Reves v. Ernst & Young is a Supreme Court case that concerns accountant liability. The case was first heard by the Arkansas District Court in April 1986. Through appeals it was carried all the way to the Supreme Court. Several accounting issues arose in the case. The accountants were sued for damages under the Arkansas Blue Sky laws, the Securities Exchange Act of 1934, and the Racketeer Influenced and Corrupt Organizations (RICO) Statute. An underlying issue of the case was the definition of a security and whether or not the debt in question qualified as a security. This paper will first describe the background of the case with an overview of the pertinent accounting issues, then the legal ramifications will be discussed, and finally, the implications of the decision on the accounting profession will be examined.
 

To raise money for its operating expenses, the Co-op sold promissory notes which were payable on demand. The notes were neither collateralized nor insured, however, they offered higher interest rates than the local financial institutions. By 1984, over 1,600 members purchased demand notes having a value of over $10 million. It was later questioned whether these notes qualified as securities under the Arkansas Blue Sky laws.
 

Gasohol Plant:
Problems with the Co-op arose after the Co-op acquired a gasohol plant. The plant was originally owned by White and Edwin Dooley. White later bought Dooley’s shares and named the company White Flame Fuels, Inc. (White Flame). White borrowed approximately $4 million from the Co-op in order to finance the construction of the plant and to initiate operations. In 1980, the Co-op had assumed White’s debt and acquired White Flame.

Also in 1980, White and Gene Kuykendall, the accountant for White Flame and a previous accountant of the Co-op, were indicted for federal tax fraud. The indictment charged White with engaging in a course of self-dealing with the Co-op and filing fraudulent tax returns. They were both convicted in January 1981.

Accounting Issues:
The Co-op hired Russell Brown (which was later taken over by Arthur Young and eventually became part of Ernst & Young) to perform both the 1981 and 1982 annual audits. For both audits, Arthur Young issued qualified opinions. Accounting issues investigated by the auditors included: (1) the status of the demand notes, (2) the value of the gasohol plant, and (3) the legitimacy of condensed financial statements issued by management.

Prior to the 1981 financial statements, the Co-op listed the demand notes as 20% current liabilities and 80% long-term liabilities. However, Arthur Young correctly changed the demand notes to 100% current liabilities since all of the notes could be redeemed during the year.

The accountants from Arthur Young encountered a lot of problems related to the valuation and acquisition of the gasohol plant. First, the fixed asset value of White Flame was provided by Kuykendall, a convicted felon and therefore could not be relied upon. The plant, which was only operating at 20% capacity, was valued by Kuykendall at $4,393,242.66. Included in the cost of the plant were 80% of the production costs that could not be associated with the current operating capacity. Arthur Young’s investigation of the plant was limited to inquiries of White and a review of the construction and capitalization costs that were prepared by Kuykendall. Arthur Young concluded that the plant’s value was exactly as Kuykendall had calculated it.

The date of acquisition of the gasohol plant would effect the value of the plant on the Co-op’s books. If the Co-op had owned the gasohol plant from the inception of its construction in 1979, the value of the plant for accounting purposes would be its fixed asset value of $4.5 million. If, however, the Co-op had purchased the plant from White, its value for accounting purposes would be its fair market value at the time of its purchase which was less than $1.5 million. Arthur Young concluded that the Co-op owned White Flame from its inception and thus valued it at $4.5 million. The conclusion was based on the fact that the Co-op lent White the funds for the plant's construction and operation; that White supervised the construction and operation; and that the court decree which gave the Co-op possession of the plant stated that the loans to White had been investments in the plant. Arthur Young ignored the fact that the court decree stated February 15, 1980, as the date of acquisition. If the plant was valued at $1.5 million on the Co-op’s books, the Co-op’s net worth would have been wiped out causing a run on the demand notes. The acquisition and valuation decisions were made solely by Arthur Young without management’s input.

In the 1981 Audit Report, Arthur Young concluded that with two exceptions the Co-op’s consolidated financial statements fairly presented the Co-op’s financial position. The relevant exception stated that Arthur Young had "some doubt as to the recoverability of the investment in the gasohol plant of White Flames Fuel, Inc. and its continuing operation (note 9)."

