Brook Corporation raised $11 million by making a private interstate offering of $7 million in common stock and negotiating a $4 million loan from Jackson Bank to expand its operations. The common stock was properly offered pursuant to securities rules, so the 1933 Act doesn't apply, but the antifraud provisions of the Federal Securities Acts does apply.
Brook engaged Walthers, CPAs to audit their financial statements. Walthers knew that the only reason for such an audit was so for the audited financial statements to provide to Jackson Bank and the buyers of the common stock. Although Walthers conducted the audit in compliance with its audit program, they failed to detect material fraud committed by Brook's president. Walthers did not notice the embezzlement because of its unintentional failure to exercise due care in designing its audit for this engagement.
Walthers rendered an unqualified audit opinion on Brook's financial statements after completion of the audit. Purchasers of the common stock relied on the financial statements in deciding whether to purchase the shares. Based on the audited financial statements, Jackson Bank approved the loan to Brook. He was then involuntarily petitioned into bankruptcy in a 60-day window after selling the common stock and attaining the loan from Jackson Bank. Brook became insolvent and defaulted on its loan to Jackson Bank due to the president's embezzlement. This caused the common stock to be virtually worthless. The purchasers of the common stock have taken actions against Walthers for damages citing the Securities Exchange Act of 1934 and Jackson Bank as a result of Walthers' negligence.
Required:
Explain the merits of the actions commenced against Walthers by the common stock purchasers and by Jackson Bank. What are the likely outcomes? Explain.
What if the purchasers of the common stock were able to bring suit under the 1933 Act and client filed a registration statement initially? How would you answer differ from the previous question? Explain.
What are the differences between the Securities Exchange Acts of 1933 and 1934?
Sample Solution