Hochfelder v. Ernst and Ernst, s. 73-1907

Citation503 F.2d 1100
Decision Date22 November 1974
Docket NumberNos. 73-1907,73-1908,s. 73-1907
PartiesFed. Sec. L. Rep. P 94,781 Olga HOCHFELDER et al., Plaintiffs-Appellants, v. ERNST & ERNST, Defendant-Appellee. Leon S. MARTIN et al., Defendants-Appellants, v. ERNST & ERNST, Defendant-Appellee.
CourtUnited States Courts of Appeals. United States Court of Appeals (7th Circuit)

Alex Elson, Donald L. Vetter, Willard L. King, Chicago, Ill., for plaintiffs-appellants.

Francis D. Morrissey, Chicago, Ill., for defendant-appellee.

Before SWYGERT, Chief Judge, CASTLE, Senior Cirfcuit Judge, and SPRECHER, Circuit Judge.

SWYGERT, Chief Judge.

Plaintiffs appeal from a grant of summary judgment in favor of the defendant Ernst & Ernst, a firm of independent certified public accountants. The plaintiffs were investors 1 in a fraudulent securities scheme perpetuated by Leston B. Nay, President of First Sequrities Company of Chicago and owner of ninety-two percent of its stock. First Securities was a small brokerage firm in Chicago which was registered with the Securities and Exchange Commission as a broker-dealer in securities and was a member of the Midwest Stock Exchange as well as the National Association of Securities Dealers, Inc. First Securities retained Ernst & Ernst as auditors beginning in 1946 and continued to engage its services up through the last audit of First Securities performed in November, 1967.

The instant action emanates from Leston B. Nay's fraudulent securities scheme which we have described in detail in our opinion in Securities & Exchange Com'n v. First Securities Co. of Chicago, 463 F.2d. 981 (7th Cir. 1972), and which needs only be briefly recounted here. The plaintiffs were brokerage clients of First Securities, dealing in securities through First Securities in regular fashion. Each plaintiff received investment counselling from Nay, and each knew Nay to be the president of First Securities. Nay induced the plaintiffs to invest funds in an 'escrow' account which Nay represented would yield interest to plaintiffs at a high rate of return. Plaintiffs began to invest in the escrow accounts as early as 1942 with the majority of the transactions entered into in the 1950's and the last of the escrow transactions consummated in 1966. It was not until 1968 that Nay's fraudulent scheme was discovered as a result of a suicide note left by Nay describing First Securities as bankrupt due to his thefts and indicating that certain escrow accounts created by him were 'spurious.' Plaintiffs had invested in the 'spurious' escrow accounts. As a result of his actions, we held in Securities & Exchange Com'n. v. First Securities Co. of Chicago, 463 F.2d 981, 986 (7th Cir. 1972), that 'Nay's conduct violated the provisions of section 10(b) of the Securities Exchange Act of 1934 and its regulatory corollary, Rule 10b-5,' and that First Securities was chargeable with Nay's fraud as an aider and abettor to Nay's Rule 10b-5 violation.

In the instant action the plaintiffs claim that Ernst & Ernst was negligent in auditing First Securities thereby aiding and abetting Nay's Rule 10b-5 violation. It is contended that had Ernst & Ernst duly executed its audit of First Securities Nay's fraudulent scheme would have been uncovered or prevented.

In resolving this appeal we must address the following matters: (1) the elements of a prima facie case for aiding and abetting must be properly defined; (2) the propriety of the district court's ruling that the evidence presented no genuine issue of material fact as to the adequacy of Ernst & Ernst's audits of First Securities under applicable auditing standards; (3) whether the district court correctly ruled that plaintiffs' claims against Ernst & Ernst are estopped by their conduct prior to the presentment of such claims; and (4) whether the district court properly held that plaintiffs' claims against Ernst & Ernst are barred by the applicable statute of limitations.

In granting summary judgment for Ernst & Ernst the district judge found that there were no genuine issues of material fact and held that on the basis of the uncontroverted evidence Ernst & Ernst was entitled to judgment as a matter of law. But it is our view there are genuine issues of material fact in dispute which go to the very question of liability. We hold, therefore, that this was not an appropriate case for summary judgment and accordingly reverse and remand for trial.

I

Ernst & Ernst contends that as a matter of law, it cannot be held liable for aiding and abetting Nay's fraud in view of the fact that admittedly it had no knowledge of Nay's fraudulent escrow scheme. We have indirectly passed upon this contention in our recent decision in Hochfelder, et al. and Martin, et al. v. Midwest Stock Exchange, 503 F.2d 364 (1974) where we stated that a claim for aiding and abetting solely by inaction can be maintained under Rule 10b-5 by a showing:

'that the party charged with aiding and abetting had knowledge of or, but for a breach of duty of inquiry, should have had knowledge of the fraud, and that possessing such knowledge the party failed to act due to an improper motive or breach of a duty of disclosure.'