At the Co-op’s annual meeting, management distributed condensed financial statements which included White Flame’s $4.5 million asset value in the co-op’s net assets, however, failed to include White Flame’s $1.2 million operating loss in the income statement. The statements also failed to include note 9 regarding the doubt associated with White Flame’s future operations. Nowhere on the condensed statements did it state that the auditors qualified their opinion. Arthur Young did not pre-approve the condensed financial statements, however, the partner in charge was at the annual meeting and he did not say that the condensed statements were a misrepresentation. Rather, he only notified the members that the complete statements and opinion could be obtained from the Co-op’s office.

The 1982 audit, annual report, and annual meeting paralleled that of 1981 with one exception. The chief financial officer (CFO) refused to sign a representation letter. Without the CFO’s signature, the auditors are suppose to either disclaim an opinion or issue an adverse opinion. Nevertheless, a qualified opinion was issued.

Bankruptcy Proceedings:
On February 23, 1984, the Co-op filed for bankruptcy under Chapter XI reorganization proceedings. The Co-op stated that three factors precipitated the bankruptcy: (1) ineffective management; (2) the use of demand notes as a primary source of financing; and (3) the financial problems associated with White Flame. As a result of the bankruptcy filing, the demand notes were frozen and no longer redeemable at will ( 937 F 2d 1310).

Legal Accusations:
The bankruptcy trustee and a class of co-op members and demand note holders filed an action against certain members of management, co-op directors, accountants, and attorneys alleging fraud, violations of state and federal securities acts, breach of contract, negligence, and breach of fiduciary duty. The parties were as follows:

Plaintiffs:   

• Thomas Robertson, Jr. - Trustee in bankruptcy of Co-op
• Bob Reves, et al. - Class of plaintiffs composed of Co-op members, distributees of unpaid Co-op patronage dividends, and holders of Co-op           demand notes

• Management Group - White, Kuykendall, and others
• Professional Group - Accountants and Attorneys
• Co-op Directors

All of the parties settled out of court except Bob Reves, et al. and Arthur Young.
 

Reves et al. contended that the demand notes issued by the Co-op were in fact securities under both the Arkansas Blue Sky laws and the Securities Exchange Act of 1934. Hence, Arthur Young should be liable for damages due to the material misstatements in the financial statements. Reves also contended that the auditors from Arthur Young acted in a manner consistent with that of management when they decided how the plant should be reflected in the financial statements. This behavior prompted the class to file a RICO claim against the accountants.

Liability Under the Federal and State Securities Acts:

District Court:
In the 1986 Arkansas District Court case of Robertson v. White (635 F Supp 85), the court ruled in favor of the plaintiffs contending that the demand notes were securities under the 1979 Arkansas Security Act. Under the Arkansas Security Act any common stock, preferred stock, promissory note, or debenture must be registered as a security unless an exemption is filed. The Co-op did not register the notes nor did it file for an exemption. The court also concluded that the magnitude of the demand note sale further illustrated its use as a security. More than 1,600 members bought demand notes worth over $10 million. Additionally, a profit element which is common for securities was involved. The noteholders were expecting to receive a profit from the demand notes as evidenced by the Co-op’s label of the demand notes as "investment transactions".

Arthur Young’s argument against the treatment of demand notes as securities is that they believe demand notes do not meet the definition of a "security" under the federal acts. The district court, however, only considered state law in reaching its verdict. Both federal and state law were examined on appeal.

Court of Appeals:
In the 1988 decision of Arthur Young & Co. v. Reves by the U.S. Court of Appeals (856 F 2d 52) it was established that the notes in question were not securities under either the federal or state laws thereby reversing the district court’s prior decision (four Judges dissented). To arrive at this conclusion the majority looked at the economic reality of the transaction.

