Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976)

Ernst & Ernst v. Hochfelder

No. 74-1042

Argued December 3, 1975
Decided March 30, 1976
425 U.S. 185

CERTIORARI TO THE UNITED STATES COURT OF APPEALS

FOR THE SEVENTH CIRCUIT

Syllabus

Petitioner accounting firm was retained to audit periodically a brokerage firm’s books and records. Respondents, who were customers of the brokerage firm, invested in a securities scheme ultimately revealed as fraudulent and perpetrated by the firm’s president and principal stockholder. After the fraud came to light, respondents filed an action for damages against petitioner under § 10(b) of the Securities Exchange Act of 1934 (1934 Act), which makes it unlawful to use or employ "any manipulative or deceptive device or contrivance" in contravention of Securities and Exchange Commission (SEC) rules. It was alleged that the brokerage firm president’s scheme violated § 10(b) and SEC Rule 10b-5, and that petitioner had "aided and abetted" the violations by its "failure" to conduct proper audits of the firm, thereby failing to discover internal practices that prevented an effective audit. The District Court granted petitioner’s motion for summary judgment and dismissed the action, holding that whether or not a cause of action could be based merely on allegations of negligence, there was no genuine issue of material fact as to whether petitioner had conducted its audits in accordance with generally accepted standards. The Court of Appeals reversed and remanded, holding that one who breaches a duty of inquiry and disclosure owed another is liable in damages for aiding and abetting a third party’s violation of Rule 10b-5 if the fraud would have been discovered or prevented but for the breach, and that there were genuine issues of fact as to whether petitioner committed such a breach and whether inquiry and disclosure would have led to discovery or prevention of the president’s fraud.

Held:

1. A private cause of action for damages will not lie under § 10(b) and Rule 10b-5 in the absence of any allegation of "scienter," i.e., intent to deceive, manipulate, or defraud on the defendant’s part. Pp. 194-214.

(a) The use of the words "manipulative," "device," and "contrivance" in § 10(b) clearly shows that it was intended to proscribe a type of conduct quite different from negligence, and, more particularly, the use of the word "manipulative," virtually a term of art used in connection with securities markets, connotes intentional or willful conduct designed to deceive or defraud investors by controlling or artificially affecting the price of securities. Pp. 197-201.

(b) The 1934 Act’s legislative history also indicates that § 10(b) was addressed to practices involving some element of scienter, and cannot be read to impose liability for negligent conduct alone. Pp. 201-206.

(c) The structure of the 1934 Act and the interrelated Securities Act of 1933 (1933 Act) does not support the contention that, since § 10(b), in contrast to certain other sections of these Acts, is not, by its terms, explicitly restricted to willful, knowing, or purposeful conduct, it should not be construed to require more than negligent action or inaction as a precondition for civil liability. In each instance that Congress in these Acts created express civil liability in favor of purchasers or sellers of securities, it clearly specified whether recovery was to be premised on knowing or intentional conduct, negligence, or entirely innocent mistake. The express recognition of a cause of action premised on negligent behavior in § 11, for example, stands in sharp contrast to the language of § 10(b). Moreover, each of the express civil remedies in the 1933 Act allowing recovery for negligent conduct is subject to significant procedural restrictions indicating that the judicially created private damages remedy under § 10(b) -- which has no comparable restrictions -- cannot be extended, consistently with Congress’ intent, to actions premised on negligence, since to do so would allow causes of action under these express 1933 Act remedies to be brought instead under § 10(b), thereby nullifying the effectiveness of such restrictions on those remedies. Pp. 206-211.

(d) While there is language in Rule 10b-5 that could arguably be read as proscribing any type of material misstatement or omission and any course of conduct that has the effect of defrauding investors, whether the wrongdoing was intentional or not, such a reading does not comport with the Rule’s administrative history which makes it clear that it was intended to apply only to activities involving scienter. More importantly, the scope of Rule 10b-5 cannot exceed the power granted the SEC under § 10(b), whose language and history compel interpreting the Rule to apply only to intentional wrongdoing. Pp. 212-214.

2. The case will not be remanded for further proceedings to require proof of more than negligent misfeasance by petitioner, since, throughout the history of the case, respondents have proceeded on a theory of liability premised on negligence, in fact, specifically disclaiming that petitioner had engaged in fraud or intentional misconduct. P. 215.

503 F.2d 1100, reversed.

POWELL, J., delivered the opinion of the Court, in which BURGER, C.J., and STEWART, WHITE, MARSHALL, and REHNQUIST, JJ., joined. BLACKMUN, J., filed a dissenting opinion, in which BRENNAN, J., joined, post, p. 215. STEVENS, J., took no part in the consideration or decision of the case.