some guidance and if you did what would be the nearest guide with the standard, Congress has provided a whole range of standards in various sections?
All away from strict liability to negligence to everything to deliberateness, now which section is nearest to this one?
Is there any?
Mr. Paul Gonson: Well, we note in our brief Your Honor.
We are now going to the question of remedy as distinguished from the question of whether there was a violation I believe.
Justice Byron R. White: Well, no I disagree.
You say that negligence is enough.
Under some sections of securities law, negligence is not enough?
Mr. Paul Gonson: I am saying that Your Honor, that even though in a particular case, a person may be held to have negligently violated the law, it still might be improper to impose damages --
Justice Byron R. White: I understand that, but I still wanted to -- at the outset we want to know whether the proof of negligence is enough.
Now, Congress has said in some Sections that where it has provided the standard itself, it has said that negligence is not enough?
Mr. Paul Gonson: Your Honor, that is correct.
Justice Byron R. White: Are there some questions that are pretty close to this that require more than just negligence?
Mr. Paul Gonson: Yes, Your Honor, there are a series of sections that require, that would impose liability absolutely without fault --
Justice Byron R. White: Less than negligent?
Mr. Paul Gonson: That is correct.
Then there are Sections on the other hand that would impose liability only for more than negligence, but there are a series of sections that do impose liability on a duty to discover kind of theory and which give defenses to persons to show that they made a reasonable investigation in the exercise in making that investigation and their basis on which to discover that the information contained was false and misleading.
And then I suppose is close to a negligent standard and we think that if in applying the question whether damages should be assessed rather than deciding on negligence yes or negligence no, it is helpful to look to the pattern of civil liabilities that do exist in the Act and we have done that in our brief and we have extrapolated from them what we think is a very useful guide.
And if we apply these principles to damage actions under Section 10b and Rule 10b-5, then recovery would be permitted for violations which were committed only negligently under three circumstances.
One, the defendant knew or had reason to believe that the plaintiff would rely on this conduct, secondly, the plaintiff did in fact so rely, and thirdly, the amount of the plaintiff’s damages are fairly ascertainable.
Unknown Speaker: (Inaudible)
Mr. Paul Gonson: No sir that is not this case and because --
Unknown Speaker: What case are you arguing then?
Mr. Paul Gonson: I am speaking largely to a possible rule that this Court if it desires to issue on the subject that auditor negligence may do.
In this case, we believe that applying those guidelines that the record would not justify a recovery for the --
Justice William H. Rehnquist: Mr. Gonson, how in this case, just following a literal text to the rule can you say that whatever Ernst and Ernst did that might have violated sub section B was done in connection with the purchaser or sale of any security?
Mr. Paul Gonson: Well, I suppose that the respondents would take the position --
Justice William H. Rehnquist: Well you are taking a position too that they could be held liable here, so this is not just what the respondent would say?
Mr. Paul Gonson: Oh! I am sorry Your Honor, I misunderstood your question.
I believe that the issuance by Nay of these notes to these investors was the issuance of the security and I would think that upon that the in-connection phrase probably was satisfied by the reading of this Court in the Superintendent case that this activity sufficiently touches upon.
Justice William H. Rehnquist: Even though these people never relied on the statements and never saw them apparently?
Mr. Paul Gonson: Well, I am not urging for that result Your Honor, but I think that the in-connection with phrase could be satisfied by tying the issuance of the note by Nay to the conduct which covered up these transactions.
Unknown Speaker: On the principles you suggest rather most followed by the Court of Appeals, what has the Ernst and Ernst do you contemplate is left to the case when it gets back to the District Court?
Mr. Paul Gonson: The complaint does not allege negligence nor does it allege intentional or reckless conduct.
It simply alleges facts.
It alleges that there is a failure of the order to perform properly.
The issue of negligence seems to have arisen later on the case.
We do not know.
We were invited into the case of course at this level of this Court.
We do not know whether if they have been advised early in the game that they would have pleaded something more than negligence.
Perhaps unwarranted and heedless conduct and so we were reluctant even though we tend to agree that judgment should be for instance Ernst and Ernst to foreclose them from a possibility of making that argument if it is still there.
Unknown Speaker: But it would have to be an argument on something more than negligence?
Mr. Paul Gonson: Yes, Your Honor.
Unknown Speaker: In admittance which alleges at least recklessness?
Mr. Paul Gonson: Well, it would have to be I would think proof that would establish.
Unknown Speaker: Or an amendment though it did not have to be?
Mr. Paul Gonson: Well, the complaint does not as I say allege any standard, it simply alleges facts.
Unknown Speaker: I think it is standard?
Mr. Paul Gonson: Thank you, your Honor.
Chief Justice Warren E. Burger: Mr. Berner, you have something any further?
You have about three minutes remaining.
Rebuttal of Robert L. Berner, Jr.
Mr. Robert L. Berner, Jr.: With respect to the question that has attracted some attention as to what is alleged in the complaint, what the theories are and what the facts are, I would point to the third defense of Ernst and Ernst in its answer filed in this case which says, it is in page 24 of the appendix, in which statements made that Ernst and Ernst had no knowledge of any conduct of Nay alleged to be fraudulent in the second count, without such knowledge, Ernst and Ernst could not aid or abet Nay’s alleged fraudulent conduct.
