Ernst & Ernst v. Hochfelder

Scienter requirement for private damages actions under Section 10(b) and Rule 10b-5.

Customers of a brokerage firm sued the firm's accountants after the firm's president carried out a fraudulent scheme involving escrow accounts. The plaintiffs alleged that the accountants failed to discover the fraud during audits.

The Court held that negligence alone is insufficient for a private damages action under Section 10(b) and Rule 10b-5.

Justice Powell focused on the statutory language prohibiting manipulative or deceptive devices and concluded that Congress required a culpable mental state. The opinion limited implied private liability by distinguishing intentional or reckless deception from ordinary professional negligence.

1. How does the rule affect information production, investor reliance, and enforcement costs?
2. What are the likely error costs for lawful market activity and for undetected misconduct?