The critical issue is that Ernst & Ernst, who were First Securities auditors for more than

two
decades, failed to utilize appropriate auditing procedures which in consequence led to Ernst
& Ernst failure to discover poor internal practices of the firm. Thereby, this prevented Ernst &
Ernst from completing an effective and efficient audit of the brokerage firm, First Securities
Company of Chicago. The discovery of the inappropriate procedures within the brokerage
firm could have led to the uncovering of other fraudulent practices done by the firm; which
could have been prevented and saved investors investments.

The key factors that gives evidence to this issue are as followed:

Critical Factor #1

Mr. Nay had opened up an escrow syndicate fund that was not an asset of First Securities
but was handled by Mr. Nay. The escrow syndicate was only offered to his nearest and
dearest friends who were widows with large amount of money left behind from their
deceased husbands. In addition, he only offered this investment fund to retirees and those
close to retiring. A widow of his close friend, Enrico Fermi testified that Nay managed her
familys investments for many years but did not offer the opportunity to invest in the escrow
syndicate until her husbands death. He betrayed and broke the trust of his investors and
close friends.

This critical factor is relevant to an auditors character of professional skepticism, in which
the auditor should never automatically or fully conclude that all things (financial statements,
accounts, clients, etc.) are 100 percent accurate or truthful, and should be investigated
thoroughly too its full extent.

Critical Factor #2

Leston Nay, the President of First Securities Company of Chicago, had deceived investors
into participating into a fund called the escrow syndicate and continuously cheated them into
thinking that this fund was doing great, when it never was. He continued to take money from
investors for the fund, which he lost in the stock market, that probably never existed. Nay
had successfully concealed the missing funds for as long as he did because he periodically
mailed the investors checks (as if it was coming directly from First Securities Company), for
interest supposedly earned through the escrow syndicate. This shows that his actions were
fraudulent because he deceived others into believing that their investments, which did not
exist, were going well while collecting more money from them.

The escrow syndicate fund could have been prevented or investigated if Ernst & Ernst
discovered the unethical practices held in Mr. Nays firm. In which, leads to our next critical
factor:

Critical Factor #3

Ernst & Ernst failed to detect the Nays mail rule, which was followed by his employees in
the firm. Nays mail rule which stated that only Mr. Nay, himself, had the privilege to open
any and all mail that was addressed to him. In addition, no one was permitted to open these
mails when he was out of the office and allowed them to pile up on his desk, even if they
were directed towards the firm for Mr. Nay's attention.

The mail rule would have initiated an investigation if it was detected and if Ernst & Ernst did
an effective audit of Nays company they would have discover this rule but it went amiss for
two decades under their audit. They didnt practice due professional care and integrity into
their audit. This shows negligence on the behalf of Ernst & Ernst because they did not abide
by the auditing procedures, which could have led to the discovery of this rule. As an auditor
Ernst & Ernst were supposed to plan accordingly before the engagement process and follow
procedures that would grant an increase of assurance to users as to the fairness of the
financial statements. However, this was not the case. In one of the court ruling, it stated that
the brokerage firm had clearly facilitated Nays fraudulent activities.

Furthermore, if the discovery of the mail rule was to happen this would have prevented and
save others from investing into a fund (fraud) personally managed by Mr. Nay. Also, if
proper procedures were taken into effect, the unveiling of the escrow syndicate fund would
have led auditors, Ernst & Ernst to take initiative action in investigating this fund. However,
this was left undetected and gave Mr. Nay the opportunity to act fraudulently toward others.
In addition the defrauded investors argue that if this mail rule was discovered then this would
have led to the investigation of the escrow fund by the Midwest Stock Exchange and SEC,
directing us to critical factor #4.

Critical Factor #4

Investors alleged that the Midwest Stock Exchange failed to adequately investigate Nays
background before admitting his firm into membership; that Nays past unethical conduct
would have forced the exchange to deny his firm a membership application. Possibly putting
a stop to the engaging in an escrow syndicate fraud.

This is relevant because if the Midwest Stock Exchange had investigated Nays background
before allowing him membership in their firm, then Nay would not have been able to use the
Stock Exchange as a back-up in helping him get this fraudulent fund up and running. Also
Ernst & Ernst should have known through financial statements that Nay was in membership
with a stock exchange firm.



