You are on page 1of 3

The critical issue in this case study is the responsibility of auditor.

Should
Ernst & Ernst be civilly liable for defrauded investors of First Securities
Company of Chicago under Securities Exchange Act of 1934 under Rule 10b-5.

According to Securities Exchange Act of 1934 under Rule 10b-5, plaintiff
which was the defrauded investor Hochfelder needed to prove that Ernst & Ernst
intentionally manipulate the escrows investors.
Ernst & Ernst had audited First Securities Company of Chicago for two
decades, Ernst & Ernst should have noticed Nay's "mail rule" policy could lead
to potential internal control weakness and misleading financial statement.
Defrauded investors were not properly informed or obtained information about
the securities they invested in "escrow syndicate" account which Nay
personally dealt with.
Since Nay was the president of First Securities Company of Chicago and he
only dealt with his closest friends whom trusted Nay fully, it was hard to
detect by others that Nay made these outside deals with his friends.

Questions
1. Under present technical standards, would auditors be required to disclose a
company policy similar to Nay's mail rule that they discover during an audit?
Explain. Assuming such disclosure had been required at the time this case took
place, would that disclosure have resulted in the mail rule being discontinued?
Under present technical standards, auditors are required to disclose company
policy similar to Nay's mail rule, and it's important for auditor to be aware
and further investigate unreasonable or doubtful company policy if it leads to
internal control weakness or possibly fraud scheme. They are also required to
report their assessment of internal controls and their opinion on management's
assessment of internal control over financial reporting. If such disclosure
had been required at the time this case took place, I believe the mail rule
could be discontinued since it can lead to possible fraud scheme.

2. Ernst & Ernst argued that the mail rule was not relevant to its audits of
First Securities since that rule only involved personal transactions of Nay
and the escrow investors. Do you agree? Why or why not?
The mail rule was relevant to the audits because auditor relied upon
management's financial information to report their opinions on a company. It's
crucial that auditors should have attested every possible or doubtful piece of
financial information that could be misrepresented by managements as well.

3. Define negligence as that term has been used in legal cases involving
independent auditors. What is the key distinction between negligence and fraud?
Between recklessness and fraud? For all three types of professional misconduct,
provide an example of such behavior in an audit context.
Negligence is defined as failure to exercise that degree of care a person of
ordinary prudence (a reasonable person) would exercise under the same
circumstances. The key distinction between negligence and fraud is intention.
Recklessness is defined as unconscious intent to deceive. Fraud is a conscious
intent to deceive.
Negligence can be found in Tommy O' Connell case, which Tommy was too caught
up on his audit on Altamesa's job, he failed to properly supervise his
subordinate Carl to make sure he did the right job. Recklessness case can be
found in this case where the auditor was aware of the mail rule policy. Rather
than challenge this policy, they ignore it. This should have been a warning
flag of possible criminal intent. This disregard for this office policy was
reckless and later proven to be a plot to deceive investors.
4. Assume that the investors defrauded by Nay could have filed their lawsuit
against Ernst & Ernst under the Securities Act of 1933. How, if at all, do you
believe the outcome of their suit would have been affected?
I believe based on the Securities Exchange Act of 1933 which states that the
plaintiff does not have to prove negligence on defendant, the burden shifted
to the auditors to perform a thorough auditing job on any public company. The
defrauded investors should have a greater chance to recover their investment
loss from Ernst & Ernst.
5. Assume that the jurisdiction in which the Hochfelder case was filed invoked
the legal precedent established by the Rush Factors case. Given this
assumption, would the defrauded investors have been successful in pursuing a
negligence claim against Ernst & Ernst under the common law? Why or why not?

Rush Factors case provided grounds for plaintiffs who are foreseeable or
limited parties that relied upon the fraudulent financial statements to file a
claim against the accounting firm who audited the firm. The accountant should
be liable in negligence for careless financial misrepresentation relied upon
by actually foreseen and limited classes of persons. Defrauded investors
would've been successful in pursuing a negligence claim against Ernst & Ernst
under the common law.