SECURITIES AND EXCHANGE COMMISSION

                         Washington, D.C.

 

SECURITIES EXCHANGE ACT OF 1934

Rel. No. 38183 / January 21, 1997

 

ACCOUNTING AND AUDITING ENFORCEMENT

Rel. No.  871 / January 21, 1997

 

Admin. Proc. File No. 3-6776

_____________________________________________

                                             :

            In the Matter of                 :

                                             :

           DAVID J. CHECKOSKY                :

                   and                       :

           NORMAN A. ALDRICH                 :

_____________________________________________:

 

OPINION OF THE COMMISSION ON REMAND

 

     RULE 2(e) PROCEEDINGS

 

          Ground for Remedial Action

 

               Improper Professional Conduct by Accountants

 

     Where accountants incorrectly interpreted Generally Accepted

     Accounting Principles and failed to comply with Generally

     Accepted Auditing Standards, held, accountants engaged in

     improper professional conduct within the meaning of Rule

     2(e)(1)(ii) of the Commission's Rules of Practice, and have

     served suspensions from practice before the Commission for a

     period of two years.

 

APPEARANCES: 

 

     Geoffrey F. Aronow, Andrew T. Karron, and John C. Massaro,

of Arnold & Porter, for David J. Checkosky and Norman A. Aldrich.

 

     Barry R. Goldsmith, Susan Ferris Wyderko, and Leo F.

Orenstein, for the Commission's Office of the Chief Accountant.

 

Remand received:    August 15, 1994

Last brief filed:   April 26, 1995

 

                                I.

 

     This proceeding under Rule 2(e) of our Rules of Prac-

tice 1/ against David J. Checkosky and Norman A. Aldrich

 

                   

1/   Although our Rules of Practice have been amended, Securities

     Exchange Act Release No. 35833, 60 Fed. Reg. 32,738 (June

     23, 1995), these proceedings were instituted before the new

     rules were adopted.  Thus, the old rules continue to apply.

                                                   (continued...)

 

 

 

 

==========================================START OF PAGE 2======

 

("Respondents") is here for the second time.  On August 26, 1992,

we issued an opinion and order finding that Respondents

incorrectly interpreted Generally Accepted Accounting Principles

("GAAP") and did not comply with Generally Accepted Auditing

Standards ("GAAS") 2/ in connection with a series of audits of

Savin Corporation ("Savin"). 3/  We suspended Respondents from

practice before us for a period of two years. 4/  On May 20,

1994, the United States Court of Appeals for the District of

Columbia Circuit remanded this proceeding to us "for a more

adequate explanation of [our] interpretation of Rule 2(e)(1)(ii)

and its application to this case." 5/   

 

                               II.

 

     Savin was a publicly traded company that, at the beginning

of the 1980's, marketed liquid-toner copiers that were

manufactured by Ricoh Company, Ltd. ("Ricoh").  Coopers & Lybrand

("C&L") was Savin's auditor.  Checkosky was the engagement

 

                   

1/(...continued)

     Former Rule 2(e)(1), which is the basis of this proceeding,

     is now 17 C.F.R.  201.102(e)(1).  There were no substantive

     changes to this rule.

 

2/   GAAP constitutes a consensus of what accounting principles

     are considered "generally accepted."  As one commentator

     observed, an accounting principle is considered generally

     accepted if it has "'substantial authoritative support'

     which may derive in turn from a respectable constituency of

     usage or from promulgation by competent authority."  James

     F. Strother, The Establishment of Generally Accepted

     Accounting Principles and Generally Accepted Auditing

     Standards, 28 Vand. L. Rev. 201, 203 (1975).  We have stated

     that we will consider principles, standards, and practices

     promulgated by the Financial Accounting Standards Board as

     having substantial authoritative support.  Accounting Series

     Release No. 150 (December 20, 1973), 3 SEC Docket 275-76.

 

     The principles of GAAS set forth "the obligations of due and

     professional care which attend the independent auditor's

     examination and his report upon audited financial

     statements."  Strother, supra, 28 Vand. L. Rev. at 208.

     GAAS is contained in 10 standards adopted by the American

     Institute of Certified Public Accountants ("AICPA"),

     describing the independent auditor's professional duties.

     AUDITING STANDARDS, AU  150.02, citing standard  110.02.

 

3/   David J. Checkosky and Norman A. Aldrich, 50 S.E.C. 1180

     (1992).

 

4/   Respondents, who did not seek a stay, completed serving

     their suspensions in 1994.

 

5/   Checkosky & Aldrich v. SEC, 23 F.3d 452. 

 

 

 

 

==========================================START OF PAGE 3======

 

partner and Aldrich was generally the audit manager 6/ on C&L's

audits of Savin for Fiscal Years 1981 through 1984 and for the

eight-month period from May 1 to December 31, 1984. 7/ 

 

     In examining Savin's books, Respondents' responsibility was

to determine, using GAAS, whether their client had adhered to

GAAP in preparing its financial statements and to express an

opinion on those financial statements. 8/  GAAS requires, among

other things, the exercise of "due professional care" (General

Standard No. 3) and independent judgment (General Standard No.

2), as well as possession of sufficient evidence to support the

conclusions (Standards of Field Work No. 3).  After their

examination, Respondents were required to report whether Savin's

financial statements were presented in conformity with GAAP. 9/

At issue is Respondents' treatment of Savin's expenditures in

creating its own copiers, under Statement of Financial Accounting

Standards No. 2 ("FAS 2"), promulgated by the Financial

Accounting Standards Board ("FASB"). 10/  FAS 2 requires that

all research and development costs be expensed as they are

incurred.

 

     A.  Savin's Decision to Develop Copiers.  In the late

1970's, Savin was informed that Ricoh would not be renewing its

distribution contract with Savin.  Although it had not previously

produced copiers, Savin decided to develop and manufacture its

own line of high-speed, liquid-toner copiers, an effort that

Savin called "Project X."  It retained an engineer, Benzion

Landa, to design a new photocopier, and purchased a subsidiary

that could produce parts for its anticipated line.  It also began

construction of an assembly plant, and formed an Engineering and

 

 

                   

6/   For the calendar year 1984 audit, Aldrich was the concurring

     partner.

 

7/   Savin's fiscal year ended on April 30 until 1984, when the

     ending date was changed to December 31.  There were 2 sets

     of statements for 1984 -- the 12 months ending April 30, and

     the 8 months ending December 31 (referred to in this

     proceeding as the "Calendar Year 1984 audit"). 

 

8/   Statement of Auditing Standards No. 1, promulgated by the

     AICPA, requires that an audit report state whether the

     financial statements are presented in accordance with GAAP.

     AUDITING STANDARDS, AU  326.01.  See also United States v.

     Arthur Young & Co., 465 U.S. 805, 818 (1984).

 

9/   AUDITING STANDARDS, AU  150.02.  Regulation S-X, 17 C.F.R.

      210.2-02(b) also requires the auditor to state whether the

     audit was made in accordance with GAAS.

 

10/  See ACCOUNTING FOR RESEARCH AND DEVELOPMENT COSTS, Statement

     of Financial Accounting Standards No. 2,    53-56 (FASB

     1974).

 

 

 

 

==========================================START OF PAGE 4======

 

Manufacturing Division ("E&M"), which eventually employed several

hundred engineers and other workers. 

 

     In early 1980, Landa delivered to E&M a model that

demonstrated certain working components but did not produce

copies, together with design drawings.  E&M then began

development of photocopiers based on the model and drawings.

Savin recognized that the anticipated market for the new machine

demanded a high degree of reliability.  It therefore established

specifications for the new copiers that required 60 copies per

minute and a criterion for reliability permitting no more than 66

failures per million copies. 11/ 

 

     Initially, Savin intended to create four models of

copiers -- from a base model to one with multiple accessories.

The anticipated models were assigned the code names, which were,

in ascending order of cost and complexity, Diamond, Ruby, Sally,

and Rhino (the "high-end" model).  In August 1980, Savin's

quarterly report on Form 10-Q stated that its development plans

for the new line were on schedule and that Savin expected to

introduce the line in early 1982.

 

     B.  Savin's Accounting Policy.  As costs of the copier

project mounted, Savin sought to defer related expenses.  In the

fall of 1980, Savin's management informed Checkosky that Savin

wanted to begin capitalizing the costs associated with the

start-up of manufacturing.  At that time, Checkosky knew that

Savin's financial condition was deteriorating.

 

     After reading FAS 2 and a text on auditing, Checkosky con-

cluded that Savin could defer the costs at issue, provided that

the company had tangible evidence that research and development

had ended.  Checkosky recommended that Savin adopt a written

policy of cost deferral to describe a start-up period after

research and development during which costs would be deferred

rather than expensed.  He also suggested that completion of a

working model of the machine that Savin committed to produce

would provide a benchmark indicating the end of research and

development.  To assist Savin in drafting the policy, Checkosky

requested that C&L's research unit provide information on other

companies that deferred start-up costs relating to new

facilities. 12/ 

 

                   

11/  A "failure" in this context was a problem that a customer

     could not fix.  23 F.3d at 474 (Randolph, J.).

