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
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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...)
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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