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August 22, 1990


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


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
  — 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;
  — 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.

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.

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

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
    d. Agreements to repurchase assets previously

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
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
  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 ...

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