First Securities Company of Chicago - Case Study Example

Summary of the Case This case is basically reflecting on the roles and responsibilities of various stakeholders in the investment industry. This casestudy also describe the rise and fall of the Leston Nay and how his firm continued to defraud its investors by providing wrong information to make investment into the Escrow Syndicate which comprised of those companies which required urgent working capital to fund their working capital shortage and therefore offered higher interest rates than most of the alternative investments could provide. Above all, this case study also indicates the relative confusion over the fixing of the responsibility of the failure of Nay’s firm to protect the interests of the investors. The defrauded investors referred the matter to the court and accused multiple parties including Midwest Stock Exchange, Nay’s firm- First Securities Company of Chicago and finally its Auditors Ernst & Ernst. The final legal battle that is described in this case is therefore based upon the final interpretation of the rule 10b-5 of The Securities Exchange Act 1934 which deals with the employment of the deceptive and manipulative devices. Court Ruled that the principle of being Scienster however, the decision still left many important questions unanswered which were finally corrected through a Bill in 1978 when Auditors were finally held civil liable to investors who relied on false information presented in the Financial Statements and duly audited by the auditors. The Critical Issue The critical issue is the fact that there were lapses in the existing regulatory environment which allowed Nay to commit such crimes and prevented auditors from taking appropriate steps to inform the investor well ahead of time for the potential implications of the practice of Nay. Critical Factors 1. Lack of Internal Controls: this was probably one of the most critical aspects of the whole situation because neither the firm nor the auditors were able to diagnose any problem with the internal controls which resulted into loss to the investors. This factor offers a critical opportunity to understand the impact of negative events on the performance of the firm as any general lack of 2. Lax interpretation of regulations allowed many important stakeholders to remain unaccountable to the investors. The firm itself was unaware of the practices that were carried on by the CEO of the firm however; most of the executives were absolved of anything which may again create an incentive for others to commit such acts because the final onus of the responsibility fell on the auditors. This critical factor is important from the perspective of fixing the responsibilities. 3. Lack of oversight by the investors is another critical factor that indicates the relative extent of the problem. This is important because investors trusted Nay blindly and failed to continusely monitor the activities of its brokers and its reputation as well as their own portfolio. This factor is relatively important because it indicates the lack of role of the external stakeholders in regulating the affairs of the firm and their failure to act accordingly. Q#3 1) Disclosure requirements are mostly based on the principle of materiality therefore if auditors find that the mail rule can have significantly impact on the financial statements than the disclosure would have been relatively more critical and the information presented in such disclosure could have been of material importance to the investors. Further, it is also critical to note that the disclosure by the auditors regarding rules like mail rule may not prevent such rules being totally scrapped until it is not approved by the Board of the firm or other competent authority to scrap the rule. 2) To some extent this argument may be correct because Nay was dealing with some of the closet friends of him who were investing solely based on the services provided by the Nay privately. However, this argument can also be faulty in the sense that Nay was acting as a custodian of the investors’ money and as such the money was managed in the name of First Securities Company of Chicago therefore the mail rule was relatively more significant for the purpose of audit and auditors should have considered this role only once they assess that its disclosure will be based on the principles of materiality. 3) The term negligence is used in two perspectives i.e gross negligence refers to the violation of the established rules and practices of accounting and auditing whereas ordinary negligence occurs due to lack of knowledge, training and expertise. The key distinction between negligence and fraud is the intent of the auditors. If the auditors willfully commit negligence the same can be considered fraud whereas recklessness is again an action that has been taken in violation of the established rules and practices of the accounting and auditing however, the outcome of the recklessness may not entirely be material to the investors of the firm. 4) This may not have been possible owing to the fact that it is 1934 act which empower an ordinary citizen to pursue a case against a security firm owing to the company’s failure to provide the timely and accurate information. However, the 1933 act is not quite explicit in this and as such the overall outcome of the case would have been different and the Accounting firm may have been in better position to dominate the overall outcome of the case and investors may not have been benefited from this. 5) The Rusch factors case identified two important criteria of foreseen and limited parties can file suit against the auditor therefore accountant is considered as the liable. Considering the same principle to this case, it becomes obvious that in current case the most critical aspect was to identify the foreseen and limited parties. It is thus established that the defrauded investors can go to the court and sue the accountant for his negligence in preparing the financial statements. Further, under Common Law defrauded investors is also liable to claim these damages because defrauded investors are considered as the foreseeable party. Read More