Question

Aves Manufacturing Solutions is a public company that produces specialty automated manufacturing equipment used in the automotive industry. The company is pursuing both debt and equity financing in order to raise funds for planned plant expansion. The company’s 2009 financial statements are being audited by Hester & Cham, CPAs. Hester & Cham is aware that the financial statements will be included in loan applications provided to lending institutions and in the prospectus for a stock offering.
Hester & Cham completed their audit and issued an unqualified opinion on March 24, 2010. The following additional information is available about the audit:
The auditors failed to obtain sufficient evidence to support a series of sales transactions that occurred near the end of the year. As a result, Hester & Cham did not discover that the company’s sales and inventory accounts were overstated by a material amount.
Attorneys provided the auditors with documentation pertaining to a major lawsuit in which Aves Manufacturing Solutions is the defendant. The attorneys believed that the lawsuit was likely to result in a future material loss to Aves. Hester & Cham did not propose any financial statement adjustment for this item because the case was still pending at year-end. The financial statements did not include either a recorded liability or any disclosure about the lawsuit.
In mid-2010, Aves obtained financing through the following means:
Borrowed $1 million from Bourey Financial Services, Inc. under the terms of a 48-month note payable. Bourey relied on the financial statements and Hester & Chem’s audit opinion as a basis for extending the loan.
Raised nearly $9 million from the sale of common stock to investors.

Aves Manufacturing began experiencing financial difficulties late in 2010. Equipment orders had plummeted, yet substantial financial commitments had already been made for the plant expansion. The company was able to stay in business through 2010 due to the financing it had obtained. However, in early 2011, Aves was found liable in the lawsuit and was ordered to pay damages of $ 5 million. Aves was forced into bankruptcy as it was unable to pay its loan obligations or its legal damages. Soon thereafter, Hester & Cham was sued by both Bourey Financial and by the class of investors who purchased Aves’ stock through the 2010 stock offering.

Required:
a. Will Bourey Financial prevail in its case against Hester & Cham? Can their case be based on negligence or common law fraud, or both?
b. Will the investors who purchased Aves’ stock through the 2010 stock offering prevail against Hester & Cham based on Rule 10b-5 of the Securities Exchange Act of 1934? Explain.



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  • CreatedJanuary 21, 2015
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