The opinion of the court was delivered by: Milton Pollack, Senior District Judge.
Co. (the trustee's investigators), found no transactions made
for Herbert's personal benefit. The illegitimate transactions
engaged in by Herbert were all made in the name of Parr.
Herbert's devious frauds revealed a "new angle" of misconduct
to Rosenthal, the trustee's expert witness:
With a prescience born of hindsight and Herbert's detailed
confessions, plaintiff's expert gave the conclusory opinion
The trustee has conceded herein that there is no evidence
that any PMM auditor or Parr's internal staff or its chief
financial officer, himself an experienced auditor, knew Parr to
be conducting transactions in the name of Parr but not
recording them on Parr's financial records. Long ago it was
prophetically stated by Judge Cardozo:
Ultramares v. Touche, supra, 255 N.Y. at 179, 174 N.E. 441.
The changed circumstances to which Rosenthal refers were the
hiring of Herbert and his engagement in proprietary trading on
behalf of Parr, especially in regard to repurchase agreements.
Rosenthal, on the basis of a deposition of a PMM staff member
taken three years after the audit, complained that Stanley
Kryla, the audit assistant, was engaged in only his first or
second audit, a fact which Rosenthal considered significant to
Kryla's ability to understand the "repo" transactions and
regulatory scheme involved in a broker-dealer audit. (Tr.
560-571). Rosenthal conceded, however, that he could instruct
an ordinarily intelligent person to understand what a "repo" is
and how it works "in an hour or less, sufficient to execute
procedures with regard to repurchase transactions." (Tr. 572).
There certainly was no evidence to indicate that Kryla had
received less than such instruction. Indeed, as McHugh, the
audit manager, stated, there is nothing especially complex
about a repurchase agreement, or a reverse repurchase
The evidence at trial indicated that both McHugh and Dill
reviewed nearly every work paper of the Peat Marwick team and
put their respective tick marks, or indications of their
review, thereon. Beyond mere review, McHugh testified that he
performed on-site supervision of the auditor's field work (Tr.
888) and that he was always available to the staff auditors to
answer questions. (Tr. 890).
Having read McHugh's trial testimony, Rosenthal pulled back
from his earlier opinion as to the supervision by Peat
Further, Rosenthal conceded, when pressed about his own
failure to detect significant errors in the Peterson Group's
"reconstruction" calculations, that the failure to detect such
errors does not represent a per se failure to exercise due care
in the supervision of a staff, nor is it necessarily
Most importantly, however, Rosenthal conceded that the amount
of supervision and planning of an audit require the application
of an auditor's judgment; professional judgment. (Tr. 1315). As
stated in the American Institute of Certified Public
Accountants ("AICPA") manual, Section 1110, "The nature and
extent of supervision and review must necessarily reflect wide
variances in practice."
There is no credible evidence that any members of the PMM
audit team had inadequate technical training or proficiency for
the respective responsibilities they were assigned to perform
on the Parr audit. The partners and the manager had extensive
experience in the auditing of brokers-dealers and both partners
served on the AICPA Committee on Stockbrokerage Auditing and
participated in the drafting of the Committee's Guide entitled
"Audits of Brokers and Dealers in Securities."
b. Time Spent
According to Rosenthal, "[b]ased on my experience, an audit
of an entity such as Parr Securities was in 1983 would require
on the order of 200 to 250 hours to perform adequately." (Tr.
527). Rosenthal then concluded that spending half that amount,
100 to 125 hours, would be "simply inadequate to deal with Parr
Securities as it existed in 1983." (Tr. 528). (Rosenthal, of
course, was speaking of Parr as reconstructed by the two-year
Peterson re-audit.) Based on this opinion, plaintiff proffered
evidence, in the form of Peat Marwick billing figures on the
1983 Parr audit displayed on a colorful demonstration chart, to
show that Peat Marwick had only billed some 77 hours on the
According to Dill and McHugh, however, the time Peat Marwick
billed on the Parr engagement is deceptively low and does not
reflect the actual time apparently spent. The Parr audit
occurred simultaneously with the audits of Kenney & Branisel,
the parent company, and its related entities. As Rosenthal
agreed, Parr was merely an incorporated department of Kenney &
Branisel, (Tr. 635), or, as McHugh stated, a special purpose
subsidiary. (Tr. 863). The evidence indicates that time
actually spent on Parr's books was sometimes attributed for
billing purposes to Kenney & Branisel or the other subsidiary
entities.*fn7 Alternatively, McHugh testified that often time
spent was not billed. (Tr. 913). For example, plaintiff's chart
indicates that McHugh spent only some eight hours on the Parr
engagement. However, he testified that to the best of his
recollection he spent more than that. (Id.). Plaintiff's chart
indicated that Dill spent zero hours on the Parr audit; yet his
testimony, supported by his accounting tick marks physically
placed and found on the work papers, make clear that the time
records were not accurate at least to that extent. As Rosenthal
agreed, there is no standard that requires an auditor to keep
a record of time spent on an audit. (Tr. 711). In short, the
credible evidence was that sufficient time was supplied for the
A further flaw in the 1983 audit assigned by Rosenthal was
that Peat Marwick did not gather "sufficient and adequate
evidence to support the financial statements and assertions
made by management in those financial statements." (Tr. 468).
In particular, Rosenthal faulted Peat Marwick for not having
had substantial contact with Herbert:
Mr. Herbert was, in addition to being the
president, the individual involved in the trading
activities of the company as well as a significant
player in the process of developing the company's
financial statements and books and records in that
he maintained the trading records and prepared the
reconciliation of those records that went into the
I believe that those three roles suggest that he
is an individual that the auditors should have had
significant contact with.
