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MISHKIN v. PEAT

United States District Court, Southern District of New York


August 22, 1990

EDWIN B. MISHKIN, AS TRUSTEE FOR THE LIQUIDATION OF THE BUSINESS OF PARR SECURITIES CORP., PLAINTIFF,
v.
PEAT, MARWICK, MITCHELL & CO., DEFENDANT.

The opinion of the court was delivered by: Milton Pollack, Senior District Judge.

      OPINION AND DECISION

The claims in this case were tried to the Court at a Bench trial. Jurisdiction of the separate Counts in the complaint rests on separate grounds.

Jurisdiction of Count I of the complaint herein is posited on the ground that the plaintiff is a SIPA trustee and that Count I thereof is related to a proceeding conducted in accordance with and as though under Title 11 of the Bankruptcy Code. 28 U.S.C. § 1334(b); 15 U.S.C. § 78fff(b).

Count I of the complaint asserts a state law claim for alleged negligence of a firm of certified public accountants in their performance of a 1983 audit for Parr Securities Corporation ("Parr").

Jurisdiction of Count II is posited on a federal question.

Parr was a non-public registered broker-dealer organized in 1981 as a special purpose wholly-owned subsidiary of Kenney & Branisel, Inc. ("K & B"), a non-public company. The principal owners and key management of K & B were also the sole directors of Parr. In December, 1984, K & B sold Parr to the latter's president, Gregory F. Herbert ("Herbert") who remained its sole owner for the balance of its business existence. In May, 1985, Parr was placed in liquidation by Court order.

Defendant Peat, Marwick, Mitchell & Co. ("PMM") (now KPMG Peat Marwick) is a partnership engaged in providing professional services, including auditing services. PMM audited and reported on Parr's financial statements as of and for the year ended October 31, 1983 — the only audit services at issue in this action. PMM's audit report was issued on December 30, 1983.

Plaintiff Edwin B. Mishkin ("Mishkin") was designated by Court order dated May 17, 1985, as Trustee for the Liquidation of the Business of Parr pursuant to the Securities Investor Protection Act ("SIPA"), 15 U.S.C. § 78aaa, et seq. The Securities Investor Protection Corporation ("SIPC") is not a party to this case. Nor are any of the customers of Parr parties to this litigation. The audit was not performed for or requested by customers of Parr. There was no knowledge of or reliance by any customer of Parr on the audit, and the customers themselves never asserted, nor indeed do they have, any cognizable claim to assert against the auditors.

Count I

The setting for the audit

On October 31, 1983, capital and surplus of Parr were intact if the balance sheet was accurate. In reality, both capital and surplus had been wiped out and Parr was insolvent. The books had been falsified by Gregory F. Herbert, Parr's president at the time so as to conceal substantial "off-book" transactions and frauds. The balance sheet corresponded to Parr's books. Herbert's off-the-book transactions were made in the belief that the adverse market which the transactions experienced was bound to turn and the transactions saved thereby with no one the wiser. However, the persistent decline in the market disappointed such hopes and expectations. The house of cards collapsed in May, 1985. A confession by Herbert to the Securities & Exchange Commission ("SEC") on May 3, 1985, unearthed the truth. The trustee's two year investigation of the confession with the aid of a skilled investigative team pieced together how Herbert was able to commit and conceal his frauds.

Herbert pleaded guilty to the frauds and was sentenced to three years in prison.

The Trustee's Claim

Briefly, plaintiff alleges: (1) that Herbert caused Parr to engage in speculative securities transactions in 1983 which resulted in approximately $3.5 million in trading losses to Parr; (2) that Herbert on behalf of Parr replenished those losses by inducing certain large institutional customers to engage unwittingly in sham repurchase transactions;*fn1 (3) that the funds from these sham transactions were deposited by Herbert into a secret off-book account at Chemical Bank and then utilized on behalf of Parr to pay its trading losses; (4) that Parr's 1983 financial statements were misstated as a result of the omission therefrom of Parr's trading losses; and (5) that PMM negligently failed to discover those misstatements during its audit of Parr's 1983 financial statements.*fn2

Plaintiff has speculated on the basis of testimony of a former SEC accountant that, but for PMM's non-discovery of Parr's financial misstatements, Parr would have been closed down by regulatory authorities at the end of 1983.*fn3

