Case Study 7.8

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Case Study 7.8 First Securities Company of Chicago 
(Ernst& Ernst v. Hochfelder et al.)

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 family’s investments for many years but did not offer the opportunity to invest in the escrow syndicate until her husband’s death.” He betrayed and broke the trust of his investors and close friends.

This critical factor is relevant to an auditor’s 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. Nay’s firm. In which, leads to our next critical factor:

Critical Factor #3

Ernst & Ernst failed to detect the Nay’s “mail rule,” which was followed by his employees in the firm. Nay’s 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 Nay’s company they would have discover this rule but it went amiss for two decades under their audit. They didn’t 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...
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