McHugh explained that he saw Parr as just a special purpose
subsidiary of K & B, the holding company, and that the people
truly responsible for Parr in 1983 were Kenney, Branisel and
A. . . . As regards the management of the company,
John Regan, Bill Kenney, I believe it was Ray
Branisel were the senior managers who ran the
Kenney [and] Branisel, to the best of my
knowledge, focused more on the business trading
sides and John Regan, although he focused on
that side as well, also focused on the
administrative and operational side of the firm.
For him worked Chuck Hawk, and Chuck was the
— I don't remember his formal title, but he was
the equivalent to the chief financial officer or
chief accounting officer of the group and was
responsible for all the accounting operations
within the group.
(Tr. 846). As for Herbert, McHugh stated:
A. He had the title president of Parr, and
Herbert, my understanding and my recollection of
it was that he was responsible for the trading
activity that was taking place in Parr and that
he was being supervised, if you will, by the
Kenney, Branisel and Regan team as regards
trading activity and trading decisions, and then
Chuck [Hawk] was responsible for the accounting
operations and financial reporting.
(Tr. 846-847). Because he considered Hawk the chief financial
officer of Parr as well as K & B and did not believe that
Herbert could have fired Hawk if he had wanted to (Tr. 847),
McHugh testified that he, along with Charles Hurty, the
original engagement partner, visited the premises of K & B and
Parr and met with Regan and Hawk. (Id.). He testified further
that he believed those discussions concerned "client
operations, what the business is, what activities were taking
place and possibly the fee." (Tr. 849).
The deposition transcript of Hawk supports both the fact of
appropriate contact with Parr management and its basic content:
Q. Do you recall having any meetings in the fall
of 1983 with anyone from Peat Marwick
regarding either the audits of Parr or Kenney
A. I don't remember when but there were planning
meetings, you know, it was an audit engagement
of our firm and of course we had meetings, all
levels of Peat Marwick.
Q. Did these meetings also address the audit of
Parr as well as Kenney & Branisel?
A. It sure did.
(Hawk Dep. 100).
Q. During these meetings, did you discuss Parr's
Q. Did you feel that you adequately conveyed to
Peat Marwick Parr's operations?
A. At planning meetings or during the course of
the audit, yes.
(Hawk Dep. 104).
On cross examination, Rosenthal was confronted with the
evidence of these discussions:
Q. Do you remember Mr. Hawk's testimony that he
had many discussions on many subjects with Mr.
McHugh during the audit with respect to both
the Kenney & Branisel audit and the Parr
A. I certainly remember that Mr. Hawk stated that
he had many discussions with Mr. McHugh. My
recollection is that the substance of those
discussions was reported as having been
with regard to Kenney & Branisel rather than
d. Confirmation of Chicago Grain Account
The parties stipulated on June 6, 1990, that "[a]s of October
31, 1983, Parr's Chicago Grain account had a zero balance."
(PTO ¶ 18). This comports with the trial balance "PBC"
(prepared by client) in the audit workpapers. (Ex. 3, Tab 17).
Inconsistently, the re-audit evidence indicates that Parr had
suffered approximately a $2 million loss in its Chicago Grain
account late in October 1983.
Herbert testified that he had received blank Chicago Grain
statements in early November, 1983, and that he had attempted
to forge such third-party statements; he claimed, however, that
he was unable to do so. In any event it is undeniably clear
that Herbert had intercepted the genuine October 1983
statement, and had secreted it until he turned it over to the
SEC on May 3, 1985, as part of his confession.
According to Rosenthal:
Had [Parr] sent a positive confirmation to Chicago
Grain of the type that they sent to A.G. Becker
and Security Pacific and received back a
confirmation of the statement, they would have
seen on that statement that the company had a $2
million loss in the month of October, that that $2
million loss was not reflected in the books of
account or in the financial statements and that
those books and records and financial statements
were significantly misstated.
(Tr. 584). Rosenthal reached this conclusion after looking at
a statement unearthed and obtained in 1985 which was
represented to be an accurate Chicago Grain statement for
McHugh testified that it was appropriate under auditing
standards to accept a zero balance as shown on Parr's trial
balance ("PBC") without further confirmation. (Tr. 904). He
I think that there is no requirement in the
professional standards that you send a
confirmation on any particular balance. In the
course of audit examinations which I've dealt
with, we have — we select samples of receivables
to confirm. We confirm all receivables. We make
mistakes. We don't necessarily send out all the
confirmations we thought, and then we do
alternative procedures or try to do alternative
procedures by looking at statements or activities
or what have you. So we do — I've seen things done
in a myriad of ways over the course of my career.
Q. Generally accepted auditing standards do not
require specifically, do they, that auditors
confirm all receivables balances?
A. No, they do not.
Q. Nor do — well, it's a matter of judgment
whether to confirm balances or not, is that a
A. Yes. It's a matter of judgment specific to the
circumstances of the audit and the degree to
which the auditor has other evidence or has
done tests of the accounting system and so
(Plf. Ex. 14).
Rosenthal criticized Peat Marwick's judgment that it was
unnecessary to perform compliance testing of Parr's internal
controls. Rosenthal believed that if Peat Marwick had done so
properly it would have discovered Herbert's falsification of
the so-called blotter which he created and thereby his frauds:
A. Yes, they do. . . .
A. No, there isn't.
(Tr. 1361). This was one of the primary nubs of Rosenthal's
opinion that Peat Marwick had not exercised professional due
care in the 1983 audit, (Tr. 799), and that Peat Marwick's
opinion letter should not have been issued without a review of
the internal controls. (Id.).
(Tr. 871). The Court sought clarification of this point:
The Witness: That is correct.