 

12/  The response from C&L's research unit to Checkosky, dated

     January 26, 1981, states that the unit had been asked

     whether the company could defer certain start-up costs

     related to building a major manufacturing facility, rather

     than whether costs related to product development could be

     deferred.  Nevertheless, in responding, the research unit

     attached four pages from a manual of another accounting firm

                                                   (continued...)

 

 

 

 

==========================================START OF PAGE 5======

 

     Savin adopted an accounting policy, dated May 1981, in which

Checkosky concurred, that allowed deferral of funds expended on

the copier project when Savin reached "a comfort level" of

marketability and believed that "the product will satisfy the

customer." 13/  Such subjective criteria had been considered

and rejected by the FASB when it adopted FAS 2.  Savin's

management adopted an interpretation of FAS 2, which was accepted

by Respondents, that the existence of a working prototype and

release of blueprints to manufacturing were to be considered

evidence of the conclusion of research and development. 

 

     C.  Fiscal Year 1981.  In January 1981, there was no

production line for the copiers.  The E&M manufacturing facility

was an "empty shell" that was still under construction.

Checkosky testified, however, that he personally inspected a

working model of a Savin photocopier in January 1981, and timed

the machine at 60 copies per minute.  There is no record in his

workpapers of either his visit or his observations.  Even if his

testimony were accepted, there is no evidence that Checkosky

ascertained whether the machine satisfied Savin's functional

specifications (including whether it met the requirements for

reliability) or was ready for manufacture.  During this period,

minutes of a meeting of Savin's Board of Directors reported that

Savin had been unable to develop a toner that would permit the

high-speed quality copies required by Savin's specifications.

The workpapers, moreover, refer to E&M's incurring costs for

"development and production of copiers." 

 

     Respondents did not test to determine whether the costs were

generated by activities that were in fact research and

development.  Instead, they tested to determine whether the

activities were directed to the copier project.  Nonetheless,

during the Fiscal Year 1981 audit, they authorized Savin to begin

deferring costs relating to Project X "after completion of [the]

first successful prototype" in November 1980.

 

     D.  Fiscal Year 1982.  Design of the copiers proved

difficult.  During Fiscal Year 1982, contemporaneous engineering

reports described "advanced development" efforts on the optical

system, the "complete design of paper path fixture," and the

"stripper finger," as well as substantial work with the toner and

"fuser."  

 

     Respondents saw a working model of a prototype of the Ruby

copier and were told that most of the drawings for Ruby and

 

                   

12/(...continued)

     describing product research and development.  See n. 33,

     infra.  

 

13/  Savin's accounting policy defined research and development

     to include "[d]esign, construction and testing or [sic]

     pre-production prototypes and models" and "[p]rototype

     pre-manufacturing activity."

 

 

 

 

==========================================START OF PAGE 6======

 

Diamond had been released to manufacturing.  Respondents,

however, were aware that substantial development work remained on

the toner and fuser and that there were issues concerning

reliability.  Moreover, they were informed that Ruby, as well as

the Diamond and Sally models, would not be introduced into

manufacturing until Fiscal Year 1983 and that Rhino would not be

introduced until Fiscal Year 1984.  Although Respondents had seen

a Ruby prototype, they did not determine whether the prototype

met Savin's specific functional and economic criteria.

Respondents nonetheless concluded that Ruby was "past the

prototype stage and deferral (and continued deferral) was

appropriate."  Respondents did not test to determine whether the

activities that were generating the deferred costs were research

or development.

 

     E.  Fiscal Year 1983.  Production did not begin as planned.

In June 1982, the company announced that it was postponing the

anticipated introduction date for its new photocopier line to

January 1983.  Savin's engineers kept redesigning every aspect of

the machine.  By summer 1982, Savin had built between 15 and 20

copiers, but those machines were unreliable.  There were

continuing problems with the fuser, toner, stripper, sorter, and

paper path.  During the summer, Landa provided a new liquid toner

that was expected to produce clearer copies, but needed further

development work.  Moreover, E&M engineers discovered that the

new toner was incompatible with the existing fuser.  Attempts to

modify the existing fuser to accommodate the new toner resulted

in fires within the copier, and attempts were made to develop a

new fuser.  In addition, the failure rate was well in excess of

1,000 failures per million copies, and rose to 1,919 failures per

million in mid-November 1982.

 

     Savin displayed several copiers at the National Office

Machine Dealers Association convention in July 1982.  The dis-

played models did not use the new toner because a compatible

fuser was not ready.  The copiers also produced copies that

smudged.

 

     By September 1982, Savin's Board of Directors was informed

that the production run would be deferred until September 1983.

The Board was also informed that the copy quality generated by

the Savin machines was "not as good as dry toner machines."  As

1982 drew to a close, the copiers still had not met the product

specifications written by Savin's engineers.  Contemporaneous

engineering reports noted "critical problems" (i.e., problems

that would preclude marketability) that had not been overcome

with the fuser, toner, and copier reliability, among other

things. 

 

     Savin concluded that it had missed the window of opportunity

for marketing less expensive copiers and abandoned

 

 

 

 

==========================================START OF PAGE 7======

 

Project X. 14/  At this time, E&M dismissed half of its 500

employees.  In January 1983, Savin informed the C&L audit staff

that it would "redesign" one of the models to create a

marketable, high-end machine, which it called "Pegasus," or the

"8000 Series."  Although the Pegasus was to be an improvement of

the Rhino model, the Rhino had not been reduced to a working

prototype and the C&L workpapers stated that Rhino had not passed

out of research and development.  In fact, the optics,

photoconductor, stripper finger, developer, and fluid and paper

handling systems were redesigned for the Pegasus. 15/    

 

     In early 1983, Savin hired McKinsey and Company

("McKinsey"), a management consultant, to study the business

viability of continuing with the Pegasus project.  McKinsey

reported in April 1983 that, to be marketable, the copier had to

be capable at introduction of producing 70 copies per minute,

with no more than 62 failures per million copies.  McKinsey also

described the fuser as an "untested concept."  McKinsey projected

that Savin would have to design, test, and redesign the copier

subsystems and prototypes, and that development and testing of

the copier would last through June 1984 -- well past the end of

Fiscal Year 1984.  In recommending that production be pursued,

McKinsey assumed that Savin would be able to begin to market its

copier by July 1984.

 

     Respondents knew that the machines were experiencing a high

number of failures and that the fuser and toner would involve new

technology.  They were aware that the engineers were working on

prototypes.  They nonetheless concluded that Savin did not have

to write off its deferred costs because the Pegasus would employ

the "same basic technology" as the Rhino.

 

     F.  Fiscal Year 1984.  Engineers in E&M devoted all their

time throughout 1983 and 1984 to designing, constructing, and

testing prototypes in an attempt to meet Savin's specific

functional and economic requirements and to get the copier ready

for manufacture. 16/  The minutes of Savin's Board of

 

                   

14/  In Fiscal Year 1983, as a result of the decision to

     reconfigure the copier, and at Respondents' insistence,

     Savin wrote off $5.7 million of deferred start-up costs

     attributable solely to the lower-end models.

 

15/  For example, the Project X copiers had had one or two paper

     trays.  Pegasus was to have four paper trays.  The entire

     mechanism was to be rotated 90 degrees around the drum.

     While the original copiers were tabletop machines, the

     Pegasus was designed to be a full-size console model.

 

16/  In September 1983, the staff of our Division of Corporation

     Finance wrote to Savin seeking detailed justification for

     its inclusion of deferred start-up costs as an asset for

     Fiscal Year 1983 and the three months thereafter.  In

                                                   (continued...)

 

 

 

 

==========================================START OF PAGE 8======

 

Directors' meeting in November 1983, which are included in

Respondents' workpapers, reported "continuous design change

throughout the prototype build."  

 

     In February 1984, Arthur D. Little, Inc., a management

consultant, submitted a review of Pegasus to Savin.  The report

stated that production was scheduled to start in late 1984 and

that Savin claimed to have two complete engineering models,

subject to preliminary testing.  However, the author reported

seeing only a skeletal frame of a prototype, which lacked most

components.  The author further had not seen an operational or

completed copier, or copies made by a Pegasus copier.

 

     In March 1984, the Pegasus copiers were still experiencing

from 700 to over 1,000 failures per million copies.

Respondents were aware that no drawings had been released for

manufacture.  Respondents also had access to Savin engineering

reports written during May 1984 that cited continuing problems,

such as transfer jams, toner leakage, and motor

overheating. 17/

 

     Respondents asked that Savin have McKinsey update its

earlier study of Pegasus' marketability.  Early versions of the

McKinsey update show editorial modifications made by Checkosky

and by Aldrich to delete or modify references to technical

problems associated with the development of the copier.  Many of

their changes were incorporated in the final version of the

updated report.  The final version of the update, dated July 13,

1984, focused on delays caused by organizational, rather than

technological problems.  Even as modified, however, the McKinsey

update stated that no working model of Savin's copier had yet

been built, and that "the key technical risks that remain center

on achieving the overall reliability goal of less than 62

[failures per million copies] before introduction."   

