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MISHKIN v. PEAT
August 22, 1990
EDWIN B. MISHKIN, AS TRUSTEE FOR THE LIQUIDATION OF THE BUSINESS OF PARR SECURITIES CORP., PLAINTIFF,
PEAT, MARWICK, MITCHELL & CO., DEFENDANT.
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
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,
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.
The setting for the audit
Herbert pleaded guilty to the frauds and was sentenced to
three years in prison.
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
— 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
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
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
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."
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.
/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.
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
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
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,
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
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 . . .
Q: You were trying to make profits for Parr,
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
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
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
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 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
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.
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
Other than the explanation of that terminology,
that's simply what one is doing: Buying and
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.
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
Q. Well, did you disbelieve his testimony?
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.
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 ...