Securities Law and Regulation: Inside Information and Accountants: Scope of Liability

CFA Institute

Securities Law and Regulation: Inside Information and Accountants: Scope of LiabilityAuthor(s): John G. GillisSource: Financial Analysts Journal, Vol. 32, No. 3 (May - Jun., 1976), pp. 16-17+32+45+74-75Published by: CFA InstituteStable URL: http://www.jstor.org/stable/4477926 .

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Securities Law~~~~~~~~~

aand Regulation by John G. Gyillis

Inside Information and Accountants: Scope of Liability Two recent judicial cases explore the scope of liability under federal anti- fraud laws. In the first, involving Geon Industries, the influential Second Circuit Court of Appeals held that company officials and a registered representative violated the inside information rule. In the second case the Supreme Court held that negligence alone is not enough to hold accountants liable for damages under Rule 10b-5.

I. Inside Information Geon Industries (principal offices in Woodbury, Long Island) was pri- marily engaged in the importation and distribution of repair and re- placement parts for imported cars and trucks. It had approximately two million shares listed on the American Stock Exchange, about 28 per cent owned by the company's founder, chief executive officer and chairman of the board, George Neuwirth.

In July 1973, Geon retained Drexel Burnham & Co., Inc. to ar- range for discussions concerning a possible merger of Geon and Bur- mah Oil Co. Ltd., a much larger company. After preliminary discussions Burmah requested and received an industry forecast, five-year pro forma income and balance sheet, estimates, and cash flow pro- jection.

In October 1973, Burmah indicated further interest in Geon and a desire to continue its investigation. Neuwirth, who was planning to attend an auto show in England, decided to take Frank Bloom, Ge- on's secretary-treasurer and financial vice president, with him to visit Burmah while in England. They left

on October 15 and met with Burmah executives, but concluded nothing definite.

Shortly before leaving for England Neuwirth met with Roy Alpert, a friend and business associate in real estate transactions, in the bar of a country club where the Neuwirths and the Alperts generally dined together each Wednesday evening.

"With some other people around, Neu- wirth announced that he was going to London and, on being asked why, answered that this was for the auto show, 'and perhaps looking at some people in view of a merger.' ' (emphasis supplied)

Alpert, who owned 250 shares of Geon, bought 2,600 additional shares and informed his two brothers of his purchase. They also bought Geon stock. Between October 15 and October 18 Roy Alpert and his two brothers purchased a total of 4,625 shares.

During this same period Neuwirth had been talking with Marvin Rauch, a registered representative who had begun working for Edwards & Hanly (E&H) at its office in Hewlett, Long Island on August 22, 1973. Rauch, who had met Neuwirth some years before at a Geon stockholders' meeting, had accumulated substantial experience as a registered representative before being em- ployed by E&H and had customers' accounts holding between 25,000 and 35,000 Geon shares. After com- mencing work at E&H, Rauch made frequent calls to Neuwirth, including one just before Neuwirth left for England.

After Neuwirth's return from the two-week trip Rauch continued to call frequently and pressed Neuwirth to have lunch with him. During the lunch on November 21 Rauch asked "broker's questions." Sometime thereafter Neuwirth received from

Rauch two bottles of liquor as a gift. About November 30, Neuwirth returned a Rauch call to Rauch's home.

On December 3', following an inquiry by Amex officials regarding some rumors, Geon announced that preliminary discussions between Geon and Burmah were under way. Between November 2 and December 3 (first press release about Burmah) Rauch placed orders for 12,250 shares of Geon for himself, James McMahon, comptroller of a Geon subsidiary, and 17 other customers. The manager and assistant manager of the Hewlett office also bought Geon shares between November 2 and December 3.

Some time in the middle of December, Neuwirth told Alpert by telephone that he could not attend his own birthday party scheduled for December 17 because business com- mitments would keep him in New York City. On December 18, a Geon press release confirmed that the Burmah negotiations were con- tinuing and predicted that a further announcement would be made shortly. On December 19, Roy Alpert and his two brothers each purchased 1,000 shares. On December 20, Geon announced an agreement in principle whereby Burmah would acquire Geon for $36 million in cash or about $16.80 per share. (This was several dollars above the prevailing market prices.)

