Ladislas Nay immigrated to the United States from Hungary in 1921 at the age of 18. The opportunities offered by his new land excited the industrious young immigrant, and he promised himself that he would make the most of them. Shortly after arriving in the United States, Nay made his way to Chicago and landed a job in the booming securities industry with a small brokerage firm. For the next several years, Nay worked long and hard hours learning the brokerage business. Unfortunately for Nay, the Great Depression hit the securities industry particularly hard. Young stockbrokers like him were the first to be laid off by their firms when personnel cuts were necessary. During the bleak 1930s, Nay, who by this time had Americanized his first name to Leston, endured several job changes and two failed marriages. In 1942, as World War II began to pull the United States out of the Depression, Nay landed a permanent job with the brokerage firm of Ryan-Nichols & Company.
Within two years of joining Ryan-Nichols, Nay was promoted to president. He eventually became the firm's principal stockholder, accumulating more than 90 percent of its outstanding common stock. In 1945, the firm successfully applied for membership to the Midwest Stock Exchange and was renamed First Securities Company of Chicago. Over the next two decades, Nay's career and personal life flourished. Nay and his wife, Elizabeth, participated in a wide range of community affairs, including serving on several prominent civic boards, and eventually purchased a home in the upper-class neighborhood of Hyde Park. Nay made numerous friends among the faculty and staff of nearby University of Chicago. In fact, many of his best customers were associated with the prestigious school.
Nay's personal attention to the financial needs of his customers earned him their respect and admiration. One of his customers described him as a kind and considerate man, much "like an old-fashioned English solicitor who took care of a family's affairs."1 His conservative investment strategies particularly appealed to his retired clients and those nearing retirement. Nay offered many of these customers an opportunity to invest in a lucrative fund that he personally managed. This fund was not an asset of First Securities, nor were any other First Securities personnel aware it existed. Nay referred to this fund as the "escrow syndicate." Nay loaned funds invested in the escrow syndicate to blue-chip companies that developed sudden and unexpected working capital shortages. These companies paid interest rates well above the prevailing market rates. Individuals who invested in the escrow syndicate earned 7 to 12 percent on their investments, considerably more than the interest rates paid at the time by banks on savings accounts.
One of Nay's closest friends, Arnold Schueren, entrusted him with more than $400,000 over three decades and granted him a power of attorney to make investment decisions regarding those funds. Nay invested a large portion of Schueren's savings in the escrow syndicate. Another individual who relied heavily on Nay for investment advice was the widow of a close associate of the famed University of Chicago scientist Enrico Fermi. This woman later testified that Nay had managed her family's investments for many years but did not offer her the opportunity to invest in the escrow syndicate until after her husband's death. Nay told her that he only offered this investment opportunity to his "nearest and dearest friends."2 Following the death of another of his customers, Norman Moyer, Nay convinced Moyer's widow to invest her husband's estate of $90,000 in the escrow syndicate. In total, 17 of Nay's friends and/or their widows invested substantial sums in the escrow syndicate.

Questions
1. Under present technical standards, would auditors be required to disclose a company policy similar to Nay's mail rule that they discover during an audit? Explain. Assuming such disclosure had been required at the time this case took place, would that disclosure have resulted in the mail rule being discontinued?
2. Ernst & Ernst argued that the mail rule was not relevant to its audits of First Securities since that rule only involved personal transactions of Nay and the escrow investors. Do you agree? Why or why not?
3. Define negligence as that term has been used in legal cases involving independent auditors. What is the key distinction between negligence and fraud? Between recklessness and fraud? For all three types of professional misconduct, provide an example of such behavior in an audit context.
4. Assume that the investors defrauded by Nay could have filed their lawsuit against Ernst & Ernst under the Securities Act of 1933. How, if at all, do you believe the outcome of their suit would have been affected?
5. The Restatement of Torts is a legal compendium issued by the American Law Institute. This compendium is relied on by courts in many jurisdictions as the basis for legal rulings. Under the Restatement of Torts, courts have ruled that negligent auditors can be held liable to unknown third parties if those parties belonged to a known group of financial statement users who the auditors were aware would likely rely on the audited financial statements. If this legal principle had been invoked in the Hochfelder case, would the defrauded investors have been successful in pursuing a negligence claim against Ernst & Ernst under the common law? Why or why not?