It is not disputed that Parr's 1983 trading losses and fraudulent transactions were successfully buried and hidden from, and remained undiscovered and unsuspected by, (i) Parr's trained internal auditing personnel, (ii) from PMM, (iii) from the auditors of the New York Stock Exchange ("NYSE"),*fn4 and (iv) from the SEC by means of various fraudulent devices including:

  — destruction and alteration of Parr's books and
    records;

  — collusion with third parties to obtain
    pre-printed blank trading statements from a
    futures commission merchant so that false
    documents could be created;

  — use of a secret "Parr" entitled account at
    Chemical Bank through which fraudulently obtained
    funds could be used to cover the hidden trading;
    and

  — failure to record the fraudulent transactions on
    Parr's books and records.

The Auditors Were Not Negligent

The plaintiff has failed to sustain factually his burden of proof of negligent breach of duty on the part of the defendant. The supporting grounds for the auditing acts of defendants were substantial and were established by the evidence and circumstances.

It has been affirmatively established by testimony, which the Court credits, that under all the facts and circumstances in evidence, the defendant exercised due professional care with reasonable professional judgment, acted in good faith in performing the audit and was not guilty of any inattention to the task or of negligence therein. Reasonably sufficient work was done on the audit; the work was competently planned, carried out, reviewed and completed in substantial conformity with the applicable generally accepted auditing standards of the profession, the regulatory requirements and the internal standards of the defendant itself, using permissible and reasonable auditing judgment in the circumstances presented. There were no sufficient circumstances to arouse suspicion or provide notice to the auditors, actual or constructive, of the fraudulent acts and criminal designs of Herbert carried out in the name of and the hoped-for benefit of Parr. The defendant had no sufficient reason or occasion to suspect the books and records of Parr which it was auditing. The criticisms of the audit by the trustee were made from the vantage point of highly costly hindsight wisdom and an undue intolerance of permissible judgmental limits.

On the totality of the evidence, and having seen and heard the witnesses I have resolved the issues of credibility in favor of the defendant and against the plaintiff. Defendant's witnesses proved to be persons worthy of belief, with impressive and lengthy professional backgrounds of vast practical experience in auditing businesses of brokers and dealers, with ample peer recognition of their professional competence, judgment and standing in the profession. PMM's interpretations and exercise of practical judgment in conducting the audit were acknowledged by plaintiff's expert, Daniel Rosenthal, to have been made by PMM in good faith and with their honest professional belief that they were in conformity with generally accepted auditing standards and with the regulatory and PMM's in-house requirements. He conceded that staffing, supervision, planning and execution of an audit were judgment calls; that: "One auditor could disagree with another and they could both be reasonable in their view."; and further that: "Q. Now, the question of reasonable adherence to the standards, in your view, is a judgment matter? A. Yes, I think it is."

In Greater Detail

Applicable Legal Considerations

For negligence, as distinguished from reckless misrepresentation amounting to fraud (not here claimed), an accountant is responsible only to his client, Ultramares Corp. v. Touche, 255 N.Y. 170, 174 N.E. 441 (1931), and to those members of a limited class whose reliance on the accountant's service was or at least should have been specifically foreseen. White v. Guarente, 43 N.Y.2d 356, 372 N.E.2d 315, 401 N.Y.S.2d 474 (1977). See also, Credit Alliance Corp. v. Arthur Andersen & Co., 65 N.Y.2d 536, 483 N.E.2d 110, 493 N.Y.S.2d 435 (1985).

PMM furnished its audit with the express caveat:

  This report is intended solely for the use of
  management, the National Association of Securities
  Dealers, the New York Stock Exchange, Inc. and the
  Securities and Exchange Commission, and should not
  be used for any other purpose.

December 9, 1983

/s/ Peat Marwick, Mitchell Co.

No claim is made in this case (certainly there was no proof) that any third-party or customer of Parr ever saw or relied on or expected to see the questioned audit.

Parenthetically, it may be noted in respect to the regulatory filing with the SEC that even where an auditor might incur liability under federal law to members of the public, including lenders, that does not suffice to create liability under state law. Westpac Banking Corp. v. Deschamps, 66 N.Y.2d 16, 484 N.E.2d 1351, 494 N.Y.S.2d 848 (1985). There is no such question raised in this case, at all events. This audit report was not a prospectus published for the use of investors or traders; no one relied on the audit for transactions made in the post-audit period and there is no proof that Parr relied on it to conduct its fictitious transactions or its market trading.