The Court of Appeals stated that for the demand notes to be considered securities under federal law they must satisfy the elements of the Howey test which was developed in SEC v. WJ Howey Co. (66 S. Ct. 1100). The Howey test defines a security as: (1) an investment; (2) in a common enterprise; (3) with a reasonable expectation of profits; (4) to be derived from the entrepreneurial or managerial efforts of others. The Court concluded that the application of this test proves that the demand notes were not securities under federal law. The conclusion was determined as follows:

• Demand notes were short-term loans with fixed interest rates used for operating funds. The Co-op began the program to obtain funds at a lower interest rate than that which would be given by a bank. At the same time the members purchased the notes in order to earn a higher return for their money than would be acquired if deposited in a bank. Therefore, the transaction more closely resembles a commercial lending transaction and not an investment transaction.

• Unlike the District Court, the Court of Appeals found that the expectation of a profit was lacking. Howey defines profit as capital appreciation resulting from the development of initial investment or a participation in earnings. Neither were present in this case.

In determining whether the demand notes were securities under the Arkansas Security Act the Court of Appeals looked at the decision in First Financial Federal Savings & Loan Assn v. E.F. Hutton Mortgage Corp. (652 F. Supp. 471 and 834 F. 2d 685). The Western District of Arkansas concluded that "the Arkansas definition of a security is essentially identical to the definition under the federal securities law and the criteria followed in making a determination on whether an instrument is a security is the same." Thus, the demand notes were not securities under state nor federal regulation.

Supreme Court:
In the 1990 decision of Reves v. Ernst & Young (110 S. Ct. 945), the Supreme Court reversed the decision of the Court of Appeals, asserting that the demand notes were in fact securities under both federal and state law. To arrive at this conclusion under federal law the Supreme Court applied the "family resemblance" test.

Under the "family resemblance" approach any note with a term of more than nine months is presumed to be a security and applicable under both the 1933 and 1934 Acts. There is, however, a judicially determined list of exceptions to the general nine month rule. Any securities that bears a resemblance to the list are not securities. A four factor test was used for comparative purposes to determine if the notes resembled any items on the exception list. The four factors dealt with (1) the motivations behind the transaction; (2) the plan of distribution; (3) the reasonable expectations of the investing public; and (4) the existence of another regulatory scheme to reduce the risk of the instruments.

In Reves v. Ernst & Young, the four factors were analyzed as follows:

• The demand notes were for investment purposes. The Co-op sold them to raise capital and the public bought them to earn a profit in the form of interest.
• The notes were commonly traded. Throughout the life of the Co-op over 23,000 notes were issued to both members and nonmembers.
• Advertisements produced by the Co-op explicitly characterized the notes as investments.
• The notes were uncollateralized and uninsured. Without the application of the 1933 and 1934 Acts they would escape regulation.

The Supreme Court concurred with the District Court’s decision that the demand notes were securities under the state law because they fell within the "note" category of instruments that are considered "securities."

Arthur Young’s Liability:
Due to the Supreme Court’s determination of the demand notes as securities, Ernst & Young’s liability under both the Arkansas Security Act and the Securities Exchange Act of 1934 had to be addressed. In the 1991 U.S. Court of Appeals case of Arthur Young & Co. v. Reves et al (937 F 2d 1310), the court concluded that Arthur Young was liable under both federal and state law and remanded the calculation of damages to the district court for further proceedings.

Arthur Young contended that even if all of the Class’ allegations were true, it could not be held liable for securities fraud under State law because it was neither an offeror nor seller of securities. The Class did not contest this point, but argued that Arthur Young was not charged with primary liability but with secondary liability under Section 106 of the Arkansas code. To determine whether or not Arthur Young possessed secondary liability, the issue of control had to be resolved.

The district court postulated that Arthur Young "originated" the material misstatements that were used to sell the demand notes. Therefore, Arthur Young had the power to control the content of the financial statements. Arthur Young countered this claim by asserting that the proper test for control is whether the defendant actually participated in the operations of the corporation thereby exercising control.

The Court of Appeals noted that Arthur Young did not direct the Co-op’s operations. However, the Court found that the other type of secondary liability under the Arkansas Security Act, aiding and abetting, was applicable to the case. To be held liable for aiding and abetting, the plaintiff need only show that the defendant’s status was that of a "controlling person, a partner, or an occupant of some other statutory classification…plus the fact of the seller’s liability (937 F 2d 1325)." The defendant’s only defense would be that, under the exercise of reasonable care, he could not have known of the facts by which the seller was found liable. The Court of Appeals concluded that the trial evidence provided sufficient evidence to support the verdict against Arthur Young.

