1. First Securities was a small brokerage firm in Chicago which

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1 SECURITIES-ACCOUNTANT'S LIABILITY-UNITED STATES SU- PREME COURT HOLDS ACCOUNTANT NOT LIABLE UNDER RULE 10b-5 UNLESS DEFENDANT INTENDED TO DECEIVE, MANIPULATE OR DEFR1AUD INVESTOR-Ernst & Ernst v. Hochfelder, 96 S. Ct (1976). FACTS AND HOLDING Leston B. Nay, president and 92 percent shareholder of the First Securities Company of Chicago,' revealed in a suicide note 2 that for approximately 26 years prior to his death he had perpetrated a fraud upon a number of First Securities' clients. 3 Nay had induced the plaintiffs, regular brokerage customers of First Securities, to invest in private "escrow" accounts 4 which Nay represented would yield a high rate of return. 5 In fact, the accounts were non-existent and Nay converted the plaintiffs' funds to his own use. 6 This disclosure resulted in a number of lawsuits. 7 In Hochfelder v. Ernst & Ernst, 8 plaintiffs brought suit for damages against Ernst & Ernst, an independent public accounting 1. First Securities was a small brokerage firm in Chicago which was registered with the SEC 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... -fochfelder v. Ernst & Ernst, 503 F.2d 1100, 1103 (7th Cir. 1974), rev'd, 96 S. Ct (1976) [hereinafter cited as Hochfelder]. 2. On June 4, 1968 Lester Nay murdered his wife then committed suicide. SEC v. First Sec. Co., 463 F.2d 981, 983 (7th Cir.), cert. denied, McKy v. Hochfelder, 409 U.S. 880 (1972) [hereinafter cited as First Sec.]. 3. See First Sec. at , detailing Nay's escrow account scheme and other facts surrounding the fraud. 4. Investors made all payments to the non-existent account payable to Nay or to a bank for his account. Nay paid the "interest" on the accounts by personal checks. Plaintiffs invested approximately $972,500 in the escrow account between 1942 and Id. at ; Hochfelder at It was originally promised that the interest would be 12 percent per annum, but this was later reduced to 9 percent. First Sec. at Hochfelder at Hochfelder v. Ernst & Ernst,, 503 F.2d 1100 (7th Cir. 1974), rev'd, 96 S. Ct (1976) (civil damages action brought by defrauded investors under rule lob-5); Hochfelder v. Midwest Stock Exch., 350 F. Supp (N.D. Ill. 1972), atf'd, 503 F.2d 364 (7th Cir. 1974), cert. denied, 419 U.S. 875 (1974) (civil damages action brought by defrauded investors under rule 10b-5); SEC v. First Sec. Co., 463 F.2d 981 (7th Cir. 1972), cert. denied, McKy v. Hochfelder, 409 U.S. 880 (1972) (equitable receivership proceedings); SEC v. First Sec. Co., 466 F.2d 1035 (7th Cir.), cert. denied, McKy v. Union Bank & Trust Co., 409 U.S (1972) (equitable receivership proceedings) F.2d 1100 (7th Cir. 1974), rev'd, 96 S. Ct (1976).

2 CREIGHTON LAW REVIEW [Vol. 9 firm. 9 Ernst & Ernst had audited First Securities annually during the period of Nay's fraudulent scheme, 10 and had prepared and filed Form X-17A-511 for First Securities with the SEC as required by section 17(a) 12 of the Securities Exchange Act of 1934 and SEC rule 17a-5.' 3 9. Plaintiffs were parties in prior equitable receivership proceedings against First Securities. See note 7 supra. In SEC v. First Securities Company of Chicago fifteen claims of individuals in the total amount of $ were asserted against the assets of the securities brokerage firm. The district court disallowed their claims, but on appeal, the Seventh Circuit reversed, holding that First Securities was liable to plaintiffs as a result of Nay's fraud. SEC v. First Sec. Co., 463 F.2d 981 (7th Cir.), cert. denied, 409 U.S. 880 (1972). Plaintiffs were also involved in an action against the Midwest Stock Exchange. Here it was asserted that Midwest was negligent in scrutinizing Nay's application as First Securities' member officer or nominee in the Midwest Stock Exchange and failed thereafter to adequately investigate his continued fitness as a member, and as a result of its action Midwest aided and abetted Nay's violation of the 1934 Act. The Seventh Circuit affirmed a summary judgment for defendant holding that, as a matter of law, Midwest had not failed in its duty to regulate First Securities and Nay. Therefore, Midwest could not be held liable as an aider and abettor of Nay's fraud. Hochfelder v. Midwest Stock Exch., 503 F.2d 364 (7th Cir. 1972), cert. denied, 419 U.S. 875 (1974). 10. Hochfelder at The Seventh Circuit indicated elsewhere that Nay's conduct was fraudulent in First Sec. at Form X-17A-5, 17 C.F.R (1975) provides: This form shall be used by every member, broker or dealer required to file reports under Rule 17a-5 (a), ( a-5 of this chapter). Specifically, detailed annual reports of financial condition are filed with the SEC on Form X-17A-5, which must be certified by an accountant. 12. Securities Exchange Act 17(a), 15 U.S.C. 78q(a) (1970), provides: (a) Every broker or dealer... shall make. and preserve. such accounts,... books, and other records, and make such reports, as the Commission by its rules and regulations may prescribe as necessary or appropriate in the public interest or for the protection of investors. 13. Rule 17a-5, 17 C.F.R a-5 (1975), passed pursuant to Section 17 (a) of the 1934 Act, in pertinent part provides: (a) Filing reports. (2) Every member, broker or dealer subject to this rule shall file reports of financial condition containing the information required by Form X-17A-5... (b) Nature and form of reports... (1) The report of a member broker or dealer shall be certified by a certified public accountant or a public accountant who shall in fact be independent... (g) Accountant's certificate. (2) Representations as to audit. The accountant's certificate (i) shall contain a reasonably comprehensive statement as to the scope of the audit made, including a statement as to