On February 20, 1974, at their weekly Wednesday dinner, Neuwirth told Alpert that Geon's board of directors would meet the next day (February 21) to "rubber stamp" the merger agreement with Burmah. On the morning of February 22, Alpert, having heard nothing from Neu- wirth, sold, along with his brothers, all their Geon stock (about 8,000 shares) during the hour when it was

John G. Gillis is a member of the law firm of Hill & Barlow, Boston, gener- al counsel of The Financial Analysts Federation.

16 C FINANCIAL ANALYSTS JOURNAL I MAY-JUNE 1976



open for trading. The proposed contract with Bur-

mah contained a condition that Geon achieve a certain level of net worth for 1973. In preparation for the February 21, 1974, board meeting Bloom's staff assembled preliminary figures. On the morning of February 21, he learned that an error had been made whereby some intra-company profits were improp- erly included in 1973 income, and that preliminary gross profits were substantially below those predicted. Together these indicated the possi- bility of a shortfall in relation to the level specified in the contract.

The directors' meeting was ad- journed to Sunday (February 24). All day Thursday, February 21, the in-house and outside accountants pored over the figures. Bloom, McMahon, and others worked until after midnight Thursday night and confirmed the existence of the intra- company profit error, but did not conclude their work on gross profits from subsidiaries. Geon's lawyers recommended that the stock be monitored the next day for possible leaks.

After leaving the Geon office McMahon called Rauch at home and instructed Rauch to sell McMahon's Geon stock. Rauch confirmed this order at 8:00 a.m. by a call to McMahon. Before trading opened on February 22, Rauch requested the E&H manager Rosen- feld to sell 1,500 Geon shares, including 1,000 shares for McMahon.

Prior to the opening of the market an Amex specialist told Gromet, a senior Amex listing representative, that pre-market activity in Geon was unusual and there were outstanding sell orders for 10,000 shares. Gromet immediately called Bloom and told Bloom about the imbalance of orders and asked him whether there were any corporate developments or any change in the status of the proposed Burmah transactions that would account for the sell orders. He subsequently testified that Bloom answered both questions neg-

atively. There was also some discussion about the Burmah transaction generally and its status. Bloom testified that, on advice of counsel, he told Gromet that there would be no public announcement that day. Trading was then allowed to begin at 10:33 a.m.

Shortly before 11 o'clock it came to the attention of another partner in

Geon's law firm that the stock price had declined on heavy volume that morning. The lawyer called the Amex, told them of the uncertainty about the financials expressed at the board meeting the day before and requested that trading be stopped. This was done at 11:19 a.m.

On Sunday evening, February 24, continued on page 32

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FINANCIAL ANALYSTS JOURNAL / MAY-JUNE 1976 O 17



stock market are based on much less. Investors who want to use a method of market timing based on a process that traces a direct link between monetary policy and the stock market owe it to themselves to investigate the process described here. a

Footnotes 1. Beryl Wayne Sprinkel. Money and Markets: A

Monetary View. (Homewood, Illinois: Richard D. Irwin, Inc., 1971.)

2. These quotations are from actual operating instruc- tions by the FOMC in 1974. For a full discussion see: Susan R. Roesch. "The FOMC in 1974: Mone- tary Policy During Economic Uncertainty," Review, Federal Reserve Bank of St. Louis (April 1974), pp. 2-13.

3. Rubin Barlow, Harvey E. Brazer, and James N. Morgan. Economic Behavior of the Affluent. (Washington, D.C.: The Brookings Institution, 1966.)

4. One familiar with flow of funds data from the Fed

may take issue with the importance given to individuals in determining stock market trends since this sector has been a consistent net liquidator of equities since the early 1950's, apparently without regard for monetary conditions. To understand this paradox one must keep in mind that in the stock market the better measure of demand is price rather than trading volume, since the supply of equities is rela- tively limited. Therefore, it is possible for increased demand to be reflected in willingness to pay higher prices or reluctance to sell rather than in a surplus of buying transactions versus selling transactions. After all, if individuals own three-quarters of all equities, it is doubtful any significant bull market could occur without increased demand in this sector. Also, keep in mind the relative importance of the factors. For example, in the first quarter of 1975 individuals li- quidated about one-half billion dollars worth of equities while the value of the remainder of their holdings increased approximately $100 billion, raising equities from 24 per cent of financial assets to an estimated 29 per cent. The latter factor has to be the better measure of demand during that period.