(Tr. 872). McHugh admitted that Peat Marwick had not literally
complied with its own audit manual by not testing the internal
controls of Parr and not testing the so-called boundary
controls. (Tr. 1020-1021). He stated, however, that
Dill, who helped develop and produce the industry audit
guide, testified that the audit guide did not require public
accountants to conduct compliance tests of internal controls,
either in general or specifically in regard to the Parr 1983
audit. (Tr. 1106). Furthermore, he quoted from the guide itself
to the effect that: "`This publication is only a guide in
determining the scope of the work for each individual audit, it
is not intended to limit or to supplant individual judgment,
initiative, imagination and vigilance.'" (Tr. 1105). When
asked, "Did you believe at the time conducting a substantive
balance sheet audit with no reliance on internal controls could
meet the objectives of Rule 17 generally?", Dill responded,
"Yes, I did, and I do." (Tr. 1112). He then explained his basis
for this opinion:
A. Yes, you can.
A. To that extent, yes.
Further, Rosenthal conceded the following in regard to
whether the trial balances and the balance sheet matched:
A. If you've done enough work, yes. (Tr. 813).
The extent to which inquiry must be pressed beyond
appearances is a question of judgment, as to which opinions
will often differ. Ultramares v. Touche, supra, at 179,
174 N.E. 441.
Rosenthal conceded also that "the trial balance [audited by
Peat Marwick] agrees to the underlying books, at least to the
general ledger" at least in regard to the on-book transactions,
i.e., those not concealed by Herbert. (Tr. 814).
The Witness: Yes, there is.
The Witness: Yes, that is true.
f. Compliance with Rule 15c3-3
Rule 15c3-3 is the rule that the Securities and Exchange
Commission uses for protection of the assets of the customers
of brokers and dealers. It requires the broker-dealer to
safeguard the customers' assets, to perform counts of any
assets under their control and to maintain sufficient reserves
in bank accounts specifically designated for the purpose to
cover any amounts owing by the broker-dealer to their
The requirement is that if the accountant has found
conditions which he believes indicate a material inadequacy as
defined in the regulations and reports such an inadequacy, then
his letter on internal accounting control is to be filed with
the balance sheet. In the event he has not determined that
there is a material inadequacy, this letter is not filed with
the balance sheet.
12 C.F.R. § 240.15c3-3k(2)(ii) (1983). This exemption was
referred to in the trial testimony as the "K2B" exemption.
Rosenthal testified that Peat Marwick was "in possession of
information contained in their working papers that at the very
least strongly suggests that the company had been at the end
— was at the end of the [fiscal] year in violation of its
exemption under Section K2B of Section 15c3-3, and in addition
had been at numerous points in time throughout 1983 in
violation of that exemption." (Tr. 468). The defendants
questioned whether customer property was involved in the
alleged illustrations except that on one occasion, on October
28, 1983, Parr was carrying customer property in Parr's
Security Pacific account, which would be a violation of Parr's
so-called K2B exemption.
Nelson Kibler, plaintiff's expert on Rule 15c3-3 and a former
staff accountant at the SEC who participated in the development
of that rule, testified regarding the customer property in the
Security Pacific account on October 28, 1983:
(Tr. 1503). According to Kibler, when Peat Marwick discovered
this violation, as the workpapers indicated, they were under an
unremitting obligation to inform the company and, if it failed
to take immediate action, the SEC:
(Tr. 1520). In Kibler's opinion, if this information had been
revealed to the SEC, the SEC would have descended upon Parr and
"whoever [was] responsible would have been severely sanctioned
and could have been barred." (Tr. 1528).
Dill testified that he was aware of the alleged violation of
Rule 15c3-3, but that in the instant situation in his judgment
there was no unremitting obligation to declare Parr in
violation of the rule:
Q. Why not?
(Tr. 1156-1157). The following colloquy further reveals Dill's
reasons for not informing
the SEC of this "momentary lapse":
Q. It wasn't up to you, was it Mr. Dill, to decide
whether or not a violation was inadvertent or an
inconsequential lapse? That wasn't your job as
an accountant, was it?
A. I think the accountant and auditor is allowed
judgment in these matters when it is his
signature on the letter, yes.
Q. So your testimony is that you were in a
position once you had discovered a violation of
the rule to decide it was inconsequential and
not report it?
A. There are other factors that relate to the
conditions of the exemption. . . . The situation
that you are referring to we concluded to be
inadvertent and not a violation of the
conditions of exemption.
The Court: Does that mean that in your opinion
there is a permissible area of tolerance?
The Witness: Well, in my experience in the
securities business, your Honor, there are
violations that are endemic on the face of it
where there is — it comes to the auditor's
attention where either through ignorance of the
rule or through just a blatant disregard of the
rule, and those are conditions at which the rule,
I would consider the rule to be violated.
An inadvertent —
The Court: That is an exercise of judgment during
The Witness: Yes, sir. Yes, sir.
The Court: And in your background and experience,
you believe that regardless of what the rule is,
that in the practical affairs of the world, you
are entitled to take cognizance of that kind of
a situation and exercise judgment.
The Witness: That's correct, your Honor.
The Court: So that the standards that we have been
talking about have built in them a tolerance of
judgment and oversight of what could be deemed
to be error?
The Witness: I believe even the experts at the
Securities and Exchange Commission would agree
with that, your Honor.
Rosenthal agreed at least somewhat with Dill's assessment:
The Court: There is always a residual judgment
factor in the application of GAAS, isn't there?
The Witness: Yes, that's true.
The Court: And in the application of 15c3-3 . . .?