3 1976] SECURITIES The plaintiffs alleged that the defendant had breached its duty of inquiry in its audits for First Securities, thereby giving rise to both a common-law action for negligent misrepresentation 1 4 and a statutory cause of action for aiding and abetting Nay's violation of section 10,(b) of the Securities Exchange Act of 19341' and its regulatory corollary, rule 10b Specifically, the plaintiffs whether the accountant reviewed the procedures followed for safeguarding the securities of customers, and including, if with respect to significant items in the report covered by the certificate any auditing procedures generally recognized as normal have been omitted, a specific designation of such procedures and of reasons for their omission, (ii) shall state whether the audit was made in accordance with generally accepted auditing standards applicable in the circumstances; and (iii) shall state whether the audit made omitted any procedure deemed necessary by the accountant under the circumstances of the particular case. (h) Accountant's certificate; options to be expressed. The accountant's certificate shall state clearly the opinion of the accountant with respect to the financial statement covered by the certificate and the accounting principles and practices reflected therein. (i) Accountant's certificate; exceptions. Any matters to which the accountant takes exception shall be clearly identified; the exception thereto shall be specifically and clearly stated; and, to the extent practicable, the effect of each such exception on the related item of the report shall be given. 14. Hochfelder at The court stated that the defendant had a common law duty of inquiry, arising out of the audit contract with First Securities. A claim for negligent misrepresentation may be made upon showing that this duty of inquiry was breached by the accountant on the basis of his simple negligence in the preparation of a financial statement or other report upon which the third party has relied and has been damaged as a result of such reliance. For further discussion of this common law duty of accountants, see materials cited in note 26 infra. 15. Id. at Securities Exchange Act 10, 15 U.S.C. 78j (1970), provides in part: It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange- (b) To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors. 16. Rule 10b-5, 17 C.F.R b-5 (1975), passed pursuant to Section 10 (b) of the 1934 Act, provides in pertinent part: It shall be unlawful for any person, directly or indirectly, by use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange, (a) To employ any device, scheme, or artifice to defraud, (b) To make any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or

4 CREIGHTON LAW REVIEW [Vol. 9 claimed that Ernst & Ernst was negligent in failing to discover or adequately investigate an alleged material inadequacy 7 in the internal accounting control of First Securities. This alleged inadequacy was an office mail rule whereby all incoming mail addressed to Nay or to his attention Was to be opened only by Nay, regardless of the duration of his absence from the office.' The plaintiffs contended that Nay's "mail rule" was the key to the concealment of his fraudulent escrow scheme, 19 and that if the audits had been,properly conducted, the fraud would have been discovered and the plaintiffs' financial loss prevented. 20 In its answer, the defendant responded, inter alia, 21 that as a matter of law, it could not be held liable for aiding and abetting Nay's fraud because it had no knowledge of the fraudulent escrow scheme. The district court granted defendant's motion for summary judgment. 22 The United States Court of Appeals for the Seventh Circuit reversed and remanded, 23 holding that where an auditor, through its negligence, has breached the statutory duty of inquiry imposed by section 17(a),24 and where, absent such breach, the underlying (c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security. 17. The Supreme Court has held that a fact is material if a reasonable investor might consider it important when making the decision to invest. Affiliated Ute Citizens v. United States, 406 U.S. 128, (1972). 18. Hochfelder at One commentator has remarked: Consequently, mail often piled up on the president's desk when he was out of town. This, of course, is highly unusual for a brokerage firm. All mail is generally required to be opened by 9:30 A.M. since the mail frequently contains buy or sell orders which must be executed as swiftly as possible. Diczok, 10b-5 Liability Expanded Against Accountants, 3 SEC. REG. L.J (1975). 19. Hochfelder at Id. at The court also briefly considered two ancillary issues: that the action was barred by the applicable Illinois statute of limitations of three years and that the plaintiffs were estopped by their conduct prior to the lawsuit. As customers of First Securities, plaintiffs were sent confirmation forms as required under section 17(a) and rule 17a-5 requesting that they verify the accuracy of the statements and notify Ernst & Ernst as to any exceptions. Although the confirmation forms contained no reference to the escrow accounts, Ernst & Ernst was not notified of this fact. The last audit of First Securities by Ernst & Ernst was completed in December 1967 and the first complaint in this action was not filed until February The district court held for the defendant on these issues, but the Circuit Court reversed and remanded in both instances. Id. at Id. at 1103 n.1. The district court opinion is unreported. 23. Id. at The extent or scope of Ernst & Ernst's statutory duty of inquiry imposed by section 17(a) and rule 17a-5 is clearly set forth in Form X- 17A-5.