 

     G.  Calendar Year 1984.  By the end of 1984, the copier

still leaked considerable amounts of liquid toner on the floor

and produced excessive heat.  One Savin engineer testified that

the copier "could have been used as a furnace as well as a copy

machine, because that's what it was."  Concerns arose that the

excessive heat emissions might violate Occupational Safety and

Health Administration standards.  Fusing the liquid toner to

paper produced toxic vapors, which caused severe eye irritation

and headaches for users.  Reliability of the machines continued

 

 

                   

16/(...continued)

     December 1983, our Division of Enforcement wrote an

     extensive follow-up letter.

 

17/  These reports and the early drafts of the McKinsey update

     were discovered in C&L's files and produced by C&L while our

     prior opinion was on appeal.  See 23 F.3d at 457-58 n. 5

     (Silberman, J.).

 

 

 

 

==========================================START OF PAGE 9======

 

to be a problem, and many of the manufacturing drawings for

Pegasus were defined as "NOT STARTED" or in redesign. 

 

     Savin abandoned its plans to develop a new copier in late

1985.  The company had failed to design any machines that

achieved its goals for commercial production.  Savin's financial

statements, filed as part of its Forms 10-K for Fiscal Years 1981

through 1984 and Calendar Year 1984, carried "deferred start-up

costs" as an asset.  This capitalization of Savin's expenses

related to copier programs totalled $68 million by the end of

1984.  We found in our prior opinion that $37 million of that

amount were research and development costs, which should have

been expensed and not deferred.  As a result, Savin's assets and

stockholders' equity were materially overstated, and its net

losses materially understated. 18/

 

     The audit reports for Fiscal Years 1981 through 1983 repre-

sented that the audits were conducted according to GAAS and that,

in the auditors' opinion, Savin's financial statements conformed

without exception to GAAP.  The audit reports for Fiscal Year and

Calendar Year 1984 contained the auditors' opinion that the

financial statements complied with GAAP, subject to the recovery

of Savin's deferred start-up costs. 19/ 

 

                   

18/  The following chart, taken in part from our prior opinion

     (50 S.E.C. at 1186 n. 13), shows the amounts of deferred

     start-up costs (in millions) found to have been improperly

     capitalized for each year and, cumulatively, Savin's net

     loss and stockholders' equity for each period, and the

     improperly capitalized amounts as a percentage of the net

     loss and stockholders' equity for each period:

 

                           FY 81   FY 82   FY 83   FY 84   CY 84

 

Improperly deferred

 start-up costs              1.8     8.8     9.1    11.7     5.6

 

Cumulative amounts           1.8    10.6    19.7    31.4    37.0

 

Net loss                     2.2    32.2    21.1    58.8    13.8

 

Stockholders' Equity       100.4   103.1   116.1    85.9    72.2

 

Start-up costs

as % of net loss            81.8    27.3    43.1    19.9    40.6

 

Cum. Start-up costs  

as % of Stock. Eqty.         2.2    10.3    16.9    36.5    51.2

 

19/  In November 1985, pursuant to a settlement with the

     Commission in which Savin neither admitted nor denied the

     Commission's allegations, Savin was enjoined from violations

     of Sections 13(a) and 13(b)(2) of the Securities Exchange

                                                   (continued...)

 

 

 

 

==========================================START OF PAGE 10======

 

                               III.

 

     A.  As discussed above, the Court of Appeals remanded this

proceeding to us for further explanation of our interpretation of

Rule 2(e)(1)(ii) and its application to the facts before us.

Each of the three opinions accompanying the court's order

expresses differing views on certain of the issues.  All three

opinions, however, recognize our authority to sanction

accountants pursuant to Rule 2(e)(1)(ii) of our Rules of

Practice.  All three further agree that our findings that

Respondents did not properly interpret GAAP and failed to act in

accordance with GAAS are supported by substantial

evidence. 20/ 

 

     B.  We previously found that Respondents engaged in improper

professional conduct and that their conduct was reckless. 21/

We begin by explaining our reasons for this conclusion and why we

continue to find their conduct reckless. 22/

 

     As accountants and auditors, Respondents are required to

comply with professional standards. 24/  At issue here is

 

                    

19/(...continued)

     Act of 1934 ("Exchange Act") and Rules 13a-1 and 13a-13

     thereunder, and agreed to restate its annual reports on Form

     10-K for Fiscal Year 1983, Fiscal Year 1984, and Calendar

     Year 1984 to write off certain deferred start-up costs

     related to development of the copiers.  Litigation Release

     No. 10928 (November 12, 1985), 34 SEC Docket 920.

 

20/  To the extent that Respondents' arguments may be viewed as

     addressing these issues, the court's opinions resolving them

     are the law of the case.  Under that doctrine, once a court

     decides an issue that decision binds all future proceedings

     in the same case.  Key v. Sullivan, 925 F.2d 1056 (7th Cir.

     1991); City of Cleveland v. Federal Power Commission, 561

     F.2d 344 (D.C. Cir. 1977).

 

21/  Checkosky, 50 S.E.C. at 1197.

 

22/  Recklessness has been described as "not merely a form of

     ordinary negligence; it is an 'extreme departure from the

     standards of ordinary care, which presents a danger of

     misleading buyers or sellers that is either known to the

     defendant or is so obvious that the actor must have been

     aware of it.'"  SEC v. Steadman, 967 F.2d 636, 641-42 (D.C.

     Cir. 1992).

 

24/       Every profession must set high standards for the

          quality of its work because people who rely on

          that work are usually unable to judge its quality

          for themselves.  Clearly, it is neither possible

          nor desirable to relieve auditors . . . of their

                                                   (continued...)

 

 

 

 

==========================================START OF PAGE 11======

 

Respondents' determination to concur in the capitalization of

certain costs associated with Savin's copier program,

specifically costs associated with research and development.

 

     FAS 2 provides definitions and examples of those costs that

should properly be expensed as research and development.

"Research" includes investigation to discover knowledge useful in

development of a new process or technique or in creating a

significant improvement to an existing product or process. 25/

"Development" is the translation of research findings or other

knowledge into a plan or design for a new product or process or

for a significant improvement to an existing product or process

whether intended for sale or use.  It includes the conceptual

formulation, design, and testing of product alternatives,

construction of prototypes, and operation of pilot plants. 26/

Among the activities that exemplify research and development are:

 

 

     (f) Design, construction, and testing of pre-production

     prototypes and models.

     . . .  

 

     (i) Engineering activity required to advance the design of a

     product to the point that it meets specific functional and

     economic requirements and is ready for manufacture. 27/

 

                   

24/(...continued)

          professional responsibility by establishing

          detailed rules of conduct . . . . Auditing

          standards, in the broadest sense, are guidelines

          for performing professionally responsible audits.

          . . .  They set the minimum level of quality that

          auditors are expected, by their clients and the

          public, to achieve.

 

     (Jerry D. Sullivan, et al., Montgomery's Accounting, 10th

     edition, (1985) 48-49).  The level of accepted

     professionalism that the accounting and auditing professions

     have set for themselves is GAAS and GAAP.

 

25/  "Research" is planned search or critical investigation aimed

     at discovery of new knowledge with the hope that such

     knowledge will be useful in developing a new product or

     service.  FAS 2   8(a).

 

26/  Development does not include routine or periodic alterations

     to existing products, production lines, manufacturing

     processes, and other on-going operations, although those

     alterations may represent significant improvements.

     Development further does not include market research or

     market testing activities.  FAS 2   8(b).

 

27/  FAS 2    9(f) and (i).  These examples may be contrasted

     with FASB examples of activities that are not considered

                                                   (continued...)

 

 

 

 

==========================================START OF PAGE 12======

 

     Respondents ignored numerous indicia that should have caused

them to question Savin's accounting treatment.  The first was

Savin's financial condition. 28/  During Fiscal Year 1981,

Respondents knew that Savin experienced a net operating loss for

the first time.  Had Savin not improperly deferred $1.8 million

as start-up costs, its operating loss would have further risen.

Checkosky characterized this information as a red flag,

warranting a heightened scrutiny of Savin's figures. 

 

     Moreover, Respondents did not require that Savin adopt a

cost deferral policy that adhered to the standards of

FAS 2. 29/  Instead, Savin's policy, which was adopted with

 

                   

27/(...continued)

     research and development:

 

          (a) Engineering follow-through in an early phase

          of commercial production.

          . . .

 

          (d) Routine, on-going efforts to refine, enrich,

          or otherwise improve upon the qualities of an

          existing product.

          . . .

 

          (h) Activity, including design and construction

          engineering, related to the construction,

          relocation, rearrangement, or start-up of

          facilities or equipment other than (1) pilot

          plants . . . and (2) facilities or equipment whose

          sole use is for a particular research and

          development project . . . .