The Witness: There can be judgment in that case as
well depending on the circumstances, somewhat
The defendants presented testimony of a highly experienced,
recognized auditing authority, who had independently reviewed
the entire audit procedure and considered the Rosenthal
criticisms. This witness, Michael Passarella, was unequivocally
of the opinion that none of the criticisms, when the facts were
fully considered in context, warranted a conclusion that PMM
had failed to comply with generally accepted auditing
standards. His opinion was that PMM's audit evidenced due
professional care, evidenced the exercise of reasonable,
acceptable professional judgment and was conducted in
accordance with GAAS and that the two reports issued by PMM as
a result of the examination were appropriate under the
Mr. Passarella, a CPA and 15 year partner at Price
Waterhouse, has 27 years experience in the field; he has served
as engagement partner in approximately 100 broker-dealer audits
and as preissuance partner in about the same number of audits.
For 10 years, he has been the national director of Price
Waterhouse's securities industry practice. He served as
chairman and as a member of the AICPA Committee on Stock
Brokerage and Investment Banking; he was a member of an AICPA
task force on "Using the Work of the Specialist" and of the
AICPA task force on the audit of Repurchase Agreements; he is
a member of the Financial Management Division and Internal
Audit Division of the Securities
Industry Association, the National Association of Securities
Dealers Operations Committee, and the New York State Society of
CPA's Committees on Stock Brokerage Accounting and Commodities
Accounting. Passarella participated in drafting Accounting and
Auditing guides issued by the AICPA Stock Brokerage Committee
and testified that these guides are not meant to supplant the
judgment of the auditor.
Passarella refuted Rosenthal's conclusions that PMM did not
conduct a proper audit of Parr by the following:
1. Passarella found clear evidence that there was a planning
exercise performed by PMM, including a visit by Hurty to Parr's
2. Passarella expressed the opinion that there was adequate
supervision of the audit; that the record demonstrates that
McHugh's review was all over the work papers and that McHugh
and Handy's testimony corroborated this conclusion.
3. Passarella testified that the PMM engagement team decided
not to rely on the internal controls of Parr and that this was
perfectly consistent with GAAS. He testified that if PMM
intended to place no reliance on the internal controls, then it
was unnecessary to review these controls. In addition, there
were areas of the internal controls that were reviewed and
tested as part of the audit.
4. Passarella countered Rosenthal's claim of insufficient
fieldwork by pointing out that PMM's standard of field work, as
measured against GAAS, was sufficient in terms of evidentiary
matter affording the basis for their opinion regarding the
5. Passarella testified that the 15c3-3 question was not a
fundamental violation of the SEC rule that should have been
reported to management or the SEC because PMM, in the exercise
of a reasonable judgment of the infraction, was not required to
disclose in its material inadequacy letter that the transaction
may have violated the exemption. Passarella was of the opinion
that the exercise of PMM's judgment was appropriate and within
judgment that could be exercised in assessing this matter; it
was an inadvertent slip that was corrected in a few days by the
system and not as a result of auditor intervention and thus,
the judgment of the engagement team that this was not a
systemic problem was reasonable.
6. In an effort to cut short further consideration of the
question raised by Rosenthal whether PMM had supplied
sufficient time to the audit, he was asked directly and shortly
by the Court whether, in his opinion, PMM had spent sufficient
time on the audit and he responded directly: "Yes, sir, I do."
7. Passarella pointed out that GAAS did not require PMM to
confirm the Chicago Grain account; that Parr's records of that
account showed a zero balance; that it was not obligatory under
PMM's audit plan to confirm the Chicago Grain account; and that
this was a commodities firm and the 100% confirmation in PMM's
work papers related to securities.
On some additional criticisms, Passarella did not see any
breach of the standards if in fact Kryla used the Security
Pacific reconciliation in carrying out his test work. (There
was no evidence one way or the other.) Further, he was of the
opinion that the primary obligation for the development and
maintenance of an adequate internal control system belonged on
the management of Parr; and that the auditors are not
originators of the records. However, were the auditors to have
found anything wrong with the management's records, which they
did not in this case, the procedure would have been to make
recommendations to modify the books of account. He found
substantial evidence that the judgment exercised in this case
was reasonable and in good faith and that PMM went far enough
in its job.
Conclusion on Count I
Exposing latent misconduct by an accounting audit,
after the clues have been confessed and handed to critics, like
solving a crossword puzzle after the answer has been published,
does not warrant a finding that there was malpractice where
convincing evidence of due professional care within the limits
of permissible exercise of professional judgment, despite the
failure to sense fraud (or in the case of the puzzle to sense
the answers to the word puzzle).
I am firmly convinced on all the facts and circumstances in
evidence there was no culpable negligence in this audit and it
would be unreasonable to assume or find that Herbert's frauds
should have been discovered by an audit under the circumstances
of this case.
Count II of the complaint was brought by the trustee on
behalf of and for the personal benefit of five financial
institutions, three banks and two federal savings and loan
associations, who engaged in purported purchases and sales of
alleged securities transactions with Parr in mid-to-late 1984,
long after PMM's audit engagement had ended.
Count II, framed under the federal securities laws, was
dismissed before trial on a motion for summary judgment
pursuant to Rule 56, Fed.R.Civ.P., aided by a hearing under
Rule 43(e) which indicated that the requisite showing of
available evidence to sustain a federal claim was lacking. The
charge was aiding and abetting Parr's frauds in the sale of the
purported securities in 1984 by a reckless audit of Parr in
1983. 15 U.S.C. § 78j(b); 17 C.F.R. 240.10b-5.
The alleged purchase and sale transactions which form the
basis for the claims in Count II never actually took place but
were negotiated by Herbert in June, November and December of
1984. The trustee alleged that Parr sold "participations" in
non-existent banker's acceptances with maturities of less than
nine months to two of the banks and to the two savings and loan
associations, and sold a non-existent treasury note with a
thirty year maturity to the third bank. It was not disputed
that defendant had no knowledge of the fraud and had not
learned information subsequent to the release of its audit
report which would have triggered a duty to disclose that the
audit report was inadequate.