5 1976] SECURITIES fraud would have been discovered or prevented, then that auditor is liable as an aider and abettor of a rule lob-5 violation. 2 5 The Court of Appeals rejected the plaintiffs' common law claim because neither foreseeability nor reliance could be established. 26 However, the court found that where the defendant, by its action or inaction, has facilitated the fraud of another, a claim for aiding and abetting under rule 10b-5 is made upon 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 facilitation of the underlying fraud; that is, adequate inquiry and subsequent disclosure would have led to the discovery of the underlying fraud or its prevention. 27 The audit shall be made in accordance with generally accepted auditing standards and shall include a review of the accounting system, the internal accounting control and procedures for safeguarding securities including appropriate tests thereof for the period since the prior examination date. It shall include all procedures necessary under the circumstances to substantiate the assets and liabilities and securities and commodities positions as of the date of the responses to the financial questionnaire and to permit the expression of an opinion by the independent public accountant as to the financial questionnaire and to permit the expression of an opinion by the independent public accountant as to the financial condition of the respondent at that date. Id. at See 32 Fed. Reg , (1967) and notes supra. 25. Hochfelder at 1111, Id. at Previously, an injured party, not in privity, had no redress in the courts. The first significant case extending liability for negligence beyond privity of contract was Glanzer v. Shepard, 233 N.Y. 236, 135 N.E. 275 (1922). In that case the court imposed liability for damages caused to a third party by the negligent performance of a contract. Nine years later the court in Ultramares Corp. v. Touche, 255 N.Y. 170, 174 N.E. 441 (1931) refused to extend the scope of liability to all foreseeable injuries resulting to third parties. The case involved public accountants who negligently performed the terms of an audit contract thereby causing economic damages to reliant third parties. Ultramares set the outer limit of an accountant's common law liability by establishing that there was no duty owing to all who might foreseeably rely on an accountant's negligent misrepresentation. However, in recent years the impact of Ultramares has been somewhat diminished. Embracing the philosophy of Glanzer, several courts have extended liability to those members of a limited class whose reliance specifically was foreseen. See, e.g., Ryan v. Kanne, - Iowa -, 170 N.W.2d 395 (1969); Rusch Factors, Inc. v. Levin, 284 F. Supp. 85 (D.R.I. 1968); Rhode Island Hosp. Trust Nat'l Bank v. Swartz, 455 F.2d 847 (4th Cir. 1972); Shatterproof Glass Corp. v. James, 466 S.W.2d 873 (Tex. Civ. App. 1971); Aluma Kraft Mfg. Co. v. Elmer Fox & Co., 493 S.W.2d 378 (Mo. App. 1973). 27. Id. at The court concluded that before it could be decided if the defendant breached its duty of inquiry, jury findings were necessary

6 CREIGHTON LAW REVIEW I[Vol. 9 The Circuit Court's opinion was recently reversed by the Supreme Court of the United States holding that an action for aiding and abetting under section 10(b) and rule 10b-5 will not lie unless the defendant intended to deceive, manipulate, or defraud the investor. 28 The Supreme Court examined the wording and legislative history 29 of section 10(b) and found that Congress intended that liability under section 10 (b) and rule 10b-5 be premised on "scienter." 30 The Court compared the language of section 10 (b) to that of other sections of the 1933 and 1934 Acts and concluded that extending a negligence standard to section 10 (b) would have the result of nullifying the effectiveness of the express civil remedies found in these other sections. 31 Finally, the Court found that the scope of rule lob-5 cannot exceed the power granted the SEC under section 10(b), whose language and history compel an interpretation requiring an intentional wrongdoing. 3 2 AIDING AND ABETTING Aiding and abetting has its origins in criminal 33 and tort 34 law. The theory of aider-abettor liability was introduced into actions involving defrauded securities investors in an injunctive proceeding brought by the Securities and Exchange Commission. 3 5 Subseon two issues of fact: (1) whether the mail rule was a material inadequacy as defined by generally accepted accounting standards; and (2) whether defendant failed to exercise due care by failing to discover this material inadequacy. Id. at Ernst & Ernst v. Hochfelder, 96 S. Ct. 1375, 1381 (1976). 29. Id. at Id. at 1385, Id. at Id. at The federal criminal aider-abettor provision provides: Whoever commits an offense against the United States or aids, abets, counsels, commands, induces or procures its commission, is punishable as a principal. 18 U.S.C. 2(a) (1970). See generally W. LAFAVE & A. SCOTT, CRIMINAL LAW :64(1972) for a discussion of the intent element. 34. RESTATEMENT OF TORTS 876 (1939): For harm resulting to a third person from the tortious conduct of another, a person is liable if he (a) orders or induces such conduct, knowing of the conditions under which the act is done or intending the consequences which ensue, or (b) knows that the other's conduct constitutes a breach of duty and gives substantial assistance or encouragement to the other so to conduct himself, or (c) gives substantial assistance to the other in accomplishing a tortious result and his own conduct, separately considered, constitutes a breach of duty to the third person. 35. Timetrust, Inc. v. SEC, 142 F.2d 744, 745 (9th Cir. 1944). The Ninth Circuit recognized the right of the Commission to enjoin aiders and

