Ernst Ernst v. Hochfelder

Decision Date30 March 1976
Docket NumberNo. 74-1042,74-1042
Citation47 L.Ed.2d 668,425 U.S. 185,96 S.Ct. 1375
PartiesERNST & ERNST, Petitioner, v. Olga HOCHFELDER et al
CourtU.S. Supreme Court
Syllabus

Petitioner accounting firm was retained to audit periodically a brokerage firm's books and records. Respondents, who were customers of the brokerage firm, invested in a securities scheme ultimately revealed as fraudulent and perpetrated by the firm's president and principal stockholder. After the fraud came to light, respondents filed an action for damages against petitioner under § 10(b) of the Securities Exchange Act of 1934 (1934 Act), which makes it unlawful to use or employ "any manipulative or deceptive device or contrivance" in contravention of Securities and Exchange Commission (SEC) rules. It was alleged that the brokerage firm president's scheme violated § 10(b) and SEC Rule 10b-5, and that petitioner had "aided and abetted" the violations by its "failure" to conduct proper audits of the firm, thereby failing to discover internal practices that prevented an effective audit. The District Court granted petitioner's motion for summary judgment and dismissed the action, holding that whether or not a cause of action could be based merely on allegations of negligence, there was no genuine issue of material fact as to whether petitioner had conducted its audits in accordance with generally accepted standards. The Court of Appeals reversed and remanded, holding that one who breaches a duty of inquiry and disclosure owed another is liable in damages for aiding and abetting a third party's violation of Rule 10b-5 if the fraud would have been discovered or prevented but for the breach, and that there were genuine issues of fact as to whether petitioner committed such a breach and whether inquiry and disclosure would have led to discovery or prevention of the president's fraud. Held :

1. A private cause of action for damages will not lie under § 10(b) and Rule 10b-5 in the absence of any allegation of "scienter," I. e., intent to deceive, manipulate, or defraud on the defendant's part. Pp. 194-214.

(a) The use of the words "manipulative," "device," and "contrivance" in § 10(b) clearly shows that it was intended to

proscribe a type of conduct quite different from negligence, and more particularly the use of the word "manipulative," virtualla term of art used in connection with securities markets, connotes intentional or willful conduct designed to deceive or defraud investors by controlling or artificially affecting the price of securities. Pp. 197-201.

(b) The 1934 Act's legislative history also indicates that § 10(b) was addressed to practices involving some element of scienter and cannot be read to impose liability for negligent conduct alone. Pp. 201-206.

(c) The structure of the 1934 Act and the interrelated Securities Act of 1933 (1933 Act) does not support the contention that since § 10(b), in contrast to certain other sections of these Acts, is not by its terms explicitly restricted to willful, knowing, or purposeful conduct, it should not be construed to require more than negligent action or inaction as a precondition for civil liability. In each instance that Congress in these Acts created express civil liability in favor of purchasers or sellers of securities it clearly specified whether recovery was to be premised on knowing or intentional conduct, negligence, or entirely innocent mistake. The express recognition of a cause of action premised on negligent behavior in § 11, for example, stands in sharp contrast to the language of § 10(b). Moreover, each of the express civil remedies in the 1933 Act allowing recovery for negligent conduct is subject to significant procedural restrictions indicating that the judicially created private damages remedy under § 10(b) which has no comparable restrictions cannot be extended, consistently with Congress' intent, to actions premised on negligence, since to do so would allow causes of action under these express 1933 Act remedies to be brought instead under § 10(b), thereby nullifying the effectiveness of such restrictions on those remedies. Pp. 206-211.

(d) While there is language in Rule 10b-5 that could arguably be read as proscribing any type of material misstatement or omission and any course of conduct that has the effect of defrauding investors, whether the wrongdoing was intentional or not, such a reading does not comport with the Rule's administrative history which makes it clear that it was intended to apply only to activities involving scienter. More importantly, the scope of Rule 10b-5 cannot exceed the power granted the SEC under § 10(b), whose language and history compel interpreting the Rule to apply only to intentional wrongdoing. Pp. 212-214.