There was no specific probative evidence proffered by the
plaintiff in the defense to summary judgment to support a claim
of intent by PMM to aid and abet Herbert or of conscious
disregard of any duty by PMM to sustain a charge of reckless
conduct by them. The most that plaintiff was able to show in a
supposed melange of auditing faults was alleged negligence in
the audit that could not sustain a federal claim on the grounds
of knowing or reckless conduct.
In addition, the claims of two of the banks and of the two
savings and loans are not cognizable under the Securities
Exchange Act because the allegedly fraudulent transactions did
not involve a "security," as defined in the Act; involved were
transactions exempt from the anti-fraud sections of that Act.
Moreover, Mishkin, as a SIPA trustee, had no statutory
authority to bring suit on behalf of the three banks because
SIPA does not provide for compensation of claims of banks nor
does it allow the assignment of choses in action by the banks
to a SIPC trustee.
Although it is unnecessary to reach and wrestle with the
trustee's standing to sue on any of these claims, a SIPC
trustee to liquidate an insolvent broker's estate lacks legal
status to sue in the personal interest and on behalf of
customers of a debtor in liquidation against third parties for
violations of Rule 10b-5.
The order of dismissal of Count II stated opinion would
Aiding and Abetting Liability
The oft-stated requirements for aiding and abetting a Rule
10b-5 violation are:
(1) the existence of a securities law violation by
the primary (as opposed to the aiding and
(2) "knowledge" of this violation on the part of
the aider and abettor; and
(3) "substantial assistance" by the aider and
abettor in the achievement of the primary
IIT v. Cornfeld, 619 F.2d 909, 913 (2d Cir. 1980); see also
Bloor v. Carro, Spanbock, Londin, Rodman & Fass, 754 F.2d 57,
62 (2d Cir. 1985); Rolf v. Blyth, Eastman Dillon & Co.,
570 F.2d 38, 44-48 (2d Cir.), cert. denied, 439 U.S. 1039, 99 S.Ct.
642, 58 L.Ed.2d 698 (1978).
Here, there is no doubt that a primary violation by Herbert
The second step of the aiding and abetting test, knowledge,
is less clear. The courts have not settled on one definition of
"knowledge" for purposes of aiding and abetting liability.
Plaintiff urged the court to find knowledge through PMM's
alleged recklessness. The "recklessness" standard has been used
when a fiduciary duty exists between the plaintiff and the
defendant. Edwards & Hanly v. Wells Fargo Sec. Clearance Corp.,
602 F.2d 478, 484 (2d Cir. 1979), cert. denied, 444 U.S. 1045,
100 S.Ct. 734, 62 L.Ed.2d 731 (1980); Rolf v. Blyth, Eastman,
Dillon & Co., 570 F.2d at 46-47 (2d Cir. 1978). But where no
fiduciary duty exists, this circuit has stated that recklessly
failing to discover a fraud does not meet the scienter
[Recklessly failing to discover fraud does not
reach] the status of an aider and abettor. . . .
Finding a person liable for aiding and abetting a
violation of 10b-5, as distinct from committing
the violation as a principle, requires something
closer to an actual intent to aid in a fraud, at
least in the absence of some special relationship
with the plaintiff that is fiduciary in nature.
Edwards & Hanly, 602 F.2d at 484, 485; see also IIT v.
Cornfeld, 619 F.2d at 925 (quoting Woodward v. Metro Bank,
522 F.2d 84, 97 (5th Cir. 1975)). In other words, there is a scale
of the degree of scienter that must meet the knowledge
requirement. The more closely related the alleged aider and
abettor is to the primary violation, the lower the level of
scienter required. Edwards & Hanly, 602 F.2d at 484; Woodward
v. Metro Bank, 522 F.2d at 97. Only if this higher level of
relationship is present will recklessness suffice for the
"knowledge" requirement of aiding and abetting liability.
"Courts do not generally regard the accountant-client
relationship as a fiduciary one." Fund of Funds, Ltd. v. Arthur
Andersen & Co., 545 F. Supp. 1314, 1356 (S.D.N.Y. 1982). This
Court agrees and does not find that recklessness meets the
second requirement of aiding and abetting here. Only conscious
awareness will suffice.
Neither the affidavits submitted by plaintiff nor the
testimony adduced at the Rule 43(e) hearing yielded specific
probative evidence of conscious misperformance by PMM of its
auditing duties, conscious avoidance of such duties or
conscious disregard for such duties. There was no claim of
specific probative evidence of a disregard by the auditors for
whether there was a basis for the audit results; there was no
evidence of absence of a genuine belief in the truth of the
audit; or a reckless disregard of truth or falsity of the
audit. There was nothing shown from which constructive intent
to aid and abet Herbert's frauds could be inferred. Nor was
PMM's failure to discover and disclose the fraud after the
submission of its audit report in December 1983 sufficient to
incur aiding and abetting of frauds committed by Herbert in
June, November and December 1984. There was no evidence that
PMM had any opportunity to discover the fraud after its 1983
auditing activities had been completed; PMM was not retained
for auditing work in 1984 and was supplanted by Herbert with a
new firm of accountants who performed the audit for the 14
month period from November 1983 through December 1984.
PMM did not "[s]tand[ ] idly by while knowing [it's] good
name [was] being used to perpetrate a fraud," Rudolph v. Arthur
Andersen & Co., 800 F.2d 1040, 1044 (11th Cir. 1986), because
it had no knowledge of the fraud.
"Participations" in Banker's Acceptances
A fundamental prerequisite to a claim under section 10(b) is
the existence of a
misrepresentation made in connection with the purchase or sale
of a "security" as that term is defined by the securities laws.
Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 95 S.Ct.
