Ernst & Ernst v. Hochfelder

Brief Fact Summary. Ernst (Defendant), and accounting firm, failed to expose an escrow account fraud plan committed by the president of the brokerage firm that retained Ernst, causing Hochfelder (Plaintiff) to seek damages for negligence under § 10(b) of the 1934 Act.

Synopsis of Rule of Law. An action for civil damages fails to fall under § 10(b) of the Securities and Exchange Act of 1934 and SEC Rule 10b-5 when lacking an accusation of intent to mislead, manipulate, or deceive on the part of the defendant.

Facts. For just over 20 years, an accounting firm, Ernst, was reserved by First Securities, a littlemidwestern brokerage firm, to completesporadic audits of the firm’s records and books. A year after retention by First Securities was through, the president of First Securities, Nay, left a suicide letter divulging a fraud committed on Hochfelder and other investors, where investors depositedcurrency into nonexistent high yield escrow accounts. Nay instantly transferred that money to his own use by having all investors make checks payable to Nay, keeping it under wraps by employing a rule forbidding anyone to open his mail, even when he was not there. Hochfeldersought damages from Ernst for its careless nonfeasance in failing to uncover the “mail rule†which kept Ernst from leading a suitable audit. The action was filed under § 10(b) of the 1934 Act and SEC Rule 10b-5. The district court dismissed on grounds that negligence alone is inadequate to file suit under those sections. The court of appeals reversed, holding that one who violates a duty of inquiry and disclosure responsible to another is liable for aiding and abetting a third party’s violation of Rule 10b-5 if the fraud would have been exposed or stopped save for the violation. This appeal ensued.

Issue. Does an action for civil damages fail to fall under § 10(b) of the Securities and Exchange Act of 1934 and SEC Rule 10b-5 when lacking an accusation of intent to mislead, manipulate, or deceive on the part of the defendant?

Held. (Powell, J.) No. An action for civil damages fails to fall under § 10(b) of the Securities and Exchange Act of 1934 and SEC Rule 10b-5 when lacking an accusation of intent to mislead, manipulate, or deceive on the part of the defendant. The usage and employment of “any manipulative or deceptive device or contrivance†in breaking SEC rules is illegal under § 10(b). The use of terms like “manipulativeâ€, “deceptive†and “contrivance†intensely advocate a congressional objective to prohibit a type of behavior nothing like negligence. Such terms imply deliberate or determined behavior intended to mislead or defraud investors. The history behind the legislation also backs an explanation like this. § 10(b) was intended as a “catch-all clause to prevent manipulative devices…the commission should have the authority to deal with new manipulative devices.†Terms like that would not be utilized by the drafters if the objective was to produce liability for simply negligent acts or omissions. A defendant could elude a liability by showing that the statement was made in good faith, as stated in the U.S. Senate report on the 1934 Act. Also each portion of the Act that is responsible for civil liabilities asserts that if recovery under S 10(b) has been generated judicially, to permit an action under § 10(b) on the grounds of negligence would permit causes of action developing under other portions of the act (§§ 11, 12[2], and 15) to be filed under § 10(b) “and thereby nullify the effectiveness of the carefully drawn procedural restrictions on these express actions.†Reversed.

Discussion. The courts of appeal were in conflict on the issue to be decided in this case. Many have held that negligence was ample to sustain an action. In the decision, the Court utilized the term “scienter†when referencing a mental state embodying intent to mislead, manipulate or swindle. The court failed to consider if recklessness would be ample to sustain an action under § 10(b) and Rule 10b-5. The Court also failed to consider the inquiry regarding if scienter is a required feature in an action for injunctive relief under that section and rule. It seemed as though § 10(b) was a rapidly drafted reply to an issue “clearly involving intentional misconductâ€, in fact, this section was drafted  the same day that a Boston corporation reported to Congress about  an issue containing a fraudulent scheme.