The plaintiff has created the aura in this case (while actually not claiming) that any deviation from regulatory requirements, from generally accepted accounting standards ("GAAS"), from the accounting profession's published Guidelines and even from PMM's in-house auditing principles, is per se negligence. None of the accounting standards, the guidelines or the law warrant such a conclusion. Certainly, deviation from the standards or guidelines may be some evidence of negligence and deviation does cast on the auditors a trial burden of explanation. But the plaintiff's burden of proof on the whole case to establish negligence of an audit remains on the plaintiff nonetheless.

An auditor who undertakes to examine the books and audit the accounts of a client does not guarantee the correctness of the accounts. He does undertake to use skill and due professional care and to exercise good faith and to observe generally accepted auditing standards and professional guidelines, with the appropriate reasonable, honest judgment that a reasonably skillful and prudent auditor would use under the same or similar circumstances. He is not responsible for mere error of judgment. Reasonable adherence to the standards is a matter calling for application of experience, skill and the exercise of independent judgment. The standards concern themselves not only with the auditor's professional qualities but also provide that judgment may be exercised by him in the performance of his examination and in his report. Deviation from standards does not perforce thereof spell negligence in an audit, nor are innocent blunders culpable fault.

Parr's Representations to PMM:

Parr's management was responsible for the accuracy of Parr's financial statements and for ensuring compliance with the NYSE and SEC rules.

On December 9, 1983, Parr, in writing, over the signature of Gregory F. Herbert, its president, and Robert C. Hawk, its treasurer, confirmed Parr's representations to PMM in connection with the audit:

1. We have made available to you:

a. All financial records and related data.

2. There have been no:

    a. Irregularities involving any member of
    management or employees who have significant
    roles in the system of internal accounting
    control.

    b. Irregularities involving other employees that
    could have a material effect on the financial
    statements.

    d. Violations or possible violations of laws or
    regulations the effects of which should be
    considered for disclosure in the financial
    statements or as a basis for recording a loss
    contingency.

3. There are no: . . .

    b. Material liabilities or gain or loss
    contingencies that are required to be accrued or
    disclosed by Statement of Financial Accounting
    Standards No. 5.

    c. Material transactions that have not been
    properly recorded in the accounting records
    underlying the financial statements.

4. Provision, when material, has been made for:

    a. Loss to be sustained in the fulfillment of,
    or from inability to fulfill, any purchase or
    sales commitments.

  8. The following have been properly recorded or
  disclosed in the financial Statements:

    a. Related party transactions and related
    amounts receivable or payable, including sales,
    purchases, loans, transfers, leasing
    arrangements, and guarantees.

    b. Capital stock repurchase options or
    agreements or capital stock reserved for
    options, warrants, conversions, or other
    requirements.

    d. Agreements to repurchase assets previously
    sold.

Plaintiff's expert witness acknowledged, as a fair statement, that:

  PMM was entitled to rely on the truthfulness of
  management representations to the extent they
  didn't have evidence to the contrary . . .

 
In fact, each of those representations was materially false and fraudulent.

Herbert was a witness called on by the plaintiff at the trial. His testimony purported to reveal his concealed misconduct, which he kept off-books, and what he hoped Parr would accomplish thereby. He testified:

  I would lose money legitimately and then get
  involved in bogus repurchase agreements or bogus
  sales of bankers acceptances which didn't exist to
  draw money in to pay off the losses . . .
  fictional collateral.

  Q:  You were trying to make profits for Parr,
      weren't you?

A:  Yes.

  Q:  Among the hopes for your conduct in these
      transactions was the hope that one day the
      market would turn and you would be on a course
      where you were making money, making all the
      money back that you had borrowed in one form
      or another and pay everybody off, isn't that
      so?

A:  Yes.

After Herbert's confessions to the SEC followed by sessions with the trustee and his representatives, which provided a detailed road map of his irregularities, there followed a two-year re-audit therefrom to trace and to establish all the accounts and transactions and records thereof.
*fn5 Peterson & 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:

  Q:  It took everybody by surprise, despite the
      lifeboats that were created to prevent it?

A:  The simple answer to your question is yes.