Arthur Young also contended that it was not liable under the federal act since the Class failed to offer evidence of transaction causation (Rule 10b-5). For transaction causation the plaintiff must prove that the alleged fraudulent acts caused the plaintiff to purchase the securities.

The Class responded to Arthur Young’s appeal by claiming that it is entitled to a "rebuttable presumption" of transaction causation because of Arthur Young’s nondisclosure of material information. Arthur Young countered the claim by postulating that it had no relationship with the Class and was therefore not liable for nondisclosure of information. The Court ruled in favor of the Class after establishing that a relationship between the Class and the auditors did exist and that the nondisclosed information (not contained in the condensed financial statements) was pertinent.

In evaluating whether or not a relationship did exist, the Court of Appeals looked to the factors established by the Fifth, Ninth, and Eleventh Circuits. In order to determine if a relationship exists that gives rise to the duty to disclose, one must consider:

• the parties’ access to the necessary information
• whether the defendant benefits from the sale of the securities
• whether the defendant is aware of the plaintiff’s reliance on the information in making investment decisions
• the defendant has a role in initiating the sale
• the extent of the defendant’s knowledge
• the significance of the disclosures
• the extent of the defendant’s participation in the fraud

Effect on the Accounting Profession:
In the decision of Reves v Ernst & Young (937 F2d 1330 and 110 S Ct. 945) the accountants were liable for material misstatements associated with demand notes. The Supreme Court decision that these notes were in fact securities extends an accountant’s liability under Federal Securities laws to "almost any transaction that results in investment by more than a few people…whether the underlying transaction involves real estate, oil and gas leases, or investments in conventional business operations (Augenbraun, B., December 1994, p. 3)."

Prior to this decision many accountants believed that they could not be found liable under the Federal Securities law because they were not involved with securities (either in management or by an audit). The Supreme Court’s comprehensive definition of a security extended an accountant’s liability to anything that may resemble a security thereby forcing accountants to look beyond the name of the transaction and to its substance.

RICO Claim:
In addition to filing a suit under the federal and state securities acts, the Class also claimed that Arthur Young was liable under Section 1962 ( c) of the RICO Statute. This section of the RICO Statute makes it a crime "to conduct or participate in the conduct of affairs of an enterprise through a pattern of racketeering activity (Keneally, February 1994, p.1)." This section is quite broad and can include mail fraud, violation of securities laws, interstate transactions of stolen property, as well as a variety of other acts. The Supreme Court’s final decision affirmed both the District Court and the Court of Appeals decisions in Arthur Young’s favor, however, two judges on the panel had strong dissenting opinions (113 S. Ct. 1163).

The majority opinion written by Justice Blackmun held that "one must participate in the operation or management of the enterprise itself" in order to be liable under RICO. The Class contended, however, that Arthur Young did participate in the operations of the Co-op when it valued the gasohol plant. The majority disagreed with the Class stating that "[t]he failure to tell the cooperative’s board that the gasohol plant should have been valued in a particular way is an insufficient basis for concluding that Arthur Young participated in the operation or management of the cooperative itself (113 S Ct 1166)."

To arrive at the majority’s conclusion, the Supreme Court first analyzed the use of the words "conduct" and "participate" as they are used in the RICO Statute. The Court concluded that the word "conduct" requires some degree of direction and the word "participate" requires some part in the direction. Hence, the meaning of Section 1962 ( c) of RICO is that in order to participate directly or indirectly in the entity’s conduct one must have some part in directing those affairs. Once this was established then the "operation or management" test could be applied.