1917, 44 L.Ed.2d 539 (1975); Tcherepnin v. Knight,
389 U.S. 332, 88 S.Ct. 548, 19 L.Ed.2d 564 (1967). If the transaction
does not involve a "security," the court lacks subject matter
The banker's acceptances allegedly purchased by two of the
banks and the two savings and loan associations on whose behalf
plaintiff asserts the claim were transactions or participations
in non-existent Morgan Guaranty banker's acceptances with
maturities of less than nine months.*fn10
Banker's acceptances and participations therein with
maturities not exceeding nine months are themselves exempt from
the definition of "securities" under Section 3(a)(10) of the
the term "security" . . . shall not include . . .
any . . . banker's acceptance which has a maturity
at the time of issuance of not exceeding nine
months. . . .
15 U.S.C. § 78c(a)(10).
Although the complaint makes other claims, it is clear and
stated in the confirmations of the transactions that what each
of the financial institutions believed it purchased here was a
banker's acceptance; not a participation in a banker's
acceptance. Because the banker's acceptances did not exist, the
only tangible evidence of the transactions and of what was
being bought and sold are the confirmations sent by Parr and by
Posey, Bryan & Associates, the broker on the transactions. In
the "Description" section of the Parr confirmations and in the
"Security Description" section of the Posey, Bryan
confirmations, the same words appear: "Morgan Guaranty BA."
While each bank purchased items with different values, none of
the transaction documents contain references to
"participations." In addition, three of the four institutions
listed "Morgan Guaranty Banker's Acceptance" (or some variation
of those words), not participations, on their customer claims
forms for the purposes of the Parr liquidation proceedings
conducted by plaintiff. Because banker's acceptances are exempt
non-securities under the Exchange Act, this court has no
subject matter jurisdiction over the four claims based on
purchases of the banker's acceptances.
Even if "participations" were sold, such participations were
not "securities" for the purposes of the Exchange Act.
A participation in a banker's acceptance gives the purchasers
an interest in that banker's acceptance. It does not give the
purchaser an undivided interest in a pool of banker's
acceptances. It is only a partial interest in an exempt
underlying security and shares all of the underlying banker's
acceptance's attributes: e.g., risk and maturity.*fn11 Because
a participation in a banker's acceptance does not have an
identity separate from the banker's acceptance, the
participation is not a "security" for purposes of the Exchange
Act. However, participations in non-exempt securities are not
exempt from the Exchange Act. 15 U.S.C. § 78c(a)(10); see, Gary
Plastic Packaging Corp. v. Merrill Lynch, Pierce, Fenner &
Smith, Inc., 756 F.2d 230 (2d Cir. 1985) (undivided interest in
a pool of exempt certificates of deposit is not an exempt
Furthermore, there is no reason to remove this type of
short-term commercial lending transaction from the class of
non-securities. See Reves v. Ernst & Young, ___ U.S. ___, 110
S.Ct. 945, 108 L.Ed.2d 47 (1990). The expert testimony of
Anthony Mottola at the Rule 43(e) hearing showed
that purchasers of participations in a banker's acceptance
(generally financial institutions) are looking for a low risk,
short-term, fixed interest rate investment. There is no
significant secondary market for such participations; investors
generally have the intention of holding the participations to
maturity. Investments in participations of a banker's
acceptance are investments in the short-term money market.
Because no purchase or sale of a "security" was made in four
of the five transactions at issue on Count II, this Court does
not have subject matter jurisdiction over those four claims for
that reason alone.
Standing of the SIPC Trustee
In Count II, Mishkin was attempting to assert claims that
belong to the five financial institutions as their assignee, or
as SIPC's subrogee in two cases, albeit that SIPC is not the
party plaintiff herein. It was expressly the position of the
liquidating trustee that he was suing solely for the benefit of
the five financial institutions claiming to be Parr customers.
Mishkin submitted that he is statutorily authorized to bring
fraud claims against third parties on behalf of customers of
the Parr estate under SIPC liquidation because the financial
institutions, the customers involved, have either assigned
their rights to Mishkin, the liquidator of the estate, or have
taken payments from SIPC subrogating Mishkin to their customer
a. Assignments from Banks
As one means of asserting the claims of the financial
institutions in Count II, Mishkin relies on "assignments"
purporting to authorize Mishkin to pursue the claims against
Peat Marwick on behalf of the financial institutions. However,
plaintiff, as a SIPC trustee, is not authorized by statute to
take any assignments from the three bank customers, or to
assert claims of any customer bank for that matter.
Leaving aside possible infirmity arising from the fact that
the "assignments" were executed in August 1987, more than one
year after the filing of this lawsuit, and assuming arguendo
that assignments may be taken before a commitment to pay claims
is made, Mishkin still may not assert assigned claims from a
The subsection of SIPA authorizing assignments, 15 U.S.C. § 78fff-2(b),
is titled "Payments to customers" and concerns
SIPC payments for net equity claims to customers.*fn12
However, § 78fff-2(b) specifically limits payments to the same
class of customers delineated in § 78fff-3(a). § 78fff-3(a)(5)
excludes banks acting on their own account, not on behalf of
customers, from the definition of "customer" for purposes of
SIPC advances, thereby removing the right of banks to advances
for net equity claims.*fn13
Furthermore, § 78fff-2(b) only allows the trustee to
condition payments "pursuant to this subsection" upon the
receipt of assignments. "This subsection" is specifically
concerned with customers' net equity claims against the estate
under SIPA liquidation. Payments "pursuant to this subsection"
are payments of customer net equity claims against the estate
in liquidation and nothing else. Payments of other claims are
considered in other sections of SIPA. Since the SIPC trustee
may not make customer net equity payments to banks, it may not
make payments "pursuant to this subsection" to banks.