Securities Law and Regulation

continued from page 17

the Geon board learned about the shortfall of earnings and a press release was issued to this effect on Monday morning, February 25. Trading in the stock of Geon did not reopen until June 10. Burmah ter- minated negotiations in July 1974.

Of the 46,000 shares traded in the hour on February 22 during which trading occurred, the Hewlett office of E&H accounted for some 8,900, of which some 1,000 had been sold by the manager and the assistant manager.

Findings of the Court The SEC brought suit against

Geop, Neuwirth, Bloom, McMahon, the Alperts, Rauch and E&H for an injunction and disgorgement of profits. McMahon, Rauch and the Alpert brothers consented to an injunction (without admitting or denying the allegations), although no disgorgement of profits was directed as sought by the SEC. It was alleged

that McMahon was an insider who traded on material non-public information and that Rauch was a tippee who did the same. It was also alleged that Roy Alpert was a tippee who traded on inside information and a tipper who passed this information to his brother who became a tippee. The District Court found, and the Court of Appeals speaking through Judge Friendly affirmed, that Neu- wirth had violated Rule 1Ob-5 under the Securities Exchange Act by fur- nishing material non-public information to Rauch and Roy Alpert and that Geon was responsible for this action. The court granted an injunction against Neuwirth and Geon.

Although neither the testimony from Neuwirth nor Rauch indicated the communication of specific inside information, the appellate court held that the circumstantial evidence was sufficient to justify the trial court's inference that Rauch was getting from Neuwirth "something that was not available to the public." The court relied on the following facts: (1) Rauch was actively engaged in selling Geon stock; (2) Rauch pur- sued Neuwirth assiduously and was the only broker calling him; (3) Neu-

wirth did not tell Rauch to stop calling him until January 1974; and (4) Neuwirth lunched with Rauch alone, something he did with no other broker, accepted two bottles of liquor after the lunch, and returned one of Rauch's telephone calls from his home.

The court also made much of the circumstance that most of Rauch's purchases of Geon stock coincided with his communications with Neu- wirth.

The court also found that Neu- wirth violated Rule 1Ob-5 by giving inside information to his friend Al- pert when he told him that he was "looking at some people in view of a merger." He also violated the rule when he told Alpert and others of the February 21 directors meeting scheduled to "rubber stamp" the Burmah deal even though, in reaching his decision to sell, Alpert combined this information with the fact that there had been no subsequent public or private communication about the proposed deal.

Rejecting the argument that the Burmah transaction was in too em- bryonic a stage at the time of Neu-

continued on page 45

32 O FINANCIAL ANALYSTS JOURNAL / MAY-JUNE 1976



curve, quality spreads, issue terms, and yield to maturity, can one imagine an equity manager who ignored the same tools and concepts, now that the Market Line is available? Paraphrasing McLuhan and Nevitt once again, the Market Line can take him from information overload to pattern recogni- tion, from experience to knowledge, from reaction to anticipation. a

Footnotes 1. John Lintner, The Journal of Finance (May 1975). 2. Ralph A. Bing, "Survey of Practitioners' Stock Eval-

uation Methods," Financial Analysts Journal (May/June 1971), pp. 55-60.

3. William F. Sharpe, Portfolio Theory and Capital Markets (New York: McGraw-Hill, 1970), p. 2.

4. Marshall McLuhan and Barrington Nevitt, Take Today (New York: Harcourt Brace Jovanovich, Inc., 1972), p. 64.

5. Amivest Corporation, The Liquidity Report.

Suggested Readings

1. Lorie, James H., Brealey, Richard, et al. Modern Developments in Investment Management. New York: Praeger Publishers, 1972.

2. Lorie, James H. and Hamilton, Mary T. The Stock Market: Theories and Evidence. Homewood, Ill.: Richard D. Irwin, 1973.