The foregoing elements comprise a flexible standard of liability which should be amplified according to the peculiarities of each case. Accordingly, where, as here, it is urged that the defendant through action as well as inaction has facilitated the fraud of another, a claim for aiding and abetting is made on demonstrating: (1) that the defendant had a duty of inquiry; (2) the plaintiff was a beneficiary of that duty of inquiry; (3) the defendant breached the duty of inquiry; (4) concomitant with the breach of duty of inquiry the defendant breached a duty of disclosure; and (5) there is a causal connection between the breach of duty of inquiry and disclosure and the faciliation of the underlying fraud; that is, adequate inquiry and subsequent disclosure would have led to the discovery of the underlying fraud or its prevention. As our analysis will demonstrate, plaintiffs state a claim of aiding and abetting a Rule 10b-5 violation under the foregoing elements.

II

With respect to the existence of a duty of inquiry it is clear that Ernst & Ernst's contractual arranagement whereby it undertook to audit First Securities gave rise to a common law duty of inquiry. The extent and scope of that duty will be the subject of additional analysis; for present purposes, however, it is sufficient to state that Ernst & Ernst's audit engagement imposed a common law duty of inquiry.

In addition, having undertaken the contractual duty to audit First Securities and prepare SEC Form X-17A-5 pursuant to section 17(a) of the Securities Exchange Act and SEC Rule 17a-5 thereunder, 2 a statutory duty of inquiry is properly imposed on Ernst & Ernst. Section 17(a) and its corollary Rule 17a-5 require a member of a national securities exchange to file with the SEC an annual report of financial condition certified by an independent certified public accountant, which report meets the requirements of Form X-17A-5. In accordance with the provisions of section 17(a) and Rule 17a-5 First Securities retained Ernst & Ernst. Thus, we find Ernst & Ernst chargeable additionally with a statutory duty of inquiry.

III

The plaintiffs must establish that they were beneficiaries of Ernst & Ernst's duty of inquiry. Unlike the common law duty of inquiry whose benefaction is narrowly drawn, it would appear that the statutory duty of inquiry imposed on the defendant inured to the benefit of plaintiffs.

Section 17(a) requires the maintenance by brokers and dealers of reports and records pertaining to their financial affairs and the submission of these reports and records to the Securities and Exchange Commission. The Commission is specifically directed to prescribe those reports and records 'necessary or appropriate in the public interest or for the protection of investors.' 15 U.S.C. 78q(a). The explicit thrust of this statutory section is the dominant concern evinced by the whole of the securities acts that those comprising the investing public be adequately safeguarded in their financial dealings with security brokers. Without reaching the question of whether there is implicit in section 17(a) a direct duty flowing to the plaintiffs, it is enough for purposes of proving defendant's aid and abetment of a Rule 10b-5 violation that the extant duty of inquiry imposed on Ernst & Ernst is grounded on a concern for the protection of investors such as the plaintiffs.

At common law the duty of inquiry owed by Ernst & Ernst would not extend to the plaintiffs. The defendant's common law duty emanates from its contract to audit First Securities. Plaintiffs were not a party to that contract or an intended third-party beneficiary. There is therefore an absence of privity between the parties, precluding action by the plaintiffs on the contract for a breach of duty. Arising out of the contractual arrangement, however, is a corollary duty of inquiry fashioned by decisional law and sounding in tort. The first significant case extending liability for negligence beyond privity of contract where, as here, only intangible economic damages were involved, was Glanzer v. Shepard, 233 N.Y. 236, 135 N.E. 275 (1922). 3 In that case, the court rejected the argument that no duty was owed to the plaintiffs because there was no contract between them and defendant. Plaintiffs were purchasers of a quantity of beans. The seller contracted with the defendant, a public weigher, to certify the correct weight of the beans. The defendant knew that the plaintiffs were to use the certificates as the basis for their payment to the seller. The defendant negligently overstated the weight, and as a result the plaintiffs overpaid. In allowing the plaintiffs to recover for their economic damages, Judge Cardozo, holding that there was a duty owed to the plaintiffs, wrote:

'We do not need to...

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38 cases
  • Ernst Ernst v. Hochfelder
    • United States
    • United States Supreme Court
    • March 30, 1976
    ...premised on negligence, in fact specifically disclaiming that petitioner had engaged in fraud or intentional misconduct. P. 215. 503 F.2d 1100, Robert L. Berner, Jr., Chicago, Ill., for petitioner. Willard L. King, Chicago, Ill., for respondents Hochfelder and others. Willard J. Lassers, Ch......
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1 books & journal articles
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