7 1976] SECURITIES quently, beginning with Kardon v. National Gypsum Co., 86 the aider-abettor theory under rule 10b-5 has been successfully used in private actions by defrauded investors trying to reach persons who were not actual participants in the fraudulent transaction.3 7 Aider and abettor liability acts as a natural and logical complement to a private right of action under rule 10b It protects the investor to the fullest extent since it imposes liability on those persons who assisted the primary violator, even though they were not direct or immediate participants in the prohibited activity. Professor Ruder 39 lists the elements of aiding and abetting as (1) an independent wrong by the primary violator, (2) "knowledge" 40 of the wrong by the defendant and (3) assistance by the defendant after such knowledge in the completion of the wrong. 41 abettors in the operation of a plan fraudulently devised for the purpose of selling capital stock of the Bank of America National Trust and Savings Association. However, the court held that if no evidence of participation could be produced, no liability could be incurred by the alleged aiders and abettors F. Supp. 512 (E.D. Pa. 1946) (motion to dismiss denied); 73 F. Supp. 798 (E.D. Pa. 1947) (accounting granted); 83 F. Supp. 613 (E.D. Pa. 1947) (findings of fact and law). This was an action to recover damages for fraudulently conspiring to induce and inducing plaintiffs to sell their stock in two corporations for less than its true value. 37. See 5 A. JAcoBs, THE IMPACT OF RULE lob , at 2-69 (1974). Despite the absence of express language in rule lob-5, all the federal circuits have implied a private right of action. For recent illustrative cases, see Ruder, Texas Gulf Sulphur-The Second Round: Privity and State of Mind in Rule 10b-5 Purchase and Sales Cases, 63 Nw. U.L. REv. 423, 431 n.46 (1968). The Supreme Court of the United States has also explicitly recognized the existence of implied private relief for a violation of rule lob-5. Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 730 (1975) (retail user of trading stamps brought action against stamp corporations and others claiming damages under rule 10b-5); Superintendent of Ins. v. Bankers Life & Cas. Co., 404 U.S. 6, 13 n.9 (1971) (company alleged fraud in sale of securities which was purchased with the company's own assets). 38. Brennan v. Midwestern United Life Ins. Co., 259 F. Supp. 673, 680 (N.D. Ind. 1966) (motion to dismiss denied), 286 F. Supp. 702 (N.D. Ind. 1968) (judgment for plaintiffs), aff'd, 417 F.2d 147 (7th Cir. 1969), cert. denied, 397 U.S. 989 (1970). 39. David S. Ruder, Professor of Law, Northwestern University. B.A. 1951, Williams College; J.D. 1957, University of Wisconsin. Member, Wisconsin and Illinois Bars. 40. The courts have defined "knowledge" or "scienter" as fraudulent intent, reckless disregard for the truth, or knowing use of a scheme or artifice to defraud. Cf. SEC v. National Bankers Life Ins. Co., 324 F. Supp. 189, 194 (N.D. Texas 1971); Lanza v. Drexel & Co., 479 F.2d 1277, 1301, 1304 (2d Cir. 1973). The Supreme Court did not address itself in Hochfelder to the question whether reckless behavior is sufficient for civil liability under section 10 (b) and rule lob-5 but did indicate that recklessness may be considered a form of intentional conduct. See note 121 infra. 41. Ruder, Multiple Defendants in Securities Law Fraud Cases: Aid-

8 782 CREIGHTON LAW REVIEW [Vol. 9 KNOWLEDGE A defendant charged with aiding and abetting must have some general awareness that his role is part of a "complex activity and that the overall conduct is in some way improper. '42 In Pettit v. American Stock Exchange, one of the earliest cases dealing with aiding and abetting a rule 10b-5 violation, the court set a standard of liability for secondary participants, stating that "knowing assistance of or participation in a fraudulent scheme under section 10(b) gives rise to liability equal to that of the perpetrators themselves.... Relying on Pettit, the court in Brennan v. Midwestern United Life Insurance Co., 44 adopted the tort standard for aiding and abetting, 45 which states that one is liable to a third party for harm done by another if he "knows that the other's conduct constitutes a breach of duty and gives substantial assistance or encouragement to the other so to conduct himself. 46 However, in several subsequent cases dealt with by the Seventh Circuit, it has been held that aider-abettor liability may be imposed for something less than actual knowledge and participation in the primary wrong. In SEC v. First Securities Company of Chicago, 47 the Seventh ing and Abetting, Conspiracy, In Pari Dilecto, Indemnification, and Contribution, 120 U. PA. L. REv. 597, (1972) A. BROMBERG, SECURITIES LAW: FRAUD 8.5 (582), at (1974) F. Supp. 21, 28 (S.D.N.Y. 1963). This was a suit by trustees appointed pursuant to Chapter X of the Bankruptcy Act against the American Stock Exchange and others for alleged complicity in a continuing conspiracy over a three year period which resulted in an illegal and fraudulent distribution of 578,000 shares of Swan-Finch stock sold to the public without registration, on a rigged market, through the facilities of the stock exchange. The Exchange's motion to dismiss was denied and the case remanded to the trial court for factual determination. Id. at F. Supp. 673 (N.D. Ind. 1966) (motion to dismiss denied), 286 F. Supp. 702 (N.D. Ind. 1968) (judgment for planning), aff'd, 417 F.2d 147, (7th Cir. 1969), cert. denied, 397 U.S. 989 (1970) [hereinafter cited as Brennan]. Michael Dobich, president of Dobich Securities, sold and failed to deliver almost $3 million worth of Midwestern stock that had not yet been issued by the corporation and instead diverted the funds he received for his own use. Although aware of Dobich's activities, Midwestern took no action, choosing neither to report Dobich to the SEC nor to take other steps which might have stopped his fraudulent scheme. Midwestern hoped to maintain the benefit of an active market in its stock for potential merger situations. A motion to dismiss was denied and the case was remanded to the trial court for factual determination. 259 F. Supp. at Brennan at 680. See also note 34 supra. 46. Brennan at F.2d 981 (7th Cir.), cert. denied, McKy v. Hochfelder, 409 U.S. 880 (1972).

