Supreme Court defines "security" in malpractice litigation.

The U.S. Supreme Court reversed a court of appeals ruling in favor of Ernst & Young and held the firm could be tried for violations of the Securities Exchange Act of 1934.

To raise funds for its operations, the Farmers' Cooperative of Arkansas and Oklahoma sold uncollateralized demand promissory notes to investors. Subsequently, the Cooperative went bankrupt and the note holders filed suit in U.S. district court against AY (Ernst & Young's predecessor), the Cooperative's auditor. The suit alleged AY violated the antifraud provisions of the 1934 Act by intentionally failing to comply with generally accepted accounting principles in its audit.

The plaintiffs alleged AY inflated the value of a gasohol plant that was a major asset of the Cooperative. Had the plaintiffs known the true value of the Cooperative's assets, they alleged they would not have purchased the promissory notes.

At the trial, the plaintiffs prevailed on their claims and were awarded a $6,100,000 judgment. The CPA firm appealed, claiming the notes were not "securities" under either state or federal law. The Eighth Circuit Court of Appeals agreed and reversed the trial court's judgment against the firm.

In reversing the appellate court's ruling, the Supreme Court ruled promissory notes issued by the Cooperative were "securities." The Court applied the "family resemblance" test, under which a note is considered a security unless it falls within one of four categories of nonsecurities. The Court found the notes to be securities in that

1. There was common trading of the notes.

2. The public perceived the notes as investments.

3. The Cooperative sold the notes to raise capital.

4. There were no risk-reducing factors to negate the need for regulation of the notes.

Consequently, the Court ruled a securities action could be maintained against Ernst & Young in this situation. (Reves v. Ernst & Young, 110 S.Ct. 945, 1990)