With a prescience born of hindsight and Herbert's detailed confessions, plaintiff's expert gave the conclusory opinion that:

  I believe that while perhaps his fraud, if I can
  use that word, might have been discovered, I
  believe that in the case of this audit, had the
  procedures followed by the auditors been
  sufficient, they would have discovered that the
  underlying books and records of Parr Securities in
  1983 were to a great extent a work of fiction with
  regard to the trading activities of the company
  and totally unreliable.

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:

  No doubt the wisdom that is born after the event
  will engender suspicion and distrust.

Ultramares v. Touche, supra, 255 N.Y. at 179, 174 N.E. 441.

The Claimed Auditing Faults

Plaintiff's expert has singled out six areas in which plaintiff claims that Peat Marwick's audit was materially lacking: 1) inadequate supervision and staffing of the Parr audit by the Peat Marwick management; 2) inadequate time spent on the audit; 3) failure to discuss the audit with the appropriate Parr management; 4) failure to confirm the Chicago Grain account; 5) failure to perform compliance tests on Parr's internal auditing procedures, allegedly in violation of § 17(a) of the Securities Exchange Act of 1934 ("1934 Act"), 15 U.S.C. § 78q(a), and the rules promulgated thereunder; and 6) failure to comport with certain federal reporting regulations by failing to report an instance of customer property discovered in Parr's account, allegedly in violation of § 15(c) of the 1934 Act, 15 U.S.C. § 78o(c), and Rule 15c3-3, 12 C.F.R. § 240.15c3-3, promulgated thereunder, and § 17(a) of the 1934 Act and the rules promulgated thereunder. Each criticism will be evaluated in turn. Additional contentions in the record have also been considered and found not to merit separate attention in the overall evaluation of the sufficiency of the audit.

a. Staffing and Supervision of the Audit

The following PMM personnel worked on PMM's audit of Parr's 1983 financial statements: Charles A. Hurty — originally engagement partner and, ultimately, Pre-Issuance Reviewing Partner; S. Leland Dill — engagement partner; Daniel A. McHugh — manager; William C. Handy — in-charge accountant; Gary D. McKiddy — staff accountant; John D. Weisenseel — staff accountant; Stanley J. Kryla — assistant accountant; Jeffrey Seidel — tax manager; and Barry Auerbach — tax partner. Mr. Hurty ceased to function as the engagement partner of the Parr audit in November 1983 when he underwent back surgery, at which time Mr. Dill assumed the responsibilities of engagement partner. Hurty thereafter became the Pre-Issuance Reviewing Partner on the 1983 Audit.

Mr. Rosenthal, plaintiff's expert, initially expressed an opinion that the planning and staffing process conducted by Peat Marwick for the 1983 audit was inadequate because:

  The understanding of the company, its business,
  its transactions, its books and records reflected
  the conditions that pertained at the end of 1982
  rather than during 1983 . . .

  the plan as it continued to be developed during
  the course of the audit was not appropriately
  altered to deal with the changed circumstances of
  the company.

(Tr. 467).
*fn6

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 agreement:

  a repo to me is, in effect, a collateralized
  lending type arrangement. I give you stock, you
  give me money, when at the same time — and then,
  when we're finished, we trade them back again and
  pay interest on the money.

(Tr. 896).

McHugh, unquestionably a seasoned accountant, rejected Rosenthal's criticism by stating that in his judgment, the staff was sufficiently experienced. (Tr. 886). McHugh noted that Kryla, sufficiently experienced himself, was not the only Peat Marwick employee engaged on the Parr audit. William Handy served as the in-charge accountant. While he had "minimal or no experience in connection with examinations of broker-dealers," he was "a second year senior in the firm, and correspondingly he was one year more advanced in his auditing career than the person . . . in charge in the prior year who did have some moderate to low level of broker-dealer experience. . . ." (Tr. 886). In McHugh's judgment Kryla was a "more senior auditor assigned to the engagement" than the auditor of the previous year, to whom neither Parr nor Kenney & Branisel objected. John Weisenseel also was a staff accountant on the 1983 audit; he had served on the 1982 audit and for the 1983 audit he was brought "in during the early start-up phase so that this staff in the field could gain off his experience." (Tr. 887).

McHugh also felt that the audit staff was sufficiently experienced and knowledgeable to understand proprietary trading, as evidenced by the following lengthy colloquy between McHugh and the Court:

  The Court: Well, is the experience level of those
    who were handling the audit sufficient to
    understand proprietary trading and its audit
    incidence?