9 SECURITIES Circuit stated that liability predicated on aiding and abetting could be found when less than actual knowledge was present. 4 The court compared that case with Brennan and Buttrey v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 49 a case not involving accountants, and found that First Securities presented a far more compelling case for the imposition of liability as an aider and abettor than did either Buttrey or Brennan. 50 This position was repeated in Hochfelder v. Midwest Stock Exchange, 5 ' in which the court went on to state that an action for aiding and abetting can be sustained if the defendant knew or, but for a breach of a duty of inquiry, should have known of the fraud. 52 Other circuits have imposed a negligence standard on secondary participants charged as aiders and abettors. 58 In SEC v. Spectrum, Ltd., an attorney who rendered an opinion letter stating that certain unregistered securities could be transferred when, in fact, such transfer was illegal was held liable as an aider and abettor by the Second Circuit.4 The cases extending the negligence standard are distinguishable from Hochfelder because they have all been 48. Id. at F.2d 135 (7th Cir.), cert. denied, 396 U.S. 838 (1969). The act of the brokerage firm which provided a foundation for aider-abettor liability was allowing a customer to trade in securities through a cash account in spite of his known financial instability and "erratic trading practices." Id. at First Sec. at 988. The court found a more compelling case here because First Securities made Nay its president, held him out as a successful investment counsellor, and then wilfully allowed Nay's enforcement of the mail rule which was antithetical to the prevention of frauds of the type which occurred. Id F.2d 364 (7th Cir.), cert. denied, 419 U.S. 875 (1974). 52. Id. at See SEC v. Spectrum, Ltd., 489 F.2d 535 (2d Cir. 1973) (negligence standard applied to attorney who prepared opinion letter on certain unregistered securities); SEC v. Dolnick, 501 F.2d 1279 (7th Cir. 1974) (broker's statements which misrepresented the financial condition of a corporation were found to constitute a violation of rule 10b-5 even though the statements were not made during solicitations of the customer and the customer was a knowledgeable investor); SEC v. Manor Nursing Centers, Inc., 458 F.2d 1082 (2d Cir. 1972) (mere negligence held to be sufficient basis for aider and abettor liability where use of misleading prospectus involved). But see SEC v. Coffey, 493 F.2d 1304 (6th Cir. 1974), cert. denied, 420 U.S. 908 (1975) (negligence standard for aiding and abetting rejected even though there was misrepresentation of $8 million in two year promissory notes which eventually proved worthless) F.2d 535 (2d Cir. 1973). The Spectrum court said: In the distribution of unregistered securities, the preparation of an opinion letter is too essential and the reliance of the public too high to permit due diligence to be cast aside in the name of convenience. The public trust demands more of its legal advisors than "customary" activities which prove to be careless.

10 784 CREIGHTON LAW REVIEW [Vol. 9 injunctive actions brought by the SEC. Furthermore, the court in Spectrum carefully emphasized that its decision should not provide the basis for applying a negligence standard to private actions. 55 This decision is in agreement with the general consensus that there is "implied a different standard for SEC actions than for private suits seeking damages." '56 The recent decisions by the Seventh Circuit conflict with the case law of the other circuits. The standard generally applied is similar to the Second Circuit's decision in Lanza v. Drexel & Co., where the court stated that "in sum, we believe that proof of a willful or reckless disregard for the truth is necessary to establish liability under rule 10b-5."1 5 7 ACTION VERSUS INACTION In the traditional sense, aiding and abetting connotes help, assistance, or facilitation of the scheme of the primary wrongdoer. 58 In Brennan the court noted that inaction as well as affirmative conduct may constitute aiding and abetting. 5 9 However, the Brennan theory of silence went through a brief period of erosion when the Ninth Circuit held in Wessel v. Buhler 0 that "nothing in rule 10b-5 purports to impose liability on anyone whose conduct consists solely of inaction,""' and the Southern District 55. Id. at SEC v. Fifth Ave. Coach Lines, Inc., 435 F.2d 510, 517 (2d Cir. 1970) (injunction against investment company for failure to register under the 1940 Act). 57. Lanza v. Drexel & Co., 479 F.2d 1277, 1306 (2d Cir. 1973). In Lanza the court was of the opinion that the words manipulative and deceptive as used in section 10 (b) negated liability for a mere negligent omission or misrepresentation. It concluded that proof of fraud is required in suits under section 10(b) and rule 10b-5-at least in private suits for damages. Id. at See notes supra. 59. Brennan at 682. The court stated: To... hold blindly that silence and inaction cannot constitute aiding and abetting under any possible set of circumstances would be to defeat and hamper the intelligent and responsible development of the law by subjecting it to a tyranny of labels F.2d 279 (9th Cir. 1971). Wessel was an. action for damages by purchasers who had been induced to buy securities through an allegedly misleading prospectus. The issuer's certified public accountant was named as an alleged aider and abettor to the fraud. The court denied liability, finding that the CPA owed no duty to prospective investors to disclose his knowledge of irregular financial conduct and of deficiencies in its financial records. Id. at Id. at 283.