I believe this should answer questions as to whether the possibility of proving or the issue as to recklessness or fraud was ever raised in this case.
It was raised in the answer to the complaint.
Chief Justice Warren E. Burger: You mean to say that aid or abet without any knowledge would be quite different from the use of those terms as words of originally field of criminal law, would it not?
Mr. Robert L. Berner, Jr.: My point is that when we -- by this defense we raise the issue as to the level of culpability and this defense tends to set up fairly clearly that the petitioner who was defendant below would take the position that without some knowledge, some scienter, there could be no recovery.
This is in response to the discussion as to whether the respondents should be permitted to return the District Court and not amend their complaint as I understand it, but simply to make a new argument which we think is unwarranted.
I would like also to point out that the record establishes very clearly that Ernst and Ernst in fact did review the system of internal accounting controls.
And with respect to the mail rule, it has never been shown in this case and there is no evidence which supports a causable connection, this issue was not included in the petition for certiorari, but was argued below and to explain the immateriality of a mail rule, if Nay had said to these people, please addressed your mail to me to lock box 1 or First Securities Company lock box 1 that he opened himself, they would have done it.
And to think that to require an accountant to review all of the incoming mail of all of the officers and directors of a brokerage house in the circumstances as to think that is -- that itself is a derogation of joint (Inaudible) fraud, we submit is absurd and finally, I would say --
Unknown Speaker: As part of the alleged fraudulent conduct in the scheme on the part of Nay was that he used for securities, he used the stationery and he used the office and the communications were sent to him at First Securities and if had told the plaintiffs when you communicate with me about this escrow business you have to do it through lock box 1, that would -- might well have raised their suspicion.
That is the point of --
Mr. Robert L. Berner, Jr.: Well --
Unknown Speaker: That is part of the fraud.
He was using First Securities.
Was that not as alleged?
Mr. Robert L. Berner, Jr.: That is as alleged, but it also is reasonable to assume that he specifically told these people to address all mail to him in connection with the escrow to his attention or to him personally because as the record indicates he told them he did not want anyone at First Securities to know about these investments.
He did not want -- this was a company whose name he never revealed and it should remain confidential.
Unknown Speaker: So, that is in your point of view that it alert them as much -- should have alerted them as much as the hypothetical which Mr. Justice Stewart gave you about the --
Mr. Robert L. Berner, Jr.: It should have alerted the respondents, yes sir.
Unknown Speaker: May I ask a question.
One of the allegations of the respondents relating to the net capital deficit is that there was concealment by Ernst and Ernst.
If you have addressed that I do not recall it.
Mr. Robert L. Berner, Jr.: I did not.
The net capital violation was a temporary violation as of October 31, 1967.
It was $9,000.00 net capital violation that Ernst and Ernst discovered in the course of its audit and which it reported to the Midwest Stock Exchange.
In the Midwest Stock Exchange at the time of reporting, had they also advised the Midwest Stock Exchange that the net capital violation had been remedied and there was no longer a violation at the time of reporting which was several weeks after the date as of which the audit was being made.
And the officer of the Midwest Stock Exchange, Mr. Rothling advised Ernst and Ernst to not to note the net capital violation on the year end audit because it had been corrected.
Unknown Speaker: The full extent of it was $9,000.00?
Mr. Robert L. Berner, Jr.: Yes sir.
Unknown Speaker: And this is an oral report, was it not?
Mr. Robert L. Berner, Jr.: No, this was on the certified financial statements that were to be submitted to the Midwest Stock Exchange.
Unknown Speaker: But the communication between was oral?
Mr. Robert L. Berner, Jr.: Yes sir, it was oral, but it is memorialized in a memorandum.
It is in the record.
It is undisputed.
There is no dispute about the facts I have just --
Unknown Speaker: But I think there is some point made at the fact that this was done orally and not officially and in writing, is that not correct?
Mr. Robert L. Berner, Jr.: Well as I understand it yes, the argument is that it was done informally rather than formal.
I am not sure what formally means.
Unknown Speaker: Well, among other things, I think it may be means oral nature of it.
Chief Justice Warren E. Burger: But did you say it was confirmed in writing?
Mr. Robert L. Berner, Jr.: No, the fact of the telephone conversation between Mr. Hooker and Mr. Rothling is the subject of a memorandum.
Unknown Speaker: It is in the memorandum, is it not?
Mr. Robert L. Berner, Jr.: It is in the record.
I beg your pardon?
Unknown Speaker: Have a one way?
Mr. Robert L. Berner, Jr.: Yes sir Mr. Rothling testified as of the conversation in related litigation right.
And it testified that he instructed Ernst and Ernst not to include the existence of the by then cured violation.
Unknown Speaker: Right.
Unknown Speaker: What is the total amount of damages?
Mr. Robert L. Berner, Jr.: The total amount of damages is a $1.56 million plus attorney’s fees that is compared to the annual fee received by Ernst and Ernst of between $2,000.00 and $25,000,000.00 for making -- performing these audits.
The damages had been reduced by approximately $200,000.00 which the respondents will be receiving as indicated in their brief out of the receivership proceeding.
Chief Justice Warren E. Burger: Thank you gentlemen.
The case is submitted.