 

         10(a), (d), and (h).

 

28/  We have judged auditors' performance in light of the "total

     audit environment."  Ernst & Ernst, 46 S.E.C. 1234, 1262

     (1978).  Thus, in Ernst & Ernst, we concluded that, among

     other things, the auditors failed to demonstrate "due

     professional care" when confronted with "a very large and

     extraordinarily profitable transaction" concluded three days

     before the end of the accounting year and were aware of

     management's desire to generate earnings.  Id.   See also

     Touche Ross & Company, 45 S.E.C. 469, 472 (1974) (auditor

     aware that management was aggressively seeking income and

     increasingly dependent on small number of complex

     transactions) (settlement).

 

29/  Respondents claim that they reasonably understood that

     "research and development" for purposes of FAS 2 ended when

     there was a working model of the new product that

     incorporated and demonstrated the new technology that had

     been pursued through research and development.  Respondents'

                                                   (continued...)

 

 

 

 

==========================================START OF PAGE 13======

 

Checkosky's advice and concurrence, permitted deferring

development costs when Savin reached "a comfort level" of

marketability and when it "believe[d] that the product will

satisfy the customer."  As discussed above, this type of

subjective standard was explicitly considered and rejected by the

FASB when it adopted FAS 2. 30/  Respondents also acceded to

Savin's view that the existence of a working prototype and

release of drawings for manufacture meant that Savin was no

longer engaging in research and development.  However, these

benchmarks were not necessarily indicia that a product had

reached the "specific functional and economic requirements"

described in FAS 2 or that there would not be continued design,

construction, or testing of other prototypes.

 

     Respondents were further aware that the copiers would have

to meet certain reliability standards to be marketable.

Checkosky claims that he personally inspected a working model of

a Savin photocopier in January 1981, and that this was evidence

supporting deferral.  It does not appear, however, that Checkosky

ascertained that the machine met Savin's functional and economic

specifications.  In fact, throughout 1981 and 1982, Savin's

engineers struggled to correct problems with fundamental

components of the copier, including the fuser and the toner, as

well as the copier's unreliability.  In the meantime, Savin's

deferred costs kept rising. 

 

     The indications that Respondents should question Savin's

policy of deferral mounted.  In Fiscal Year 1983, Savin abandoned

Project X and began work on Pegasus.  Although Respondents assert

that Pegasus was a refinement of the Rhino model, they knew that

there had been no prototype of Rhino and no release of drawings.

Indeed, C&L workpapers describe Rhino as remaining in research

and development. 

 

     Respondents were aware that the timing of market entry and

copier reliability were critical to the success of Pegasus.  They

knew that the staff of E&M had been drastically reduced in

December 1982.  They were also aware that substantial re-

engineering was being done to major components of Pegasus. 

Difficulties and continuing delays are described in engineering

reports and in minutes of the Savin Board of Directors.

Respondents further learned during the fall of 1983 that our

 

 

                   

29/(...continued)

     contention that FAS 2 is aimed only at the production of

     "new technology" was rejected by the law judge, by us, and

     by the Court of Appeals.  As Judge Randolph observed, the

     design of a model and its testing are considered research

     and development under FAS 2.  23 F.3d at 477.

 

30/  23 F.3d at 456-57 (Silberman, J.), citing ACCOUNTING FOR

     RESEARCH AND DEVELOPMENT COSTS, Statement of Financial

     Accounting Standards No. 2,    53, 54 (FASB 1974).

 

 

 

 

==========================================START OF PAGE 14======

 

staff was seeking detailed justification from Savin for its

inclusion of deferred start-up costs as an asset. 

 

     The first McKinsey report, in outlining what would be

required for successful marketing of the Pegasus project,

recommended strict production and completion benchmarks.  Those

benchmarks were not met in Fiscal Year 1983 or Fiscal Year 1984.

Nor were the difficulties minor.  By the end of 1984, for

example, the copiers still leaked liquid on the floor and

generated excessive heat.

 

     Respondents apparently relied on management's view that none

of the costs deferred with respect to the Pegasus project were

research and development.  Instead of assessing Savin's

activities to determine whether costs associated with the project

had passed out of research and development, Respondents merely

verified the amounts of project costs and that Savin had incurred

the costs in connection with the Pegasus project.  Although each

projection for production passed unfulfilled and no copier

progressed beyond the prototype stage, Respondents failed to

question Savin's continuing practice of deferring increasingly

higher amounts.  Moreover, there is nothing in the workpapers

that suggests that, in the face of all the contrary evidence that

they amassed over this period, Respondents ever reconsidered the

merits of their decision to permit deferral.

 

     Moreover, even under the much lower standards of Savin's

accounting policy, Savin's expenditures should not have been

deferred.  Respondents claim that they applied two benchmarks in

their Fiscal Year 1981 and 1982 audits to determine whether

Savin's project had passed out of research and development:

whether Savin had developed the actual machine that it would

produce and whether blueprints had been released from engineering

to manufacturing. 31/  Yet, in 1982, many of the blueprints

had not in fact been released.  The accounting policy standards

were apparently abandoned completely for the succeeding audits.

There were neither completed Pegasus blueprints nor any

successful working prototype of the Pegasus at the time of the

1983 or 1984 audits.

 

     Thus, over a period of years, Respondents were aware of

functional and economic problems that resulted in Savin's

repeatedly postponing introduction of copier models.  By the

Fiscal Year 1983 audit, Respondents knew of the cancellation of

development of the original designs, lay-off of a significant

number of employees, and attempts to develop a reconfigured

design.  The new design attempts were unsuccessful, resulting in

prototypes that leaked toner, generated very excessive heat, and

were unreliable.  These events, coupled with Savin's financial

condition and the accelerating deferred costs, should have

alerted them to the need for "heightened vigilance" in

 

 

                   

31/  50 S.E.C. at 1191.

 

 

 

 

==========================================START OF PAGE 15======

 

determining whether the deferrals were proper.  As described

above, Respondents did not make such efforts.

 

     Respondents' lack of independent judgment is underscored by

their involvement with the 1984 McKinsey update report.  Before

the law judge and in their initial appeal to us, Respondents

cited this update as evidential matter supporting their audit

work.  As described above, however, Respondents made editorial

modifications to the 1984 update.  Their changes struck out

phrases that suggested that Savin was in the "design phase" or

had incurred "development costs" and minimized the preliminary

nature of the copier project. 32/  Many of their changes were

incorporated in the final version of McKinsey's report.  Such

involvement is a complete deviation from the requirement that

auditors bring professional skepticism to their work.      

 

     Respondents argue that, even if we did not accept the

testimony of their expert witnesses who concurred with

Respondents' interpretation of FAS 2, these experts' testimony

shows that Respondents' conclusions were not unreasonable, and

certainly not reckless. 33/  In our prior opinion, we found

 

                   

32/  For example, "[t]he technical risks of an unproven copier

     project" was changed to "the risks of a new copier project,"

     and "the development team" to "the engineering team."  And

     the following section was marked in the draft:

 

          A year ago, the major risk was whether the

          basic technical concept was sound.  The fuser

          concept had not been demonstrated and no

          subsystems were even under test.  Given the

          high reliability and copy quality benchmarks,

          there were major concerns as to whether the

          product was feasible.  With prototypes now

          under test . . . .

 

     In the final McKinsey update report, this language was

     replaced with:

 

          As of March 1983 the major risk on the

          program was whether the 8000 concept as a

          system could meet the high reliability and

          copy quality benchmarks that were established

          as the requirements for commercial success.

          No working models incorporating all of the

          planned modifications to the earlier

          generation of machines (i.e., Diamond/Ruby)

          has as yet been built.  Now, as it has been

          explained to us, with prototypes having been

          tested . . . .

 

33/  Respondents also claim to have consulted the Price

     Waterhouse manual in 1981, which lent support to the

                                                   (continued...)

 

 

 

 

==========================================START OF PAGE 16======

 

that Respondents' expert witnesses were satisfied with the

Respondents' actions because the experts were unaware of the

seriousness of the designs' deficiencies, or that the designs had

not progressed to manufacture. 34/  Moreover, we are uncertain

whether any of these experts reviewed the after-disclosed

evidence, including the edits to the McKinsey update report and

the Savin staff 1984 engineering reports.  We do not know,

therefore, how that evidence would have affected their views.

 

     The facts that Respondents qualified their opinions on the

Fiscal and Calendar Year 1984 audits and that Savin expensed

certain copier-related costs beginning in 1981 do not change our

conclusion that they recklessly failed to account for all such

costs properly.  The qualified opinions raised questions

regarding Savin's ability to bring its product to the market on a

timely basis and to recover its costs.  They did not raise

questions about Respondents' opinion that it was proper for Savin

to book as assets costs that should have been expensed,

particularly after years of Savin's failures to manufacture a

copier. 35/

 

 

                   

33/(...continued)

     standards adopted in Savin's policy statement.  As Judge

     Randolph observed, the law judge did not indicate whether

     she credited Checkosky's testimony that he had read the

     materials sent by the research unit.  Moreover, we do not

     agree that the Price Waterhouse manual supports Respondents'

     position.  The manual observes that research and development

     activities are undertaken with the goal of bringing new

     products to a "technologically feasible status where they

     are ready to be produced, utilized, or offered."  The manual

     includes examples of charges that should be expensed, such

     as "translation of research output into a new product

     concept" and "designing a new product."