3. Sharpe, William F. Portfolio Theory and Capital Markets. New York: McGraw-Hill, 1970.

4. Williams, John Burr. Theory of Investment Value, third printing. Amsterdam: North-Holland Publish- ing Company, 1964.

Securities

and Regulation continued from page 32

wirth's early conversations with Al- pert, the court used as its test of ma- teriality whether a fact "in reasonable and objective contemplation might affect the value of the corporation's stock or securities." This in turn depends, the court stated, on the probability that the event will occur and on its anticipated magni- tude in light of the totality of the company activity. It added that there is no specific rule as to when information respecting a merger becomes material. The court also stated that "the information takes on an added charge just because it is inside information" as contrasted with information in a publicly dissemi- nated press release. Alpert testified that Neuwirth's information was one of the reasons for his purchases. The court held that the reasonable infer- ences from the evidence were sufficient to support a violation of Rule 1Ob-5, at least for purposes of the requested remedies-an injunction and a "disgorgement" of profits.

However, the court limited its ruling as follows:

"Our holding is limited to disclosure (or use) of inside knowledge of negotiations

with respect to the type of merger which will result in a company's ceasing to exist as such, without implication what other transactions should invoke so severe a rule."

With regard to Neuwirth's mid- December telephone call to Alpert, the court stated:

"Unfortunately, even the majesty of the law cannot prevent the relentless annual recurrence of birthdays of the chief of- ficers of corporations, and we do not see how Neuwirth could have said less than he did."

The court held that Geon, as con- ceded by it, was responsible for Neu- wirth's violations with respect to Rauch. The court also held that Geon was responsible for Bloom's violations, which are discussed below. The court did not address the question whether Geon was responsible for Neuwirth's tipping to Alpert although they "tend to agree" with the SEC's argument that any tipping by the chief executive officer of a corporation is in his official ca- pacity.

The court found that Bloom did not answer truthfully the questions by Gromet, the AMEX listing representative. Gromet testified (and Bloom's testimony corroborated) that he had inquired whether there was anything about the Burmah deal that would account for the large number of sell orders. The court in-

dicated that Bloom's negative answer was at best an omission to state a material fact and withheld from the Exchange the facts needed to make an informed decision whether to suspend trading. Without citing any authority the court found that Bloom violated Rule 1Ob-5, re- versing the trial court's determina- tion.

However, the court affirmed the dismissal of the action against Ed- wards & Hanly as the firm had acted in good faith and it was not estab- lished that the firm had participated in Rauch's misconduct or had been negligent in supervision. The court based its decision on several factors enumerated by the trial court:

(1) E&H had devised detailed compliance manuals, which its per- sonnel were required to maintain and study.

(2) Each registered representative, including Rauch, had his own copy of a registered representatives' man- ual, and classes were held from time to time to review it, which Rauch at- tended.

(3) Rauch had extensive experience in the securities business. His work and reputation were checked with his prior employer and he was given a favorable recommendation.

(4) On at least one occasion, Rauch was monitored by three mem-

continued on page 74

FINANCIAL ANALYSTS JOURNAL / MAY-JUNE 1976 O 45



Securities Law an Regulation

continued trom page 45

bers of the compliance staff of E&H who questioned him about his famil- iarity with the E&H rules and man- ual.

(5) The manager spot-checked the work of the registered representatives and reviewed those accounts in which there was unusual activity.

(6) E&H canceled all trades based on inside information, absorbing shares into its own "error" account, which resulted in a loss of S12,500 on the subsequent sale.

(7) When definitive proof of Rauch's wrongdoing was adduced, E&H promptly discharged him.

The court rejected the application of the doctrine of respondent su- perior-a principal being liable for the acts of its agent-at least in this situation where the "consequences of an injunction against a brokerage firm are potentially very great."

II. Limitation of Accountant's Liability

On March 30, 1976, the Supreme Court announced a most important decision resolving a conflict among lower courts. The Court restricted recovery for damages under Section 10(b) of the Exchange Act and Rule 10b-5 to situations involving scienter-intent to deceive, manipulate or defraud. The facts were as follows:

Ernst & Ernst audited the financial statements of First Securities Company of Chicago from 1946 through 1967. First Securities was a registered brokerage firm, a member of the Midwest Stock Exchange, as well as the National Association of Securities Dealers. Among other things, Ernst & Ernst prepared for filing with the Securities and Ex- change Commission the required annual report as well as First Securi- ties' responses to financial question- naires of the Exchange.