11 19761 SECURLTIES of New York in Fischer v. Kletz 62 determined that a group of auditors would sustain no liability in the absence of evidence that they gave substantial "assistance or encouragement" to a corporation's issuance of false financial statements. 6 3 Neither the Wessel nor the Fischer courts would declare the accountants liable under rule 10b-5 for failing to publicly disclose that misleading figures were being used. 6 4 Despite this departure from Brennan by some courts, inaction as well as affirmative action remained the standard for aiding and abetting in the Seventh Circuit. The court in Hochfelder v. Midwest Stock Exchange 6 5 implied that aiding and abetting a section 10(b) and rule 10b-5 violation may be made by affirmative action, by inaction in combination with affirmative action or by inaction alone. 66 The Hochfelder court also adopted this position. 7 THE SEVENTH CIRCUIT OPINION Adopting a standard of negligence 6 8 for aiding and abetting a rule 10b-5 violation, the circuit court examined the individual elements of its formula. 6 9 Initially, the court determined whether the defendant had a duty of inquiry which would benefit the plaintiffs. 70 Rejecting the plaintiffs' claim of a common-law duty of inquiry, 71 the court turned to section 17 (a) F. Supp. 180 (S.D.N.Y. 1967). In Fischer the public accounting firm of Peat, Marwick, Mitchell & Co., learned that certain figures which it certified were misleading. It did not disclose this information either to the SEC or to the public until a special study had been completed approximately six months later. Id. at Id. at 197. The court found that from the facts pleaded in the complaint it would be "difficult to characterize Peat, Marwick, Mitchell & Co.'s action as assistance or encouragement in the sense contemplated by the RESTATEMENT." Id. 64. See 437 F.2d at 283 and 266 F. Supp. at 195. The courts found no independent duty to disclose by application of either statutory or common law principles F.2d 364 (7th Cir.), cert. denied, 419 U.S. 875 (1974). 66. Id. at Hochfelder at The court noted it indirectly passed upon this contention in Hochfelder v. Midwest Stock Exch., 503 F.2d 364 (1974). 68. The negligence referred to is with respect to an existing duty to investigate questionable conduct, or to come to the knowledge of another's misconduct. This type of negligence is contrasted with the situation where the defendant knew of the misconduct and then solely breached a duty of disclosure, either intentionally or negligently. See note 119 and accompanying text infra. 69. See note 27 and accompanying text supra. 70. Hochfelder at Id. at See notes 14 and 26 and accompanying text supra.

12 CREIGHTON LAW REVIEW [Vol. 9 The court found implicit in section 17(a) an "indirect duty" flowing to the plaintiffs, holding that "it is enough for purposes of proving defendant's aid and abettment 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. ' 72 Under this theory, recovery for breach of this "indirect duty" created by the courts under section 17(a) would be allowed where it can be shown that the wrong perpetrated violates rule 10b Having established as a matter of law the existence of the first two elements of its aiding and abetting formula, the court attempted to determine whether Ernst & Ernst had breached its statutory duty of inquiry under section 17(a). 7 4 The court's examination here was twofold: (1) the scope of the Ernst & Ernst's duty of inquiry must be ascertained; and (2) the standard of conduct by which Ernst & Ernst executed its duty must be delineated. 7 Rule 17a-5 and Form X-17A-5 define the scope of an accountant's duty of inquiry under section 17(a). 76 Section 17(a) requires a filing of such financial reports as the SEC may deem necessary and appropriate for investor protection. Rule 17a-5 requires a filing with the SEC of detailed annual reports of financial condition on Form X-17A-5, 7 7 which must be certified by an accountant. 78 Specifically, Form X-17A-5 requires that the audit conducted by the accountant be in accordance with "generally accepted auditing standards," 79 meaning that the accountant must test the adequacy of internal accounting controls as well as make inquiry into other 72. Id. at In Shapiro v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 495 F.2d 228 (2d Cir. 1974), the court found that the policy behind section 10(b) and rule 10b-5 was "to protect the investing public and to secure fair dealing in the securities markets by promoting full disclosure of inside information so that an informed judgment can be made by all investors who trade in such markets." Id. at Hochfelder at Id. at See notes supra C.F.R a-5 (a) (2) (1975). 78. Id. at a-5(b) (1). "The auditor's standard report consists of a statement describing the nature of the examination,.usually in an opening or 'scope' paragraph, and an expression of the auditor's opinion, usually in a closing or 'opinion' paragraph." STATEMENTS ON AUDITING STANDARDS No. 2, REPORTS ON AUDITED FINANCIAL STATEMENTS, AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS, at 2 (1974) Fed. Reg , (1967).

13 1976] SECURITIES factors which reflect the accuracy and reliability of financial statements. 80 The court determined that a negligent failure to discover a material inadequacy in First Securities' internal accounting controls i.e., Nay's "mail rule," would not satisfy generally accepted auditing standards. 8 ' On this basis the circuit court concluded that there were genuine issues of material fact sufficiently present to remand the case to trial.a 2 Continuing with its aiding and abetting formula, the court concluded that if it were found that the defendant had breached the statutory duty of inquiry, then it would have breached its duty of disclosure. 83 The court reasoned that an accountant's duty to investigate internal accounting controls necessarily implies that any material inadequacy in those controls will be disclosed. 84 Thus, by failing to uncover and identify this "material inadequacy," 85 the defendant necessarily breached its duty of disclosure as a matter of law. 8 6 THE SUPREME COURT OPINION Reversing the Seventh Circuit, the Supreme Court held that an action for aider and abettor liability under section 10(b) and rule lob-5 will not lie absent any allegation of "scienter," that is, the intent to deceive, manipulate, or defraud by the defendant Id. Based upon such audit, the accountant shall comment upon any material inadequacies found to exist in the accounting system, the internal accounting control and procedures for safeguarding securities, and shall indicate any corrective action taken or proposed. See note 27 supra. 81. Hochfelder at Id. 83. Id. at Id. 85. See note 17 supra. 86. Hochfelder at The court appears to be saying that for purposes of causation analysis it will assume that defendant would have disclosed to the SEC or to the client the existence of a material inadequacy in the client's internal accounting control. 87. The Court, dismissing respondents' contention that Ernst & Ernst owed them a direct duty under section 17(a) and rule 17a-5 of the 1934 Act to conduct a proper audit of First Securities and that Ernst & Ernst had violated that duty, stated: Respondents' cause of action, however, was premised solely on the alleged violation of Section 10(b) and Rule 10b-5. During the lengthy history of this litigation they have not amended their original complaint to aver a cause of action under Section 17(a) and Rule 17a-5. We therefore do not consider that a claim of liability