 

34/  50 S.E.C. at 1195.

 

35/  Respondents cite certain inquiries to the FASB staff made by

     our staff as supporting the position that their inter-

     pretation of FAS 2 was reasonable.  The inquiries and their

     responses are quite general, and at least one response notes

     that the FASB staff did not provide interpretations as to

     specific situations.  It appears, moreover, that the

     majority of these responses dealt with a company that was

     "working on" or making alterations to existing products, a

     situation not applicable here.  One of the responses also

     observes that, in determining whether an activity is

     research or development, "It may be significant that the

     enterprise is continuing in its attempts to find a

     commercially successful application of the developed

     technology rather than merely attempting to adapt an

     existing, commercially successful product to a broader

     market."

 

 

 

 

==========================================START OF PAGE 17======

 

                               IV.

 

     Respondents assert that any finding that Respondents acted

recklessly fails to satisfy due process and administrative notice

requirements because the Office of the Chief Accountant did not

allege that Respondents acted with scienter.  Respondents rely,

in part, on In re Ruffalo. 36/  Ruffalo had been charged with

attorney misconduct.  At the hearing, the state board added a

different charge based on Ruffalo's testimony before it, and gave

Ruffalo a continuance to defend the new charge.  The board

ultimately dismissed the original charges and disbarred Ruffalo

based on the charge added at the hearing.  The Supreme Court held

that, despite the continuance, Ruffalo was deprived of procedural

due process because he had a right to know of the charges against

him before the hearing commenced. 37/ 

 

     Unlike Ruffalo, we are not dealing with an uncharged

offense, nor alleged misconduct predicated on the unwitting

testimony of a respondent.  Respondents understood the charge

against them.  The Order Instituting Proceedings alleged that

Respondents engaged in improper professional conduct. 38/  As

discussed infra, we have found improper professional conduct

committed under circumstances evidencing a variety of mental

states.  Throughout this proceeding, Respondents have argued that

they must be found to have acted with scienter if their conduct

is to be adjudged improper.  As Respondents have urged, we have

evaluated their conduct against GAAS and GAAP and considered the

degree of their deviations from those standards. 39/ 

 

                                V.

 

 

                   

36/  390 U.S. 544 (1968), modified on other grounds, 392 U.S.

     919.  Compare also 23 F.3d at 481-82 (Randolph J., agreeing

     with Respondents' assertion) with 23 F.3d at 460-62

     (Silberman, J., disagreeing).

 

37/  390 U.S. at 552.

 

38/  See, e.g., Aloha Airlines, Inc. v. CAB, 598 F.2d 250, 262

     (D.C. Cir. 1979) (discussing sufficiency of notice under the

     Administrative Procedure Act).

 

39/  Respondents complain that our consideration of the issue has

     somehow been waived.  However, Rule 17(g) of our former

     Rules of Practice (which govern this proceeding) authorizes

     this Commission, with notice to the parties, to raise and

     determine matters that it deems material.  We asked the

     parties here to address (1) what constitutes recklessness

     for purposes of Rule 2(e)(1)(ii); and (2) what facts, if

     any, in the record demonstrate that Respondents did or did

     not act recklessly or negligently.  See David J. Checkosky

     and Norman A. Aldrich, Securities Exchange Act Release No.

     34983 (November 14, 1994), 58 SEC Docket 19.

 

 

 

 

==========================================START OF PAGE 18======

 

     We have explained above why we find Respondents' conduct to

be reckless.  As noted, however, the Court of Appeals unanimously

directed that we generally supply a "more adequate explanation"

of our interpretation of Rule 2(e)(1)(ii).  The opinions of the

panel focus on the mental state required for improper

professional conduct. 

 

     Rule 2(e)(1) governs the conduct of professionals --

including accountants, attorneys, engineers, and geologists --

who appear before us.  In light of the different roles of each of

these professionals, we hold "those professionals who practice

before us to generally recognized norms of professional conduct .

. . .  To do so upsets no justifiable expectations, since the

professional is already subject to those norms." 40/  In the

case of accountants, those standards include GAAS and GAAP.

Accountants' audit reports publicly represent that "the code of

conduct embodied in the statements of auditing standards

promulgated by the AICPA has been followed." 41/  As Judge

Randolph observed,

 

     [c]ompliance with these requirements gives credibility to

     financial statements.  It promotes the use of financial

     statements as the [Securities Exchange Act of 1934

     ("Exchange Act")] intended them to be used:  to assess the

     financial health of a company; to compare one company's

     performance with another's; and to evaluate any single

     company's progess over several accounting periods. 42/

 

     Improper professional conduct by accountants encompasses a

range of conduct.  We agree that improper professional conduct by

an auditor includes the "auditor who certified financial

statements despite realizing his lack of independence from the

reporting company, or who knowingly assisted in the filing of

materially false statements with the Commission.  Such

individuals cannot be trusted and neither can their

reports." 43/  We have not hesitated to sanction auditors for

such conduct. 44/  However, it has equally been our experience

 

                   

40/  William R. Carter, 47 S.E.C. 471, 508 (1981).

 

41/  Carter, 47 S.E.C. at 478.

 

42/  Checkosky, 23 F.3d at 471-72.

 

43/  Id. at 471.

 

44/  See, e.g., Myron Swartz, 41 S.E.C. 53 (1961) (sanctioning

     accountant who certified financial statements when no

     examination was made of books and records, failed to

     disclose falsity of such statements while continuing to

     perform accounting services for the company, prepared false

     and misleading financial statements for filing with this

     Commission, and testified falsely to Commission staff about

     these matters).

 

 

 

 

==========================================START OF PAGE 19======

 

that "[a]n incompetent or unethical practitioner has the ability

to inflict substantial damage on the Commission's processes, and

thus the investing public." 45/

 

     Our conclusions about the propriety of particular

professional conduct are driven by the impact on Commission

processes of the specific facts presented in a given proceeding

before us.  We have, for example, disciplined an auditor who

employed a discredited accounting principle; 46/ an auditor

who failed to bring healthy skepticism to management's repre-

sentations in the face of indications that those representations

should be questioned; 47/ an auditor who expressed an opinion

without sufficient basis; 48/ and an auditor who failed to

perform required minimum audit procedures. 49/

 

     We believe that Rule 2(e)(1)(ii) does not mandate a

particular mental state and that negligent actions by a

professional may, under certain circumstances, constitute

improper professional conduct. 50/  Unlike Rule 2(e)(1)(iii),

 

                   

45/  Carter, 47 S.E.C. at 475, quoting Keating, Muething &

     Klekamp, 47 S.E.C. 95, 120 (1979) (Chairman Williams,

     concurring).

 

46/  F.G. Masquelette & Co., Accounting Series Rel. No. 68,

     [1937-1982 Accounting Series Releases] Fed. Sec. L. Rep.

       72,087 (July 5, 1949) (using the "now thoroughly

     discredited device of employing par value as a

     representation of value for financial statement purposes.").

 

47/  Ernst & Ernst, 46 S.E.C. at 1262 (criticizing accountants'

     failure to bring "healthy skepticism" to management

     representations when aware of management's willingness to

     "stretch a point" and conceal material information); Touche,

     Ross & Co., 45 S.E.C. at 472 (observing that failure to

     question management's representations delayed discovery of

     "pattern of manufacturing profits").

 

48/  Barrow, Wade, Guthrie, & Co., Accounting Series Rel. No. 67

     [1937-1982 Accounting Series Releases] Fed. Sec. L. Rep.

     (CCH)   72,086 (April 18, 1949) (auditor acquiesced in

     decision of management not to take a physical inventory of

     work in process yet certified that there was "no reason to

     believe" that inventories were "unfairly stated.").

 

49/  See, e.g., Harmon R. Stone, 41 S.E.C. 532, 535 (1963).

 

50/  Respondents make certain arguments based on the recognized

     inherent powers of an administrative agency to discipline

     attorneys and the mental state required for such action.

     However, while we have such inherent powers, we do not agree

     with Respondents' arguments that those powers mandate a bad

     faith finding.  Respondents rely on Roadway Express, Inc. v.

                                                   (continued...)

 

 

 

 

==========================================START OF PAGE 20======

 

Rule 2(e)(1)(ii) does not require that the conduct be "willful."