Questions:

1. Under present technical standards,would auditors be required to disclose a company
policy similar to Nay's mail rule that they discover during an audit? Explain. Assuming such
disclosure had been required at the time this case took place, would that disclosure have
resulted in the mail rule being discontinued?

Under present technical standards auditors are required to disclose a company's policy, like
Nay's mail rule, and that it is important that auditors further investigate unreasonable policies
a company make if it leads to the weakness of internal control or possibly fraud. Auditors are
also required to report their assessment of internal controls and their opinion on
management assessment of internal control over financial reporting. If these same
requirements of disclosures had been present during the time this case had taken place then
I believe that this mail-rule could have been discontinued since it was a possible lead to
fraud.
2. Ernst & Ernst argued that the mail rule was not relevant to its audits of First Securities
since that rule only involved personal transactions of Nay and the escrow investors. Do you
agree? Why or why not?

I absolutely do not agree with this statement at all. The mail rule was exceptionally relevant
to audits because auditors relies on management financial information in order to report their
opinion on the company they are auditing. Ernst & Ernst should have attested every piece of
information concerning First Securities financials' information and statements that could be
misrepresented by management. In addition, the mail was being sent to his firms office and
this should have alerted the auditors to take a look at it especially since it was address to the
company itself. If it was address to the company it is relevant to the company, and the
auditors should have checked it since it is apart of the procedures. However, since this was
not done, it tells you that proper procedures were not followed and managements word are
not supporting evidence to the assurance of the transactions and events that actually
occurred.
3. Define negligence as that term has been used in legal cases involving independent
auditors. What is the key distinction between negligence and fraud? Between recklessness
and fraud? For all three types of professional misconduct, provide an example of such
behavior in an audit context.

Negligence: the failure to exercise a degree of care that a reasonable person would exercise
under the same circumstances. The key distinction between negligence and fraud is intent.
Negligence has no intentional motives to do wrong, but fraud is done with every intention to
hurt others. Recklessness is known as an unconscious intent to deceive; it has no scienter.
Fraud is a conscious intent to deceive.
Negligence can be found in the Tommy OConnell case, in which Tommy gets caught up in
the auditing of Altamesa Manufacturing Company and fails to properly supervise Carl (a staff
accountant), making sure that Carl did his job as an auditor correctly. Recklessness is seen
when Tommy suspects that Carl had not completed all of his auditing procedures, although
he signed off on them and failed to say anything. The same is with the mail rule policy in our
case with Ernst & Ernst. Instead of opposing this policy, it goes undetected. This should have
been a red flag to auditors to possible intent of fraud. The disregard to this policy was
reckless and later proven to deceive investors.
4. Assume that the investors defrauded by Nay could have filed their lawsuit against Ernst &
Ernst under the Securities Act of 1933. How, if at all, do you believe the outcome of their suit
would have been affected?

If the defrauded investors were able to file the lawsuit against Ernst & Ernst under the
Securities Act of 1933 then they would have gotten some recovery and the only thing they
would have to prove is that information that was provided to them was inaccurate. In addition,
they could have proved it through using the mail rule as evidence because it showed
negligence and fraudulent act on the firms part. If the mail were being piled up there is
something wrong with that and it shows carelessness of the firm.

5. The Restatement of Torts is a legal compendium issued by the American Law Institute.
This compendium is relied on by courts in many jurisdictions as the basis for legal rulings.
Under the Restatement of Torts, courts have ruled that negligent auditors can be held liable
to unknown third parties if those parties belonged to a known group of financial statements
users who the auditors were aware would likely rely on the audited financial statements. If
this legal principle had been invoked in the Hochfelder case, would the defrauded investors
have been successful in pursuing a negligence claim against Ernst & Ernst under the
common law? Why or why not?

I believe that they probably would have been successful since they did rely on the financial
statements of the company that were prepared by the auditors, who did not follow proper
procedures. However, I believe that it would have not worked since the financial statements
were based on the firm and not on the escrow syndicate fund. Therefore, they dont have any
evidential support that can help them hold Ernst & Ernst liable for their negligence.