14 CREIGHTON LAW REVIEW [Vol. 9 Initially, the Court turned to the language of section 10(b). 8 Section 10(b) of the Securities Exchange Act of 1934 makes unlawful the use or employment of "any manipulative or deceptive device or contrivance" in contravention of SEC rules. At issue was the meaning of the words "manipulative or deceptive" used in connection with "device or contrivance," which strongly suggest that section 10 (b) was intended to proscribe knowing or intentional misconduct. 89 In particular, the use of the word "manipulative" 90 connotes intentional or willful conduct designed to deceive or defraud investors. 9 1 Looking at the express civil remedies in the 1933 and 1934 Acts, the Court found that Congress fashioned standards of liability on a particularized basis. 9 2 Therefore, the Court concluded that ascertainment of congressional intent as to the standard of liability in a particular section of the Acts must rest primarily on the language of that section. 9 3 The Court, relying heavily on the 1934 Act's legislative history, sought support for a section 10 (b) negligence standard. The Court found that while the scope of section 10(b) is not explicitly revealed in the legislative history, there is no indication that liability would attach absent scienter, thus supporting the conclusion that Congress intended no lesser standard under section 10 (b)9 4 While section 10(b), in contrast to certain other sections of the 1933 and 1934 Acts, is not by its terms explicitly restricted to willful, knowing or purposeful conduct, it should be construed in all cases to require more than negligent action or inaction as a prerequisite under Section 17(a) is properly before us even assuming respondents could assert such a claim independently of Section 10 (b). 96 S. Ct. 1375, 1381 n.13 (1976). 88. See note 15 supra S. Ct. 1375, 1383 (1976). See also note 57 supra. 90. Manipulate is defined as:... to manage or treat artfully or fraudulently; as to manipulate accounts Exchanges. To force (prices) up or down, as by matched orders, wash sales, fictitious reports... ; to rig. Id. at 1384 n.21, citing WEsTE's INT'L DIcrONARY (2d ed. 1934) S. Ct. 1375, 1384 (1976). 92. [I]n seeking to accomplish its broad remedial goals, Congress did not adopt uniformly a negligence standard even as to express civil remedies. In some circumstances and with respect to certain classes of defendants, Congress did create express liability predicated upon a failure to exercise reasonable care. E.g., 1933 Act 11 (b) (3) (B), 48 Stat. 82 as amended 15 U.S.C. 77k(b) (3) (B) (liability of "experts," such as accountants, for misleading statements in portions of registration statements for which they are responsible). Id. 93. Id. 94. Id. at

15 1976] SECURITIES for civil liability. 9 5 The Court found that whenever Congress created civil liability in favor of investors it clearly specified whether recovery was to be premised on knowing and intentional conduct or on negligence. 9 6 The recognition of a cause of action premised on negligent behavior in section 11, 9 7 for example, stands in sharp contrast to the language of section 10(b).98 The Court also considered it significant that each of the civil remedies in the 1933 Act allowing recovery for negligent conduct 99 was subject to significant procedural restrictions not applicable under section 10(b). 1 O These procedural limitations indicated to the Court that the judicially-created private right damage remedy under section 10(b)-which has no comparable restrictions' could not be extended to actions premised on negligent wrongdoing. The Court felt such an extention would allow causes of action for the 1933 Act remedies to be brought under section 10(b) thereby 95. Id. at Id. The court cited the following sections as examples: 1933 Act. 11, 12, 15, 48 Stat. 82, 84, as amended 15 U.S.C. 77k, 771, 77o; 1934 Act 9, 18, 20, 48 Stat. 889, 897, 899, as amended 15 U.S.C. 781, 78r, 78t. Id. at Id. The Court stated: [Section] 11 of the 1933 Act unambiguously creates a private action for damages when a registration statement includes untrue statements of material facts or fails to state material facts necessary to make the statements therein not misleading. Within the limits specified by 11 (e), the issuer of the securities is held absolutely liable for any damages resulting from such misstatement or omission. But experts such as accountants who have prepared portions of the registration statement are accorded a "due diligence" defense. In effect, this is a negligence standard. Id. 98. Id. 99. Id. The Court cited: 11, 12(2), 15, 15 U.S.C. 77k, 771, 77o. Id Id. at The Court stated: Section 11(e) of the 1933 Act, for example, authorizes the court to require a plaintiff bringing a suit under 11, 12(2), or 15 thereof to post a bond for costs, including attorneys' fees and in specified circumstances to assess costs at the conclusion of the litigation. Section 13 specifies a statute of limitations of one year from the time the violation was or should have been discovered, in no event to exceed three years from the time of offer or sale, applicable to actions brought under 11, 12(2), or 15. These restrictions, significantly, were imposed by amendments to the 1933 Act adopted as part of the 1934 Act. Id. '101. Id. at 1389 n.29. 'Since no statute of limitations is provided for civil actions under section 10 (b), the law of limitations of the forum state is followed as in other cases of judicially implied remedies. See Holmberg v. Armbrecht, 327 U.S. 392, 395 (1946), and cases cited therein.