The plaintiffs were customers of

First Securities who had invested in a fraudulent securities scheme per- petrated by the president of First Se- curities, who owned substantially all its stock. The scheme involved an investment in "escrow" accounts that were represented as yielding a high rate of return. These investments were made from 1942 through 1966, with most transactions occur- ring in the 1950's. In fact, the president never invested these funds and immediately converted them to his use. The transactions were handled differently from more conventional transactions involving First Securi- ties customers: The checks for these investments were made payable to the president or to a designated bank for his account. No escrow accounts were reflected on the books of First Securities and none were shown on its periodic accountings to the plaintiffs in connection with their other investments. Nor were these accounts included in First Securities' filings with the SEC or the Ex- change.

The fraud was discovered in 1968 when the president committed sui- cide, leaving a note describing First Securities as bankrupt and the escrow accounts as spurious. There- after the plaintiffs sued Ernst & Ernst, alleging violations of Section 10(b) of the Exchange Act and Rule lOb-5, in that Ernst & Ernst "aided and abetted" the president's violation of these laws by its "failure" to conduct proper audits of First Secu- rities.

It became apparent through pretrial discovery that the plaintiffs based their case on the theory of "negligent nonfeasance" rather than any type of intentional misconduct or fraud. The plaintiffs' theory was that Ernst & Ernst had failed to use "appropriate auditing procedures" in its audits of First Securities, hence did not discover certain practices initiated by the president that pre- vented an effective audit. The principal practice alleged by the plaintiffs was the so-called "mail rule" whereby the president was the only person who could open mail ad- dressed to him or his attention at

First Securities. It was alleged that if a proper audit had been conducted it would have discovered this mail rule and disclosed it as an irregular practice preventing an effective audit. This in turn would have lead to an investigation revealing the fraudulent scheme.

After extensive pretrial discovery the District Court granted Ernst & Ernst's motion for summary judgment (a judgment without a trial) and dismissed the action against it. While the court did not accept Ernst & Ernst's argument that a violation of Rule 1 Ob-5 cannot be based merely on allegations of negligence. it found no issue of fact in the case sufficient to conduct a trial.

The Court of Appeals for the Seventh Circuit (sitting in Chicago) reversed that decision and remanded the case for further proceedings. That court held that Ernst & Ernst had a common law and statutonr duty of inquiry into First Securities' internal control system based on its contract with it. The court further held that the plaintiffs were benefi- ciaries of these duties and that there were genuine issues of fact whether Ernst & Ernst had breached its duties, failing to discover and dis- close the irregular mail rule. The Su- preme Court explained its acceptance of the case as follows: "We granted certiorari to resolve the question whether a private cause of action for damages will lie under section 10(b) and Rule lOb-S in the absence of any allegation of 'scienter'-intent to deceive, manipulate or defraud. 421 U.S. 909 (1975). We conclude that it will not and therefore we reverse."

History of Federal Securities Regulations

In a careful and closely reasoned decision Mr. Justice Powell (joined by five other justices) traced the history and policy behind the federal securities regulation, which first began in 1933 with the enactment of the Securities Act of 1933 and continued with the Securities Exchange Act of 1934, including Section 10(b). The Court pointed out that, although Section 10(b) does not by

74 O FINANCIAL ANALYSTS JOURNAL / MAY-JUNE 1976



its terms create an express civil remedy for its violation and there is no indication that Congress or the SEC when adopting Rule 10b-5 con- templated such a remedy, judicial decisions have recognized the existence of a private cause of action for violations of Section 10(b). The Court cited three recent Supreme Court decisions that followed nu- merous earlier lower court decisions. The Court noted the conflict among lower courts as to whether scienter is a necessary element of a Section 10(b) claim or whether negligent conduct alone is sufficient. Laud- ably, the court went on to state that the proper starting point in constru- ing a statute is the language of the statute itself.

Meaning of the Statutory Words First, the Court indicated that

Section 10(b) makes unlawful the use or employment of "any manipulative or deceptive device or contri- vance" in contravention of SEC rules. The court reasoned that these words used together strongly suggest a prohibition of knowing or intentional misconduct. The Court rejected the SEC's argument, made in its amicus curiae brief, that the statute must be construed in light of the Congressional objectives to prevent injury to investors, as this would lead to imposing "liability for wholly faultless conduct."

