For 19 years, Ernst & Ernst audited a small brokerage firm, First Securities Company of Chicago (First Securities). Leston B. Nay was president of the firm and owned 92 percent of its stock. He convinced some customers to invest funds in “escrow” accounts that would yield a high rate of return. And, indeed, from 1942 through 1966, they did. The investments were unusual in that the customers wrote their checks to Nay personally, not to First Securities. None of these escrow accounts appeared in First Securities’ records. 

As you perhaps have guessed, there were no escrow accounts. Nay was spending the customers’ money on himself. The fraud came to light when Nay killed himself, leaving a note that described First Securities as bankrupt and the escrow accounts as “spurious.”

In investigating the fraud, customers discovered that Nay had had a rigid rule prohibiting anyone else from ever opening mail addressed to him, even if it arrived in his absence. The customers alleged that if Ernst had done a proper audit, they would have found out about this mail rule which would have led to an investigation of Nay and discovery of the fraud. 

The customers filed suit against Ernst under §10(b). The accounting firm filed a motion for summary judgment, alleging that liability under §10(b) requires scienter, that is, an intent to deceive, manipulate, or defraud. Ernst admitted that it had been negligent but denied any intentional wrongdoing. The trial court granted Ernst’s motion, the Court of Appeals reversed and the Supreme Court granted certiorari. 

Questions:

1. Was Ernst liable under §10(b) when it acted negligently but not intentionally?

2. What was the result for Ernst?