2. The case will not be remanded for further proceedings to require proof of more than negligent misfeasance by petitioner, since throughout the history of the case respondents have proceeded on a theory of liability premised on negligence, in fact specifically disclaiming that petitioner had engaged in fraud or intentional misconduct. P. 215.

503 F.2d 1100, reversed.

Robert L. Berner, Jr., Chicago, Ill., for petitioner.

Willard L. King, Chicago, Ill., for respondents Hochfelder and others.

Willard J. Lassers, Chicago, Ill., for respondents Allison and others.

Paul Gonson, Washington, D. C., for the Securities and Exchange Commission as, Amicus curiae, by special leave of Court.

Mr. Justice POWELL delivered the opinion of the Court.

The issue in this case is whether an action for civil damages may lie under § 10(b) of the Securities Exchange Act of 1934 (1934 Act), 48 Stat. 891, 15 U.S.C. s 78j(b), and Securities and Exchange Commission Rule 10b-5, 17 CFR § 240.10b-5 (1975), in the absence of an allegation of intent to deceive, manipulate, or defraud on the part of the defendant.

I

Petitioner, Ernst & Ernst, is an accounting firm. From 1946 through 1967 it was retained by First Securities Company of Chicago (First Securities), a small brokerage firm and member of the Midwest Stock Exchange and of the National Association of Securities Dealers, to perform periodic audits of the firm's books and records. In connection with these audits Ernst & Ernst prepared for filing with the Securities and Exchange Commission (Commission) the annual reports required of First Securities under § 17(a) of the 1934 Act, 15 U.S.C. § 78q(a).1 It also prepared for First Securities responses to the financial questionnaires of the Midwest Stock Exchange (Exchange).

Respondents were customers of First Securities who invested in a fraudulent securities scheme perpetrated by Leston B. Nay, president of the firm and owner of 92% Of its stock. Nay induced the respondents to invest funds in "escrow" accounts that he represented would yield a high rate of return. Respondents did so from 1942 through 1966, with the majority of the transactions occurring in the 1950's. In fact, there were no escrow accounts as Nay converted respondents' funds to his own use immediately upon receipt. These transactions were not in the customary form of dealings between First Securities and its customers. The respondents drew their personal checks payable to Nay or a designated bank for his account. No such escrow accounts were reflected on the books and records of First Securities, and none was shown on its periodic accounting to respondents in connection with their other investments. Nor were they included in First Securities' filings with the Commission or the Exchange.

This fraud came to light in 1968 when Nay committed suicide, leaving a note that described First Securities as bankrupt and the escrow accounts as "spurious." Respondents subsequently filed this action 2 for damages against Ernst & Ernst 3 in the United States District Court for the Northern District of Illinois under s 10(b) of the 1934 Act. The complaint charged that Nay's escrow scheme violated § 10(b) and Commission Rule 10b-5,4 and that Ernst & Ernst had "aided and abetted" Nay's violations by its "failure" to conduct proper audits of First Securities. As revealed through discovery, respondents' cause of action rested on a theory of negligent nonfeasance. The premise was that Ernst & Ernst had failed to utilize "appropriate auditing procedures" in its audits of First Securities, thereby failing to discover internal practices of the firm said to prevent an effective audit. The practice principally relied on was Nay's rule that only he could open mail addressed to him at First Securities or addressed to First Securities to his attention, even if it arrived in his absence. Respondents 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 in reports to the Exchange and to the Commission by Ernst & Ernst as an irregular procedure that prevented an effective audit. This would have led to an investigation of Nay that would have revealed the fraudulent scheme. Respondents specifically disclaimed the existence of fraud or intentional misconduct on the part of Ernst & Ernst.5

After extensive discovery the District Court granted Ernst & Ernst's motion for summary judgment and dismissed the action. The court rejected Ernst & Ernst's contention that a cause of action for aiding and abetting a securities fraud could not be maintained under s10(b) and Rule 10b-5 merely on allegations of negligence. It concluded, however that there was no genuine issue of material fact with respect to whether Ernst & Ernst had conducted its audits in accordance with generally accepted auditing standards.6

The Court of Appeals for the Seventh Circuit reversed and remanded, holding that one who breaches a duty of inquiry and disclosure owed another is liable in damages for aiding and abetting a third party's violation of Rule 10b-5 if the fraud would have been...

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