The Court concluded that such an interpretation would fly in the face of the words of the statute:

"Use of the word 'manipulative' is espe- cially significant. It is and was virtually a term of art when used in connection with securities markets. It connotes intentional or willful conduct designed to deceive or defraud investors by controlling or artificially affecting the price of securities."

The Court concluded that Con- gress provided standards of fault in the express civil remedies in the Se- curities Act and Securities Exchange Act on a particularized basis. For example:

". . . in seeking to accomplish its broad remedial goals, Congeess did not adopt uniformly a negligence standard even as

to express civil remedies. In some circumstances and with respect to certain classes of defendants, Congress did create express liability predicated upon a failure to exercise reasonable care. E.g., 1933 Act ? 1 1 (b) (3) (B),. . . (liability of ,experts,' such as accountants, for misleading statements in portions of registration statements for which they are responsible). But in other situations good faith is an absolute defense. 1934 Act ? 1 8, . . . (misleading statements in any document filed pursuant to the 1934 Act). And in still other circumstances Congress created express liability regard- less of the defendant's fault. 1933 Act ?1 1 (a) (issuer liability for misleading statements in the registration state- ment)."

As the Court noted, statutory language in a section where there is ju- dicially implied liability is no less important (and is probably more important) than in a section with express civil remedies.

While the Court suggested that such a holding could be the end of its decision, it nevertheless con- sidered the legislative history of Sec- tion 10 and Rule 10b-5.

Legislative History of Section 10(b) and Statutory Content

In an exhaustive analysis of the legislative history of Section 10(b), the Court found that the voluminous legislative history of the Securities Exchange Act does not contain any direct explanation of the Congres- sional intent as to Section 10. It concluded, however, that the history does support the conclusion that Section 10(b) was directed to practices involving some element of scienter and cannot be read to im- pose liability for negligent conduct alone. Nor did the Court find per- suasive the SEC's contention that the scheme of the federal acts revealed that the scienter standard was applicable only when it was ex- pressly stated.

Finally, the Court rejected the SEC's argument that the language of Rule 1Ob-5, promulgated by the SEC under Section 10(b), could en- compass both intentional and negligent behavior. It stated:

'Thus, despite the broad view of the

Rule advanced by the commission in this case, its scope cannot exceed the power granted the Commission by Congress under Section 10(b)... When ai statuite speaks so specifically in terms of ma- nipulation and deception, and of im- plenmenting devices and contriv- an ces -the commonly understood ter- minology of intentional wrongdoing-and when its history reflects no more expansive intent, we are quite unwilling to extend the scope of the statute to negligent conduct. '(eml- phasis supplied)

As the Court held that negligent conduct alone was insufficient to support recovery against Ernst & Ernst, and as no other misconduct had been asserted by the plaintiff, the Court dismissed the suit. a

QUARTERLYDIVIDENDS SINCE 1935

NATIONAL DISTILLERS DCHEM ICAL CORPORATION DIVIDEND NOTICE The Board of Directors has declared a quarterly dividend of 35? per share on the outstanding Common Stock, payable on June 2, 1976 to stockholders of record on May 10, 1976. The transfer books will not close. April 22, 1976

RAMSEY E. JOSLIN, Vice President-Financial

K DIYISIONS: U.S. INDUSTRIAL CHEMICALS CO. | JNATIONAL DISTILLERS PRODUCTS CO.

BRI DGEPORT BRASS CO. . ALMADEN VINEYARDS. INC.

S EACON MANUFACTURING COMPANY

MINNESOTA GAS COMPANY

733 Marquette Avenue Minneapolis, Minnesota 55402

Common Stock Dividend The Board of Directors of Minnesota Gas Company at a meeting held on April 8, 1976, declared a dividend of 411/2 cents per shore payable in cash on May 10, 1976, to common stockholders of record as of the close of business April 21, 1976.

PAUL W. KRAEMER, PresidBntl

FINANCIAL ANALYSTS JOURNAL / MAY-JUNE 1976 n] 75



Documents

Securities Law and Regulation: Inside Information and Accountants: Scope of Liability