  The Witness: I think they were, your Honor,
    because — well, for two reasons: My recollection
    is that Bill Handy, in addition to being a
    second-year senior, had some experience with
    investment portfolio work at some of his other
    clients. While that's not specifically
    broker-dealer related, a securities transaction
    is probably much like any other transaction. It
    is a purchase and sale of something with an
    opportunity to make a profit by selling at a
    higher price, et cetera.

    So I think, while I don't remember anything
    specific I wrote, I think the staff had adequate
    knowledge from their general audit experience to
    carry out processes we were doing.

  The Court: In other words, proprietary trading
    didn't pose any specialized background, training
    or experience other than what you would get in a
    normal commercial transaction.

  The Witness: I think there are jargon differences
    and things like different words that are used in
    the securities industry for specific
    transactions, but proprietary trading simply
    means trading on behalf of the firm as the
    proprietor trading.

  Other than the explanation of that terminology,
    that's simply what one is doing: Buying and
    selling securities.

  The Court: Wasn't that a new venture that was
    different from the 1982 audit?

  The Witness: In connection with Parr Securities,
    it was a new type of instrument which they were
    trading. They had been involved, I believe, from
    having reviewed the 1982 work papers over the
    last few days, with some municipal securities
    trading in the prior year. . . . So, yes, it was
    a new venture in the fact that it was government
    securities trading they were doing and the
    futures trading they were doing, but they had
    been doing some trading activities.

(Tr. 893-894).

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 Marwick's management:

Q.  Well, did you disbelieve his testimony?

A.  No.

(Tr. 1291-1292).

  A.  The evidence of [McHugh's] review of the audit
      is all over the work papers, yes.

  Q.  Isn't it also true that many of the work
      papers were created by McHugh?

A.  A number of them were created by McHugh, yes.

(Tr. 699).

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 negligence:

  Q.  So you can supervise people with due care and
      yet not find errors, is that true?

A.  Yes, it is.

  Q.  That's true in all of the financial statements
      as well?

A.  Yes, it is.

  Q.  Is it possible for Mr. McHugh to have used due
      care in supervising the audit team [during]
      the 1983 audit, but failed to find some
      errors?

A.  In a general sense, yes.

(Tr. 770).

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 Parr engagement.

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 audit.

c.  Contact with Appropriate Parr Management

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
  monthly journals.

  I believe that those three roles suggest that he
  is an individual that the auditors should have had
  significant contact with.

(Tr. 497-498).

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 Regan:

  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
    firm.

    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
      & Branisel?

  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
      operations?

A.  Yes.

  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
      audit?

  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
      Parr.

(Tr. 700).

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 October 1983.

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 stated:

  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.

(Tr. 904-905).

Rosenthal admitted:

  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
      fair statement?

  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
      forth, yes.

(Tr. 825).*fn8

e.  Reliance on Internal Controls and Compliance Tests

Peat Marwick's opinion letter stated:

  As part of our examination, we made a study and
  evaluation of the Company's system of internal
  accounting control to the extent we considered
  necessary to evaluate the system as required by
  generally accepted auditing standards and Rule
  17a-5 under the Securities Exchange Act of 1934.
  This study and

  evaluation included the accounting system, the
  procedures followed by the Company in making
  periodic computations of aggregate indebtedness
  and net capital under Rule 17a-3(a)(11) and the
  procedures for determining compliance with the
  exemptive provisions of Rule 15c3-3. . . . Our
  study was more limited than would be necessary to
  express an opinion on the system of internal
  accounting control taken as a whole.

(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:

  Q. And what obligation, if any, does an accounting
    firm auditing a broker-dealer have to learn
    whether such books of original entry, such as
    the blotter you refer to, are, in fact, being
    kept?

  A. Well, the books I just described are important
    in the audit of a brokerage concern for two
    reasons:

    First because the accountant is reporting on
    them in his letter on internal accounting
    control and, second, because they are critical
    elements of the company's accounting system and
    its system of controls and of checks and
    balances.

    An auditor has to perform a study and reach an
    understanding about the system itself, the
    structure of the system, the way it works, the
    controls in place in order to design his audit
    and execute the audit procedures.

