CASE 7.6
FIRST SECURITIES COMPANY OF CHICAGO
(HOCHFELDER)
Synopsis
Prior to the Supreme Court’s ruling in the Hochfelder case, it was unclear exactly what degree of
malfeasance on the part of auditors had to be proven for them to be held civilly liable under the
Securities Exchange Act of 1934. For many years, plaintiff legal counsel had maintained that if an
audit firm was found to have been negligent in auditing financial statements included in a
registration statement filed under the 1934 Act, third parties who relied on those statements to their
detriment were entitled to recover damages from the audit firm. Conversely, attorneys representing
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First Securities Company of Chicago – Key Facts
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1. Leston Nay was well respected and trusted by his customers.
3. The alleged escrow syndicate was an investment fund personally managed by Nay and not an
asset of First Securities.
5. After failing to recover their losses from the Midwest Stock Exchange and First Securities, the
escrow investors filed a lawsuit against Ernst & Ernst, the longtime audit firm of First Securities.
9. The Supreme Court ruled that negligence was not a sufficient basis for a civil lawsuit filed
against an audit firm under the 1934 Act; instead, a plaintiff must prove either intent to deceive
(scienter) or possibly reckless disregard for the truth on the part of an audit firm to recover damages.
Instructional Objectives
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1. To define auditors’ legal liability under the Securities Exchange Act of 1934.
Suggestions for Use
This case is best suited for coverage during discussion of auditors’ legal liability, specifically
auditors’ liability under the federal securities laws. The key learning points in this case focus on
what I like to refer to as auditors’ “culpability standard” under the Securities Exchange Act of 1934.
Although the Hochfelder ruling clearly established that negligence is an insufficient basis for a civil
lawsuit filed against an auditor under the 1934 Act, it was much less definitive regarding when
Suggested Solutions to Case Questions
1. The mail rule would likely qualify as a “material weakness” under AU Section 325,
“Communicating Internal Control Related Matters Identified in an Audit:” “A material weakness is
a deficiency, or combination of deficiencies, in internal control, such that there is a reasonable
possibility that a material misstatement of the entity’s financial statements will not be prevented, or
detected and corrected on a timely basis” (AU 325.06). AU Section 325 requires auditors to
communicate material weaknesses that they discover to “management and those charged with
Note: For a more in-depth discussion of significant internal control deficiencies and material
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2. The mail rule clearly had important financial implications for First Securities. In one of the legal
cases prompted by the First Securities fraud, the court pointed out that while engaging in the fraud
Nay was acting as an agent of First Securities.
” . . . First Securities also provided Nay with the printed letterhead, printed
In fact, in another court case, First Securities was found liable for the investment losses suffered by
the participants in the escrow syndicate. This finding was essentially a moot point, however, since
First Securities was insolvent.
The mail rule also had significant implications for the brokerage firm‘s internal controls. If Ernst
3. The definitions of negligence, recklessness, and fraud presented here are found in the following
source: D.M. Guy, C.W. Alderman, and A.J. Winters, Auditing, Fifth Edition (San Diego: Dryden,
1999), 85-86.
Negligence. “The failure of the CPA to perform or report on an engagement with the
due professional care and competence of a prudent auditor.” Example: An auditor
Recklessness (a term typically used interchangeably with gross negligence and
Fraud. “Fraud differs from gross negligence [recklessness] in that the auditor does
not merely lack reasonable support for belief but has both knowledge of the falsity
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financial statements.
4. Most likely, the escrow investors would have been successful in recovering their losses from
Ernst & Ernst if they had been entitled to file their suit under the Securities Act of 1933. Auditors
5. In a jurisdiction that invokes the legal precedent established by the Restatement of Torts, both
“primary” and “foreseen” beneficiaries are allowed to recover damages resulting from the actions of
a negligent audit firm. Foreseen beneficiaries include a reasonably small or limited group of