Nor do we believe that Respondents are correct that the overall

structure of the securities laws mandates that scienter is an

element of Rule 2(e)(1)(ii).  Respondents observe that Section

10(b) of the Exchange Act requires scienter. 51/  However,

other provisions of the securities laws that can involve

accountants do not.  The Office of the Chief Accountant directs

our attention to Section 11 of the Securities Act of 1933, which

imposes civil liability on auditors in the absence of scienter.

Moreover, other provisions of the Exchange Act that may impose

liability based on audited financial reports filed with us, such

as Sections 15(c)(3) and 13(a), similarly do not contain a

scienter requirement. 52/  

 

     Moreover, we have found improper professional conduct where

an auditor was negligent or acted while mentally and physically

 

 

 

                   

50/(...continued)

     Piper, 447 U.S. 752, 767 n. 13 (1980), which dealt with the

     issue of whether courts had the inherent powers to assess

     attorneys' fees as a sanction for bad-faith conduct.  That

     opinion, while recognizing that state courts had sanctioned

     attorneys for negligent conduct, specifically limited its

     holding to the issue of bad-faith conduct before it.  With

     respect to this case, the Court of Appeals noted, in any

     event, that Section 2(e)(1)(ii) was enacted pursuant to our

     broad rulemaking authority under Section 23(a)(1) of the

     Exchange Act.  Checkosky, 23 F.3d at 455-56 (Silberman, J.),

     23 F.3d at 469-72 (Randolph, J.), 23 F.3d at 493-94

     (Reynolds, J.).

 

51/  We previously expressed the view that the standards for

     fraud or for injunctive relief "have no bearing" on Rule

     2(e)(1)(ii) proceedings.  Checkosky, 50 S.E.C. at 1197 n.

     38.

 

52/  Respondents assert that Section 15(b) of the Exchange Act

     authorizes this Commission to discipline broker-dealers and

     their associated persons for willful conduct.  However,

     certain provisions of Section 15(b) do not require

     willfulness.  See, e.g., Section 15(b)(4)(E) (failure to

     provide reasonable supervision).  Moreover, courts have

     construed "willfully" under Section 15(b) as "intentionally

     committing the act which constitutes the violation."  Tager

     v. SEC, 344 F.2d 5, 8 (2d Cir. 1965).

 

     Respondents also cite the recent amendments to the

     securities laws that authorize imposition of director and

     officer bars.  However, the fact that this particular remedy

     may be imposed only for a scienter-based violation is not

     apposite to the question of what constitutes improper

     professional conduct.

 

 

 

 

==========================================START OF PAGE 21======

 

exhausted; 53/ "failed to fulfill [its] responsibilities of

serving as" an independent accountant; 54/ "failed to give

this professional undertaking the degree of care and inquiry it

demanded," (conduct that we found "so deficient" as to warrant

disciplinary action); 55/ or behaved in a manner that was

"manifestly unethical, improper, and unprofessional." 56/

While the acts in each case demonstrated varying degrees of care

or mental state, we concluded in each that the accountant had

improperly certified that financial statements complied with the

applicable auditing requirements and that the resulting financial

statements could not be relied upon.

 

     Respondents argue that our opinion in Carter mandates that

scienter must be established to demonstrate improper professional

conduct.  In Carter, two attorneys were charged both with

improper professional conduct (Rule 2(e)(1)(ii)) and with aiding

and abetting their client's violations of the antifraud and

disclosure provisions (Rule 2(e)(1)(iii)).  Carter, however,

dealt with a limited issue -- the responsibilities of an attorney

acting as an adviser to a client on disclosure matters where the

reasonable lawyer "must conclude that his advice is not being

followed, or even sought in good faith, and that this client is

involved in a continuing course of violating the securities

laws." 57/  The particular question we confronted was what

 

                   

53/  Barrow, Wade at 62,176.  Consistent with then-current

     procedures, Barrow, Wade was instituted as a private

     proceeding.  Under those procedures, among other things, the

     name of the respondent was not disclosed unless an adverse

     judgment was entered against the respondent.  Although, as

     Respondents note, we dismissed the case against the Barrow,

     Wade respondents, this Commission adopted the recommendation

     of the hearing examiner that we identify the respondents and

     publish a statement detailing the basis for our findings

     that these respondents engaged in improper professional

     conduct.

 

54/  Ernst & Ernst, 46 S.E.C. at 1271.

 

55/  Haskins & Sells, Accounting Series Rel. No. 73 [1937-1982

     Accounting Series Releases] Fed. Sec. L. Rep. (CCH)   79,092

     (October 30, 1952).

 

56/  Myron Swartz, 41 S.E.C. at 57.

 

57/  Carter, 47 S.E.C. at 511-12.  We made clear that our opinion

     was:

 

          directed only to the narrow range of lawyers engaged in

          a federal securities practice, to the specific factual

          context of an ongoing disclosure program of a corporate

          client, and to the limited question of when it is

          appropriate for a lawyer to make further efforts within

                                                   (continued...)

 

 

 

 

==========================================START OF PAGE 22======

 

further steps the lawyer had to take "to avoid the inference that

he has been co-opted, willingly or unwillingly, into the scheme

of non-disclosure." 58/ 

 

     In Carter, we further acknowledged that, at that time, no

generally recognized professional norms provided guidance to

attorneys faced with this difficult situation. 59/  For that

reason, we issued an interpretation, applicable after the date of

the opinion, as to what constituted improper professional conduct

in that instance. 60/

     In contrast, here Respondents are not being held to account

for advice to a client that the client refused to follow.

Indeed, Respondents concurred in management's desire to defer

 

                   

57/(...continued)

          the corporation to forestall continuing violative

          conduct.  Id. at 476.

 

58/  Id. at 511.  Respondents make much of the fact that we refer

     to the attorney's awareness of the client's violation.  The

     attorney's knowledge of the violations was the precise

     problem we were facing in Carter.  We did not suggest that

     "awareness" was somehow an element of improper professional

     conduct. 

 

59/  Id. at 508.

 

60/  We expressed the opinion that the lawyer was "in the best

     position" to evaluate the correct course of action.  We

     suggested, as possibilities, approaches to the board of

     directors or individual officers or directors.  We also

     observed that resignation was not the only permissible

     course under these facts. 

 

     We concluded that, as long as the attorney was exerting

     reasonable, good faith efforts, the attorney would be found

     to have met his or her professional obligations.  Id. at

     512.  In this regard, we distinguished efforts that might on

     their face appear reasonable (e.g., continuing to counsel

     disclosure) but are not in good faith (i.e., the attorney

     knows that the client is disregarding the advice and using

     the attorney as a shield.)  Id. at 511-12.  This observation

     is consistent with our opinion in Haskins & Sells.  We found

     that the auditors there acted in good faith but failed to

     give their "undertaking the degree of care and inquiry it

     required" in a manner which was "so deficient" that it

     warranted discipline.  Haskins & Sells at 62,197.

     Similarly, in Ernst & Ernst, we found that the auditors

     failed in their "responsibility to perform audits" in

     accordance with GAAS although we recognized that they "were

     victims of management's fraud and deception."  46 S.E.C. at

     1272.  We have found that work done either in bad faith or

     incompetently adversely impacts our processes.  Compare nn.

     44, 56 with n.53.

 

 

 

 

==========================================START OF PAGE 23======

 

Savin's research and development costs.  Moreover, we have found

improper Respondents' failures to comply with GAAS and to apply

properly GAAP, and there is a recognized professional standard

that applies to the issue, FAS 2.

 

     The Carter opinion separately analyzed the alleged improper

professional conduct and the aiding and abetting claims against

the attorneys.  Although Respondents here are not charged with

aiding and abetting Savin's violations, they cite the aiding and

abetting section of the Carter opinion to support their

assertions that Carter held that the "element of intent"

distinguishes professionals who should be disciplined from those

who committed "errors of judgment or have been careless."

However, as is clear from the remainder of the paragraph from

which this quotation is drawn, we stated only that, absent

wrongful intent, a lawyer will not be found to be an aider and

abettor merely because he gives incorrect advice. 61/

 

     Respondents further assert that Carter observed that

paragraphs (ii) and (iii) of Rule 2(e) serve the "same function"

and must therefore mandate the same degree of scienter.  Again,

we believe that they misconstrue Rule 2(e) and our opinion.  In

Carter, we observed that all three sections of Rule 2(e) have the

same goal and seek to effectuate the same policies:

 

     [I]f a [professional] violates ethical or professional

     standards, or becomes a conscious participant in violations

     of the securities laws, or performs his professional

     function without regard to the consequences, it will not do

     to say that because the [professional's] duty is to his

     client alone, this Commission must stand helplessly by

     while the [professional] carries his privilege of

 

 

 

 

                   

61/  Carter, 47 S.E.C. at 504.  Nor, as Respondents hypothesize,

     does our analysis mean that the improper professional

     conduct standard in Rule 2(e)(1)(ii) has engulfed the

     wilfulness standard in Rule 2(e)(1)(iii).  We have continued

     to bring proceedings under Rule 2(e)(1)(iii).  See, e.g.,

     Davy v. SEC, 792 F.2d 1418 (9th Cir. 1986) (affirming

     findings that respondent should be permanently denied the

     privilege of practicing before this Commission both for

     improper professional conduct and violations of the

     antifraud provisions of the securities laws).  Similarly, we

     continue to bring proceedings under all three sections of

     17(a) of the Securities Act of 1933 although the Supreme

     Court has held that Section 17(a)(1) requires scienter to

     establish a violation, while Sections 17(a)(2) and (3) do

     not.  Aaron v. SEC, 446 U.S. 680, 696 (1980).  See, e.g.,

     Jay Houston Meadows, Securities Exchange Act Rel. No. 37156

     (May 1, 1996), 61 SEC Docket 2444, 2453 n. 16, appeal filed,

     No. 96-60328 (5th Cir.)