  Q. And do professional standards provide the
    auditor to take a further steps and create tests
    to determine whether or not these original
    records in fact reflect the transactions which
    the broker-dealer is counting in? [sic]

A. Yes, they do. . . .

    An auditor may choose to perform detailed tests
    of specific controls in the accounting system,
    of transactions as they flow through the
    accounting system in order to develop a level of
    reliance on that accounting system for use in
    subsequent work, or he could choose to follow a
    slightly different route and perform less
    detailed and substantive procedures.

    However, at a minimum, I believe he should
    perform procedures designed to determine that
    that system exists as documented as he
    understands it and is functioning.

(Tr. 462-464).

  Q. What is your opinion as to whether Peat,
    Marwick needed to do substantive testing or
    compliance testing of those records in order to
    perform an audit in conformity with GAAS and the
    requirements of 17c-5?

  A. I believe that in order to reach the audit
    objectives in their working papers and audit
    planning in conformity with GAAS and 17c-5, they
    should have performed some testing of those
    systems.

  Q. Is there any indication in the work papers that
    they did that work?

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.).

  McHugh stated that he performed the work on the regulatory
compliance in the 1983 Parr audit, which was later reviewed by
Dill. (Tr. 869). McHugh explained that Peat Marwick had
performed a substantive balance sheet audit*fn9 of Parr and
explained

why Peat Marwick had not relied on Parr's internal controls in
performing such an audit:

    . . The reason that for particularly smaller
  securities industry clients we would place no
  reliance on internal control was because of the
  fact that they had a small, small group with
  heavily involved management and there was a
  significant possibility of management override . . .

(Tr. 871). The Court sought clarification of this point:

  The Court: The point is no matter what their
    internal controls were, if they were small
    enough, you would not place reliance on it
    because it wasn't sufficiently objective for
    your purposes?

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

  these manuals that we're looking at are to provide
  guidance to the auditor in connection with the
  manner in which the auditor approaches the
  examination they are conducting. And in each of
  those examinations, the auditor is using their
  professional judgment, their experience, the
  experience of the people who have trained them in
  developing the procedures and the approach which
  they've taken, and that I think is important to
  realize.

(Tr. 1021).

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:

  Well, a substantive balance sheet audit looks at
  all of the major components in the balance sheet
  and requires or tries to achieve virtually a
  hundred percent test verification of the accounts
  in the balance sheet. In doing that, you have an
  opportunity to prove these balances and thereby
  make a judgment on the effectiveness of the
  internal accounting control of the enterprise.

  For example, the bank accounts, confirm the bank
  balances with the bank, review the bank
  reconciliations, the reconciliations prepared by
  the client. Do they agree with the records of the
  company? Yes they do. The controls with respect to
  these accounts appear to be functioning.

  The accounts receivable, does the trial balance
  agree with the subsidiary ledger? Is it in
  balance? Are the confirmations that are received
  back indicative that these accounts are correct?

  Yes, they are. There's an indication that the
  internal controls regarding the accounts
  receivables section are functioning.

  You can go down the balance sheet, including
  inventories, accounts payable, and are all of
  these accounts fairly stated, yes, they are. Can
  you conclude that the controls, the internal
  accounting controls that produce the information
  for these accounts are functioning? I think you
  can, yes.

(Tr. 1112-1113).

On cross examination, Rosenthal made the following concessions regarding Peat Marwick's treatment of Parr's internal accounting controls:

  Q. Isn't it also true that in 1983, the
    substantive balance sheet approach, if executed
    properly, was an appropriate approach in
    auditing a nonclearing broker-dealer like Parr?

A. Yes.

  Q. So at least to the extent that Mr. McHugh and
    Mr. Dill had determined in the plan to do a
    substantive balance sheet audit, they were using
    professional due care to that extent?

  A. [After clarification by the Court that the
    questioner was asking about the planning stage:]
    To the extent that they had a plan to do a
    substantive balance sheet audit and had
    identified all of the appropriate components of
    such a plan, that would have been exercising due
    care.

(Tr. 797-798).

  Q. . . . Is it appropriate under generally
    accepted auditing standards to do a substantive
    balance sheet audit without reliance on internal
    controls, putting aside for the moment whether
    or not you are also going to write this letter
    to the regulators about the internal controls,
    just generally, can you do a GAAS audit that
    way?