The claims of the three banks asserted in Count II were not
net equity claims for the recovery of customer's property or
money entrusted to Parr; they were claims on a supposed chose
in action of its customers against a third party. The trustee
had no statutory authority to act on an assignment of such a
chose in action belonging to a customer. See SIPC v. Vigman,
803 F.2d 1513, 1520 (9th Cir. 1986) (SIPC may only pursue
claims when funds
have been advanced against net equity claims).
Because assignments may only be taken as a condition of
payment, the Trustee may not act on behalf of the banks. The
financial institutions themselves have never asserted any claim
Nothing in SIPA enables a SIPC, or indeed even a bankruptcy,
trustee to collect money not payable to the estate in
liquidation. This is clear from the language of the statute,
the purpose of the statute as revealed in the legislative
history, and the writings of SIPC attorneys and other
1. History of SIPA
The late 1960's saw a rash of broker-dealer failures and the
concomitant loss to investors of their investments. While the
New York Stock Exchange had set up a trust funded by
contributions from Stock Exchange members, the Exchange was
under no compulsion to compensate anyone and customers of
broker-dealers that were not members of the Stock Exchange had
no protection. In addition, it was clear that there was not
enough money to compensate all potential claimants of insolvent
broker-dealers. In order to remedy this situation, Congress
enacted the Securities Investor Protection Act ("SIPA"), Pub.L.
91-598 (codified as amended at 15 U.S.C. § 78aaa et seq.). See
generally, SIPC v. Barbour, 421 U.S. 412, 95 S.Ct. 1733, 44
L.Ed.2d 263 (1975); Bloomenthal & Salcito, Customer Protection
From Brokerage Failures; The Securities Investor Protection
Corporation and the SEC, 54 U.Colo.L.Rev. 161 (1983); Focht,
The Securities Investor Protection Act, 501 PLI/Corp 243
(Corporate Law and Practice Course Handbook Series,
Broker-Dealers 1985: Regulation and Litigation) (1985).
The House Report made clear what the primary purposes of SIPA
The primary purpose of the reported bill is to
provide protection for investors if the
broker-dealer with whom they are doing business
encounters financial troubles. In these
circumstances public customers sometimes encounter
difficulties in obtaining their cash balance or
securities from broker-dealers. . . . The proposed
legislation would provide for the establishment of
a fund to be used to make it possible for the
public customers, in the event of the financial
insolvency of the broker, to recover that to which
they are entitled. . . .
H.R.Rep. No. 91-1613 reprinted at 1970 U.S.Code Cong. &
Admin.News at pp. 5254, 5255.
In addition to the congressional report, the remarks of the
individual senators and representatives show that the intent of
the statute was to protect individual investors from losing
their investments when broker-dealers failed. The purpose of
the bill was to "protect[investors] . . . from losses because
of the failure of their brokers." 116 Cong.Rec. 40868 (1970)
(statement of Sen. Muskie); see also id. at 40869 (statement of
Sen. Bennett); id. at 40885 (statement of Sen. Cranston); id.
at 40890 (statement of Sen. Proxmire); id. at 40901 (statement
of Sen. Brooke). "[The legislation] is intended to protect the
consumers and those who invest." 116 Cong.Rec. 39346 (1970)
(statement of Rep. Staggers); see also id. at 39352 (statement
of Rep. Rostenkowski); id. at 39353 (statement of Rep.
Anderson); id. at 39353-54 (statement of Rep. Rangel); id. at
39362 (statement of Rep. Springer).
The basic scheme of SIPA is to create a preferred class of
creditors. Investors who had left identifiable securities in
their name with the broker-dealer or who had left cash balances
to be used for investment purposes with the broker-dealer
(which together are referred to as "net equity claims") are
entitled to receive such securities and cash from the
liquidator before other creditors may share in the estate.
15 U.S.C. § 78fff.*fn14
As one means of expediting the recoveries of customers of
bankrupt brokers, Congress gave SIPC the power to make advances
of SIPC money for customers' net equity claims:
(a) Advances for Customer Claims. — In order to
provide for prompt payment and satisfaction of net
equity claims of customers of the debtor, SIPC
shall advance to the trustee such moneys . . . to
pay or otherwise satisfy claims . . .
15 U.S.C. § 78fff-3.
Originally set at a maximum of $50,000, Congress, in 1980,
raised the amount that may be advanced to $500,000, no more
than $100,000 of which may be in cash. Pub. Law. 96-433
(codified at 15 U.S.C. § 78fff-3).
The ability quickly to pay off net equity claims of customers
is the most important feature of SIPA. See 116 Cong.Rec. 39353
(statement of Rep. Anderson) ("The important aspect of this
provision is the prompt payment feature which avoids lengthy
delay which otherwise might result if customers had to wait
until the completion of the liquidation proceeding."); 116
Cong.Rec. 40905 (statement of Sen. Bennett) ("The protection
afforded by this bill could not be effective unless the means
were given for those customers to promptly receive their
securities. This is the basic purpose of the legislation.").
In return for advances made to customers, SIPC becomes
subrogated to the net equity claims of such customers against
the debtor. 15 U.S.C. § 78fff-3(a). Only the two savings and
loan associations received advances from SIPC.
2. Standing to Assert Subrogation Rights
As outlined above, SIPC is subrogated to customer claims it
pays off. The subrogation rights that may be enforced are those
"provided in this chapter." 15 U.S.C. § 78fff(a)(3). The only
subrogation rights "in this chapter" are found in §§ 78fff-3(a)
and 78fff-4(c). Because the subrogation rights found in §
78fff-4 are not applicable to a liquidation proceeding, the
subrogation rights in issue here are those found in §
78fff-3(a) which reads, in relevant part:
To the extent moneys are advanced by SIPC to the
trustee to pay or otherwise satisfy the claims of
customers, in addition to all other rights it may
have in law or in equity, SIPC shall be subrogated
to the claims of such customers with the rights
and priorities provided in this chapter . . .