 

 

 

 

==========================================START OF PAGE 24======

 

     appearing and practicing before the Commission on to the

     next client. 62/

 

     Rule 2(e)(1)(i), which is not at issue here, permits us to

discipline those who do "not . . . possess the requisite

qualifications to represent others."  Rule 2(e)(1)(i) does not

require any level of intent.  If a person is not properly

admitted or qualified in the appropriate professional capacity

and nonetheless seeks to appear before us, that professional is

subject to discipline under Rule 2(e).  The fact that this

section does not require scienter does not mandate any conclusion

with respect to whether Rules 2(e)(1)(ii) or (iii) should be

construed in the same way.  Each paragraph addresses a different

potential harm to our processes. 63/

 

     Respondents also claim that our opinion in Kenneth N.

Logan, 64/ supports their position that an auditor cannot be

found to have engaged in improper professional conduct if the

auditor acted in good faith.  In Logan, an auditor improperly

certified that he was independent, although eight percent of his

and his family's net worth was invested in the client's

securities.  We held that Logan's conduct was "grossly

improper." 65/ However, we observed, in dicta,

 

          if the evidence showed that Logan in good faith held

          himself out as an independent accountant, we should not

          hold him to be lacking in character or integrity or to

          have engaged in improper and unethical professional

 

 

 

 

 

 

                   

62/  Carter, 47 S.E.C. at 478.

 

63/  Thus, in Carter, 47 S.E.C. at 478, we observed, 

 

          Not every violation of law, however, may be sufficient

          to justify invocation of the sanctions available under

          [Rule 2(e)(1)(iii)].  The violation must be of a

          character that threatens the integrity of the

          Commission's processes in the way that the activities

          of unqualified or unethical professionals do.

 

64/  10 S.E.C. 982 (1942).

 

65/  Id. at 998.  Logan had argued that he was unfamiliar with a

     Commission rule and release that made clear that an

     accountant who had a substantial interest in a client would

     not be viewed as independent with respect to that client.

     We rejected his assertion of good faith, noting that both

     the rule and release were in effect at the time he made the

     subject certifications.

 

 

 

 

==========================================START OF PAGE 25======

 

          conduct merely by reason of the fact that he was found

          to be not in fact independent. 66/

 

     When Logan was issued in 1942, we and the accounting

profession were attempting to determine what constituted

independence on the part of accountants. 67/  In 1959, we

rejected a second claim that an auditor had certified mistakenly,

but in good faith, that he was independent. 68/  We conceded

that the accountant had made no effort to deceive us and that the

accuracy and completeness of the audit were not questioned.  We

nonetheless concluded that the accountant had engaged in improper

professional conduct, evidenced by "a careless and unprofessional

attitude with respect to a most fundamental concept under both

the [federal securities laws] and Accounting Standards." 69/

 

                   

66/  Id. at 985.  We note that Logan dealt not simply with

     whether the auditor had engaged in improper professional

     conduct, but whether he was "lacking in character or

     integrity" or had engaged in "improper and unethical

     professional conduct." (emphasis added).  Respondents have

     asserted that, "[a]side from the reference to 'improper

     professional conduct,'" the remaining phrases in Rule

     2(e)(1)(ii) "suggest wrongdoing, dishonesty, immorality or

     other instances of moral turpitude."

 

67/  One year before our decision in Logan, we noted that we had

     found that "conscious falsification . . . or lack of care

     and of proper verification in going over accounts, or

     uncritical acceptance of the orders of an officer of the

     registrant may cast grave doubts on the independence of an

     accountant."  A. Hollander & Son, Inc., 8 S.E.C. 586, 612

     (1941) (citations omitted).  Beginning in 1937, and on

     several occasions thereafter, we issued statements as to

     whether particular facts could affect an accountant's

     independence.  See, e.g., Accounting Series Rel. No. 81,

     [1937-1982 Accounting Series Releases] Fed. Sec. L. Rep. 

     72,103 (Dec. 11, 1958) (summaries of staff opinions as to

     whether, given a particular set of facts, an accountant was

     independent).

 

68/  The accountant's partner was also an officer, director, and

     the majority shareholder of an issuer.  The partner

     prevailed on the accountant to audit the issuer in his

     "individual" capacity.  The accountant claimed that he had

     reviewed an AICPA rule which did not specifically deal with

     the issue of whether one partner's lack of independence

     would be imputed to others in the firm.  He also consulted

     the issuer's counsel, who was, in addition, an officer and

     director of the issuer.  We held that the accountant was

     obligated to acquaint himself with our and the AICPA's rules

     and opinions respecting independence.  Bollt and Shapiro, 38

     S.E.C. 815, 820-21 (1959).

 

69/  Id. at 823.

 

 

 

 

==========================================START OF PAGE 26======

 

     We wish to make clear, however, that the fact that GAAP and

GAAS are professional standards against which we examine the

conduct of accountants does not mean that every deviation from

GAAP or GAAS is improper professional conduct warranting

discipline under Rule 2(e)(1)(ii).  Our processes are not

necessarily threatened by innocent or even certain careless

mistakes. 70/  At times, we have found improper professional

conduct by accountants who engage in several deviations of GAAS

or GAAP, 71/ or who deviated from GAAS or GAAP in more than

one audit, 72/ or with more than one client. 73/  

 

     However, isolated failures may be so serious as to warrant

discipline. 74/  Thus, as explained above, we concluded that a

single misrepresentation, which we characterized as "careless and

unprofessional," by an auditor that he was independent warranted

discipline.  We concluded that the importance of independence by

the auditor is "a most fundamental concept under [the securities

laws] and Accounting Standards." 75/ 

 

                               VI.

 

     Respondents urge that we dismiss this proceeding, alleging

that they at most engaged in isolated instances of negligent

behavior in the early 1980's.  As discussed in detail above, we

disagree both that their failures were isolated or merely

negligent.  We previously suspended Respondents from appearing

before us for a two-year period.  Those suspensions were

 

 

                    

70/  Thus, in Carter, we observed that a lawyer did not risk

     being held to have violated Rule 2(e)(1)(ii) if he or she

     failed "to correct every isolated disclosure action or

     inaction" the attorney believed varied from "applicable

     disclosure standards."  47 S.E.C. at 511.

 

71/  See, e.g., Myron Swartz, 41 S.E.C. at 58; Haskins & Sells,

     at 62,184 (various failures in valuing intangible assets).

 

72/  See, e.g., Touche Ross & Co., 47 S.E.C. 965 (1983) (improper

     professional conduct with respect to financial statements

     covering five years).

 

73/  See, e.g., Peat, Marwick, Mitchell & Co., 45 S.E.C. 789

     (1975) (relating to the examination of financial statements

     of National Student Marketing Corporation, Talley

     Industries, Inc., Penn Central Company, Republic National

     Life Insurance Company, and Stirling Homex Corporation.)

 

74/  See, e.g., Carter, 47 S.E.C. at 511 ("There may be isolated

     disclosure failures that are so serious that their

     correction becomes a matter of primary professional

     concern.").

 

75/  Bollt and Shapiro, 38 S.E.C. at 823.

 

 

 

==========================================START OF PAGE 27======

 

concluded in September 1994. 76/  We do not believe vacating

this order would be in the public interest.

 

     An appropriate order will issue. 77/

 

     By the Commission (Chairman LEVITT and Commissioner HUNT);

Commissioner JOHNSON dissenting, and Commissioner WALLMAN not

participating.

 

 

 

                                   Jonathan G. Katz

                                      Secretary

 

 

 

 

 

                   

76/  Respondents recently filed a notice suggesting that Johnson

     v. SEC, 87 F.3d 484 (D.C. Cir. 1996) was applicable to these

     facts.  In Johnson, the Court of Appeals ruled that the

     statute of limitations contained in 28 U.S.C. 2462

     prohibited this Commission from imposing a censure and a

     supervisory suspension in an administrative proceeding

     because that proceeding had been initiated more than five

     years after the entire conduct at issue.  Respondents assert

     that, since the first decision to defer Savin's costs was

     made more than five years before this proceeding was

     instituted, claims based on their subsequent conduct within

     the period are somehow barred.  In the alternative, they

     urge that we remand this proceeding for a new hearing

     limited to the conduct within the five-year period.