16 CREIGHTON LAW REVIEW [Vol. 9 nullifying the effectiveness of the carefully drawn procedural restrictions on these express remedies The Court conceded that the language of subsections (2) and (3) of rule lob-5,1 0 3 when viewed in isolation, might encompass a course of wrongful conduct which was either intentional or negligent However, the Court concluded that such a reading does not comport with the rule's administrative history which makes it clear that it was to apply only to activities involving scienter.' 0 5 More importantly, the Court held that the scope of rule 10b-5 could not exceed the power granted the SEC under section 10(b), whose language and history compel interpreting the rule to apply only to intentional wrongdoing. 0 6 Finally, the Court determined that since the respondents had proceeded on a theory of liability premised on negligence throughout the lengthy history of the case, it would be inappropriate to remand the action for further proceedings S. Ct. 1375, 1389 (1976). Congress regarded these express restrictions on private damage actions as significant. One of its purposes was to deter actions brought solely for their potential settlement value. This deterrent is lacking in the section 10 (b) context, in which a district court's power to award attorney's fees is sharply circumscribed. Id. at 1389 n See note 16 supra S. Ct. 1375, 1390 (1976) Id. at 1390 n.32. The Court stated: Although adopted pursuant to section 10(b), the language of the rule appears to have been derived in significant part from section 17 of fhe 1933 Act, 15 U.S.C. 77q. E.g., ibid.; SEC v. Texas Gulf Sulphur Co., 401 F.2d 883, 867 (CA2 1968) (Friendly, J., concurring), cert. denied sub nom. Kline v. SEC, 394 U.S. 976 (1969). There is no indication in the administrative history of the Rule that any of the subsections was intended to proscribe conduct not involving scienter. Id Id. at Id. In his dissenting opinion, Mr. Justice Blackmun argued that an investor can be victimized just as much by negligent conduct as by positive deception and that it is not logical to say Congress intended the one and not the other. This is consistent with Congress' intent, repeatedly recognized by the Court, that securities legislation enacted for the purpose of avoiding frauds be construed "not technically and restrictively, but flexibly to effectuate its remedial purposes." SEC v. Capital Gains Research Bureau, 375 U.S. 180, 195 (1963); Superintendent of Insurance v. Bankers Life and Cas. Co., 404 U.S. 6, 12 (1971); Affiliated Ute Citizens v. United States, 406 U.S. 128, 151 (1972). Mr. Justice Blackmun saw no real distinction between the fact that negligence is a violation factor when the SEC sues but is not when a private party sues since the concern of this case is with the issue of violation, not of the private party's judicially created entitlement to damages or other specific relief. Id. at 1392.

17 1976] SECURITIES ANALYSIS The traditional tort' 08 and criminal' 0 9 law theories of aiding and abetting generally require that the defendant have knowledge of another's wrong and that he substantially assist or encourage that conduct. The state of mind requirement is important for it prevents the imposition of liability for unwitting assistance or facilitation in the criminal or tortious act." 0 Applying a negligence standard to an alleged aider and abettor who neither gave substantial assistance nor consciously intended to aid a securities violation seems questionable. The Seventh Circuit in Hochfelder based the standard of care which an accountant must comply with on generally accepted auditing standards."' However, it left to the trial court the task of defining these standards. 1 ' 2 A judicially imposed determination of auditing standards would have the effect of negating the auditor's professional judgment based on his entire perspective of the particular situation." n In determining whether a representation was negligently made in a particular case, it must be remembered that the audit is, of necessity, based upon testing and sampling with the examination premised to some extent upon the adequacy of management's internal control. Errors by management, whether deliberate or unintentional, will not always be detected by a normal audit. 1 ' The dangers of judicially imposed standards are readily apparent. In Herzfeld v. Laventhol, Kreckstein, Horwath & 108. See note 34 supra See note 33 supra See United States v. Peoni, 100 F.2d 401, 403 (2d Cir. 1938) (conspiracy to pass counterfeit money) Hochfelder at Id. at In deciding whether the effects of a departure from generally accepted accounting principles are sufficiently material to require either a qualified or an adverse opinion, one factor to be considered is the dollar magnitude of the effect. However, materiality does not depend entirely on the relative size: the concept involves qualitative as well as quantitative judgments. The significance of an item to a particular enterprise, the persuasiveness of the misstatement (e.g. whether it affects the amounts and presentation of numerous financial statement items), and the impact of the misstatement on the financial statements taken as a whole are all factors to be considered in making a judgment regarding materiality. STATEMENTS ON AUDITING STANDARDS No. 2, REPORTS ON AUDITED FINANCIAL STATEMENTS, AMERICAN INSTITUTE OF CERTIFIED PUBLIc ACCOUNTANTS, at 5-6 (1974) Hallett & Collins, Auditors' Responsibility for Misrepresentation: Inadequate Protection for Users of Financial Statements, 44 WASH. L. REv. 139, 183 (1968).