To illustrate that Arthur Young did not direct the affairs of the Co-op, the majority noted that Arthur Young relied on existing records in preparing the 1981 and 1982 audit reports. Additionally, Arthur Young’s audit reports revealed that the gasohol plant had been calculated based on the Co-op’s investment in the plant. The only issue in regards to Arthur Young’s liability under RICO, therefore, would arise from Arthur Young’s failure to tell the Co-op’s board that the plant should have been recorded at fair market value. In the majority’s opinion, Arthur Young’s failure in this respect was not adequate for liability under the RICO Statute.

Justice Soulter and Justice White both dissented claiming that even if they could support the majority’s view of the words "conduct" and "participate," they do not believe that the conclusions reached by the majority regarding the "operation and management" test are supported by the facts of the case.

Soulter contended that in this case Arthur Young did not conduct a traditional audit, but stepped outside of the position of auditor into a position consistent with that of management when Arthur Young decided to value the gasohol plant. Soulter added that Arthur Young determined its own figure for the Co-op’s most important fixed asset (the gasohol plant) without calling on management. The judgment regarding the valuation of the plant belonged to management, not to the auditors. Soulter further stipulated that in addition to wrongfully valuing the gasohol plant, Arthur Young also "adopt[ed] a blatant fiction - that the Co-op owned the entire plant at its inception in May 1979 - in order to justify carrying the asset on the books at its total cost (113 S. Ct. 1177)" and not its fair market value. In arriving at these decisions, Arthur Young did not consult with management and made conclusions that contradicted the 1980 financial statements and the local court decree that the Co-op acquired White Flame in February 1980.

Since Arthur Young had such an active role in making management decisions, Soulter rejected the majority opinion and concluded that Arthur Young was liable under the provisions of the RICO statute.

Effect on the Accounting Profession:
For the most part, accountants were pleased with the decision of the Supreme Court in favor of Ernst & Young because it narrowed the application of RICO for accountants and other professionals. The Reves decision states that if an auditor maintains his role as an outsider and does participate in management decisions, he will escape RICO liability. The accountant must, however, stay within his boundaries. If the accountant gets too involved with the company’s management he may be found liable.

Although most accountants were happy with the decision, some were skeptical. Other cases, both prior and subsequent to the Reves decision, limited the verdict of Reves. The main reason for the discrepant decisions was the definition of an enterprise as it is stated in the RICO Statute. Ernst & Young was sued as an entity enterprise, however, in some circumstances it is possible to sue the auditors as an association-in-fact enterprise. An association-in-fact enterprise is a group of people joined together for the same purpose (Keneally, February 1994, p.4). In Reves v. Ernst & Young, if the suit was filed against all the original defendants (management, professionals, and Co-op directors) as an association-in-fact enterprise instead of against Ernst & Young as an enterprise entity, then the outcome may have been different (Keneally, February 1994, p. 3-6).
 

In sum, the demand notes issued by the Co-op were securities under both the state and federal laws. Arthur Young was found liable for damages under both the Arkansas Security Act and the Securities Exchange Act of 1934; however, Arthur Young was not found liable under the RICO Statute. These rulings are important for accountants who deal with documents which are similar in nature to securities without being called securities. They also provide a standard for participation in management which auditors should avoid to be protected from RICO liability.
 

(By Ayisha Pregno, Ruth Murrow, and Glen Shields)

• Robertson v. White. 633 F Supp 954. April 4, 1986.
• Robertson v. White. 111 F.R.D. 607. May 16, 1986.
• Robertson v. White. 635 F Supp 851. June 10, 1986.
• Robertson v. White. 113 F.R.D. 20. September 5, 1986.
• Arthur Young & Co. v. Reves. 856 F 2d 52. September 1, 1988.
• Reves v. Ernst & Young. 110 S. Ct. 945. February 21, 1990.
• Arthur Young & Co. v. Reves. 937 F 2d 1310. June 27, 1991.
• Reves v. Ernst. 113 S Ct. 1163. March 3, 1993.

• Augenbraun, B.S. December 1994. Liability of Accountants Under the Federal Securities Laws. The CPA Journal Online. www.luca.com/cpajournal/old/16531678.htm.

• Keneally, K. February 1994. Partial Limitation on the Risk of RICO Liability (Accountant’s Liability). The CPA Journal Online. www.luca.com/cpajounral/old/15203142.htm.