 

     Respondents concede that the majority of their conduct is

     within the five-year period.  As described above, they

     persisted in their determination to permit Savin to defer

     its costs in the face of Savin's repeated, unsuccessful

     attempts to develop copiers.  Even if the initial conduct

     were time-barred, such conduct can be considered as evidence

     of motive, intent, or knowledge.  See, e.g., Fed. R. Evid.

     404(b).

 

     Respondents further contend that the court in Johnson

     determined that Commission sanctions were not remedial.  We

     do not understand the court in Johnson to hold that the

     Commission may not impose sanctions for conduct that is not

     time-barred.  Respondents also make various arguments about

     whether the suspensions would serve a prophylactic purpose.

     Since these suspensions are concluded, we believe those

     arguments are moot.  See also Checkosky, 50 S.E.C. at 1197,

     n.38.

 

77/  All of the arguments advanced by the parties have been

     considered.  They are rejected or sustained to the extent

     that they are inconsistent or in accord with the views

     expressed in this opinion.

 

 

 

==========================================START OF PAGE 28======

 

Commissioner JOHNSON, dissenting:

 

     Having reviewed the record in this proceeding, the earlier

opinion of this Commission, and the opinions of the United States

Court of Appeals for the District of Columbia Circuit in this

matter, I respectfully dissent from the majority's opinion.   

 

      My disagreement with the majority relates to two important

issues.  The first is the mental state that should be considered

necessary to trigger professional discipline under Rule

2(e)(1)(ii). 1/   The second is the appropriateness of

disciplining the respondents considering the age of this

proceeding.

 

     The majority opinion concludes that professionals may be

sanctioned under Rule 2(e)(1)(ii) based on conduct that is merely

negligent.  I disagree.  I think that this Commission's processes

can be protected sufficiently by disciplining professionals under

Rule 2(e)(i)(ii) only when it is demonstrated that they acted

with scienter. 

 

     The success of our system of truthful and accurate

disclosure relies in large part on the work of talented, well-

trained professionals.  Thus, I agree with former Chairman

Williams' statement that we would be unable to administer

effectively the securities laws if those "involved in the capital

raising process were not routinely served by professionals of the

highest integrity and competence, well-versed in the requirements

of the statutory scheme Congress has created." 2/  I am of the

view, however, that this Commission's mandate for determining who

may no longer "practice" before us under Rule 2(e) is a limited

one and that we should continue to exercise an appropriate degree

of self-restraint in this area.

 

                   

1/   Former Rule 2(e), which is the basis for this proceeding, is

     now 17 C.F.R. 201.102(e).  There are no substantive

     differences between the two rules.

 

2/   Keating, Muething & Klekamp, 47 S.E.C 95, 120 (1979)

     (concurring opinion of Chairman Williams).

 

     The United States Court of Appeals for the Second Circuit

     also recognized the importance of the role served by

     accountants and attorneys:

 

          By the very nature of its operations, the Commission,

          with its small staff and limited resources, cannot

          possibly examine, with the degree of close scrutiny

          required for full disclosure, each of the many

          financial statements which are filed.  Recognizing

          this, the Commission necessarily must rely heavily on

          both the accounting and legal professions to perform

          their tasks diligently and responsibly.

 

     Touche, Ross & Co. v. SEC, 609 F.2d 570, 580-81 (2d Cir.

     1979).

 

 

 

==========================================START OF PAGE 29======

 

     A professional often must make difficult decisions,

navigating through complex statutory and regulatory requirements,

and, in the case of accountants, complying with Generally

Accepted Auditing Standards ("GAAS") and applying Generally

Accepted Accounting Principles ("GAAP").  These determinations

require the application of independent professional judgment and

sometimes involve matters of first impression. 3/  For this

reason, I believe that an earlier Commission was correct to

assert that, if a professional is to exercise his or her "best

independent judgement . . . [the professional] must have the

freedom to make innocent -- or even, in certain cases, careless -

- mistakes without fear of [losing] the ability to practice

before" us. 4/  

 

     The majority's position will impair the relationships

between professionals and their clients.  Such an adverse impact

will damage our ability to rely on these professionals to enhance

compliance with the securities laws.  I share the view expressed

by the  Commission in the William R. Carter case that

professionals "motivated by fears for their personal liability

will not be consulted on difficult issues." 5/   The

professional owes a duty to serve the interests of his clients.

To discharge this duty, the professional requires the cooperation

and trust of the client.  As Judge Randolph observed:

 

     [W]ithout a scienter requirement, lawyers would slant their

     advice out of fear of incurring liability, and management

     therefore would not consult them on difficult questions.  I

     cannot see why this sort of reasoning would not apply as

     well to auditors.  I recognize that although companies need

     not retain outside counsel, they are legally compelled to

     "consult" independent accountants. . . .  This creates an

     obligation on the part of management to cooperate with and

     provide information to the auditor. . . .  There are,

     however, degrees of cooperation.  Encouraging management to

     be completely candid with its auditor about difficult

     accounting issues may be just as desirable as encouraging

 

 

 

                   

3/   Thus, Judge Randolph observed:

 

          "The complexity of generally accepted accounting

          principles and generally accepted auditing standards is

          belied, and perhaps obscured, by their familiar

          acronyms."  Accounting principles must be interpreted.

          Judgments must be made about specific transactions.

          "[R]easonable preparers of financial statements"--

          often management --"and auditors can disagree about

          those interpretations and judgments."  Checkosky v.

          SEC, 23 F.3d 452, 479 (D.C. Cir. 1994) (citations

          omitted).

 

4/   William R. Carter, 47 S.E.C. 471, 504 (1981).

 

5/   Id.

 

 

 

==========================================START OF PAGE 30======

 

     management to consult candidly with outside lawyers, and for

     similar reasons. 6/

 

Thus, I believe that this Commission should not hold a

professional liable for improper professional conduct under Rule

2(e)(1)(ii), absent a finding of scienter.

 

     Accountants and attorneys are members of "ancient

professions," regulated according to rigorous ethical rules

enforced by professional societies and, in the case of

accountants, state licensing boards.  As Judge Silberman

observed, disciplining an accountant for every violation of GAAS

or failure correctly to construe GAAP puts the Commission at risk

of engaging in "a de facto substantive regulation of the

profession. . . ." 7/  

 

     I simply do not believe that we should recast negligent

violations of an accounting standard as improper professional

conduct under the Commission's Rules of Practice.  That is not an

appropriate role for this Commission.  Difficult ethical and

professional responsibility concerns are generally matters most

appropriately dealt with by professional organizations or, in

certain cases, malpractice litigation.  Nor do I believe that

mere misjudgments or negligence establishes either professional

incompetence warranting Commission disciplinary action or the

likelihood of future danger to the Commission's processes.    

 

     My concern with imposing a negligence standard on

accountants under Rule 2(e)(1)(ii), as set forth above, compels

me to refrain from joining in the majority opinion.  Moreover,

assuming respondents had acted with scienter, as the majority

finds, I would still dissent.  This proceeding involves audits

that took place at the beginning of the 1980s.  As described in

Commissioner Roberts' dissent to the earlier Commission opinion,

this proceeding was brought several years after the initial audit

and took several more years to work its way through the

administrative process.  It was then considered by the Court of

Appeals and returned to us.  Even if, technically, there is no

legal impediment to continuing this proceeding, given the age of

the conduct at issue, I believe that dismissal is the appropriate

remedy.

 

     In light of these factors, I would dismiss this proceeding.

 

 

 

 

 

 

 

 

 

 

                   

6/   Checkosky v. SEC, 23 F.3d at 485 (Randolph, J.)

 

7/   Checkosky, 23 F.3d at 459 (Silberman, J.).

 

 

                     UNITED STATES OF AMERICA

                            before the

                SECURITIES AND EXCHANGE COMMISSION

 

SECURITIES EXCHANGE ACT OF 1934

Rel. No. 38183 / January 21, 1997

 

ACCOUNTING AND AUDITING ENFORCEMENT

Rel. No.  871 / January 21, 1997

 

Admin. Proc. File No. 3-6776

_____________________________________________

                                             :

            In the Matter of                 :

                                             :

           DAVID J. CHECKOSKY                :

                   and                       :

           NORMAN A. ALDRICH                 :

_____________________________________________:

 

ORDER AFFIRMING FINDINGS AND DENYING RESPONDENTS' MOTION TO

DISMISS

 

     On the basis of the Commission's Opinion issued this day, it

is

 

     ORDERED that the findings of improper professional conduct

made against David J. Checkosky and Norman A. Aldrich

("Respondents") in this proceeding under Rule 2(e) in the

Commission's opinion dated August 26, 1992 (50 S.E.C. 1180), be,

and they hereby are, affirmed; and it is further

 

     ORDERED that the Respondents' request that this proceeding

be dismissed be, and it hereby is, denied.

 

     By the Commission.

 

 

 

 

                                      Jonathan G. Katz

                                         Secretary