"Claims of customers" are defined as net equity claims against
the debtor. Id. They are not claims that third parties have
defrauded a customer. Cf., 15 U.S.C. § 78fff-4(c) ("SIPC shall
be subrogated to the claims of such customers against the
member."); see also Focht, The Securities Investor Protection
Act, supra ("SIPC [is] subrogated to customer claims paid").
The fact that the Trustee is subrogated only to claims [as
defined in the statute] against the debtor is also made clear
in § 78fff-2(c)(1)(C) which provides for the allocation of
customer property upon liquidation of a broker-dealer. Third in
line in the allocation is "SIPC as subrogee for the claims of
customers." In other words, SIPA provides for SIPC's recovery
as subrogee to come from the estate of the debtor.
Besides the congressional debates and the language of the
statute, the courts have stated that SIPA was never intended to
protect claims against third parties based on fraud and that
the trustee may not sue for such claims. See SIPC v. Vigman,
803 F.2d at 1517 n. 1:
SIPC's allegations show a fraudulent market
manipulation scheme which, if true, might support
securities fraud recoveries for those in the class
action who bought stock at inflated prices and
held either the stock or a net equity claim for it
when prices fell.
For example, if a broker used fraudulent means to
convince a customer to purchase a stock and the
customer left that stock with the broker, who
became insolvent, SIPC would be required by SIPA
only to return the stock to the customer. . . .
The customer would retain any securities fraud
claim against the broker for inducing the purchase.
If the stock in question were missing from the
broker's inventory . . . [h]ere too the customer
would retain any securities fraud claim against
the broker for inducing the original purchase.;
see also SIPC v. Charisma Sec. Corp., 371 F. Supp. 894, 899 n. 7
(S.D.N.Y.), ("general contract and fraud claims as well as
claims for market losses against brokerage houses are not
included in the insurance umbrella afforded by SIPC. . . ."),
(2d Cir. 1974); In re Government
Securities Corp., 90 B.R. 539, 541 (S.D.Fla. 1988) ("[I]t seem
plain that SIPA's primary intent and policy are to protect
customer securities being held for them by a broker-dealer,
rather than to serve as a vehicle for the litigation of claims
of fraud or violations of Rule 10b-5." (quoting In re MV
Securities, Inc., 48 B.R. 156, 160 (S.D.N.Y. 1985))); Focht,
The Securities Investor Protection Act, supra (citing cases).
In sum, SIPA was intended only to protect individual
investors from the loss of their investment if the
broker-dealer became insolvent. In order to speed their
recovery of their investments, SIPC was authorized to advance
payments of the customer's net equity claim against the estate.
In return, SIPC (not a SIPC trustee) becomes subrogated to such
claims of customers against the estate.
Policy issues are also implicated here. If SIPC were allowed
to press fraud claims of individual customers against third
parties it would defeat the purpose of the preference system
set up by Congress.
Count II is not an action for retrieval of customer property.
It is an action for securities law fraud. Pursuit of such a
claim by a liquidating trustee is preferential to those who
c. Common Law Subrogation Rights
Plaintiff argues that even if the statute does not explicitly
grant SIPC the subrogation rights claimed here, the Second
Circuit Court of Appeals, in Redington v. Touche Ross & Co.,
592 F.2d 617 (2d Cir. 1978), rev'd on other grounds,
442 U.S. 560, 99 S.Ct. 2479, 61 L.Ed.2d 82 (1979), found that SIPC has a
"general common-law right of equitable subrogation." Id. at
The Supreme Court expressly did not consider this question in
reversing on other grounds. 442 U.S. at 567 n. 9, 99 S.Ct. at
2484 n. 9.
In reaching its decision, the circuit court relied on a
common-law right stated in 31 N.Y.Jur., Insurance § 1620 at
510. However, SIPA is not an insurance statute and was not
intended to be an insurance-type statute. Its roots are in
section 60(e) of the old Bankruptcy Act. 11 U.S.C. § 96(e)
(1976). See 116 Cong.Rec. 40905 (1970) (Statement of Sen.
Bennett) (SIPA liquidations "are to be conducted as if they
were under section 60(e) of the Bankruptcy Act, which section
is the present bankruptcy law governing the liquidation of
stock-brokers. . . . The actual liquidation procedure will be
conducted in accordance with, and as though it were being
conducted under the provisions of Chapter 10 of the Bankruptcy
Act. . . ."); Focht, The Securities Investor Protection Act,
supra. The Second Circuit had previously rejected an analogy to
the Federal Deposit Insurance Act (FDIA). The court stated:
SIPC v. Morgan, Kennedy & Co.,
, 1318 (2d Cir.)
(emphasis supplied), cert. denied, sub nom., Trustees of
Reading Body Works Inc. v. SIPC,
49 L.Ed.2d 387 (1976). An application of insurance principles
Nor did the addition of the words "in addition to all other
rights it may have at law or in equity" to what is now §
78fff-3(a) give the trustee the power to bring this claim. §
78fff-1 expressly limits the powers and duties of a SIPA
trustee. The trustee may only exercise the same powers as a
bankruptcy trustee plus those additional powers granted by
SIPC.*fn16 15 U.S.C. § 78fff-1(a); see also S.Rep. 95-763
reprinted in 78 U.S.Code Cong. & Admin. News at pp. 764, 775
(same). The liquidating trustee is not granted the power to
bring fraud claims against third parties on behalf of
Regardless of the subrogation of the claims of the two
savings and loan associations (St. Clair and City Federal),
SIPC has not sued herein. Moreover, the bankers acceptances
which they purchased are exempt from the Exchange Act; they are
not securities under federal law.
On both counts, the complaint is dismissed in all respects,
with costs. The foregoing shall constitute the findings of fact
and conclusions of law required by Rule 52(a), Fed.R.Civ.P.