A. Yes, you can.

  Q. So at least to the extent that Mr. McHugh and
    Mr. Dill were trying to do a GAAS audit and were
    planning to do a GAAS audit, at least to that
    extent they were using professional due care at
    this point in the plan?

A. To that extent, yes.

(Tr. 799).

Further, Rosenthal conceded the following in regard to whether the trial balances and the balance sheet matched:

  Q. And if the trial balances in the end are deemed
    by the auditors, after the application of all of
    their tests, to be reliable, isn't it fair to
    say that a reasonable auditor can conclude that
    apparently the internal controls over the
    accounting information that gets into the trial
    balance are reliable?

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).

Finally, Rosenthal conceded that:

  The Court: There is always a residual judgment
    factor in the application of GAAS, isn't there?

The Witness: Yes, there is.

  The Court: And that is true also in connection
    with Regulation [Rule] 17?

The Witness: Yes, that is true.

(Tr. 1314).

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 customers.

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.

Rule 15c3-3(k)(2) provides:

  The provisions of this section shall not be
  applicable to a broker or dealer: . . .

  (ii) Who, as an introducing broker or dealer,
  clears all transactions with and

  for customers on a fully disclosed basis with a
  clearing broker or dealer, and who promptly
  transmits all customer funds and securities to the
  clearing broker or dealer which carries all of the
  accounts of such customers and maintains and
  preserves such books and records pertaining
  thereto pursuant to the requirements of §§
  240.17a-3 and 240.17a-4 of this chapter, as are
  customarily made and kept by a clearing broker or
  dealer.

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:

  Q. Is this, in your opinion, a technical
    violation?

  A. No, it's a fundamental violation of the rule to
    claim an exemption and then expose customer
    funds and securities to this type of activity
    without benefit of complying with the rule.

(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:

  A. If there was a violation of the rule, 17a-11
    requires that the auditor notify the firm. The
    firm then would have an obligation to notify the
    SEC under that rule, and if the firm did not,
    the auditor then has an obligation to notify the
    commission.

  Q. Isn't this just a matter of judgment, whether
    the auditor notifies the commission or not?

  A. I don't believe so, sir. The rule is very
    clear, very specific, that the scope of the
    audit should be sufficient to be able to
    determine whether he was complying with the
    exemption as of the audit date.

(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. At the time you and Mr. McHugh talked about
    this and reviewed the situation, did you believe
    that Parr had committed a violation of its
    exemption that required you to report to the
    — that was required to be reported to the SEC?

A. No.

Q. Why not?

  A. Well, it appeared to us, I think, after I
    discussed this with Mr. McHugh, that this was
    inadvertent. And, more than that, as a result of
    the discussion I had with Mr. McHugh — I believe
    his memo reflects it — the security [in
    question] was delivered out on November 1, which
    was a date immediately following our audit date,
    and it had been delivered before we discovered it
    wasn't delivered. So it indicated to me that the
    company was trying to comply with their
    exemption, even though there may have been a
    momentary lapse.

(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 audit?

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.

(Tr. 1232-1233).

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
    less?

(Tr. 1314).

Michael Passarella

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 circumstances.

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 financial principals.

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 financial statements.

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 there is 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

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 follow.

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
  abetting) party;

  (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
  violation.

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 occurred.

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 requirement.

  [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 jurisdiction.

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 Exchange Act:

  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 security).

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 claims.

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 banking institution.

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 against PMM.

b. Subrogation

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 commentators.

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 were:

  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
  subsequently

  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.
  [emphasis supplied]

  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. . . ."), aff'd, 506 F.2d 1191 (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 would recover.

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 624.

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:

  SIPA and FDIA are independent statutory schemes,
  enacted to serve the unique needs of the banking
  and securities industries, respectively. The
  Congress recognized this when it rejected several
  early versions of the SIPA bill which were
  patterned on FDIA and which extended insurance
  coverage to certain beneficial interests
  represented by customer accounts.

SIPC v. Morgan, Kennedy & Co., 533 F.2d 1314, 1318 (2d Cir.) (emphasis supplied), cert. denied, sub nom., Trustees of Reading Body Works Inc. v. SIPC, 426 U.S. 936, 96 S.Ct. 2650, 49 L.Ed.2d 387 (1976). An application of insurance principles of subrogation is seemingly inappropriate.*fn15

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 customers.

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.

Conclusion on Both Counts

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.

So ordered.


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