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Initial Decision of an SEC Administrative Law JudgeIn the Matter of
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In the Matter of MICHAEL J. MARRIE, CPA,
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INITIAL DECISION
September 21, 2001 |
| APPEARANCES: | James A. Howell and Craig D. Martin for the Division of Enforcement and the Office of Chief Accountant, Securities and Exchange Commission.
James W. Denison, Wrenn E. Chais, and Michael F. Perlis for Respondents. |
| BEFORE: | James T. Kelly, Administrative Law Judge |
The Securities and Exchange Commission (Commission or SEC) instituted this proceeding on August 10, 1999, pursuant to Rules 102(e)(1)(ii) and 102(e)(1)(iv)(A) of its Rules of Practice, 17 C.F.R. §§ 201.102(e)(1)(ii) and 201.102(e)(1)(iv)(A). The Order Instituting Proceedings (OIP) charged that Michael J. Marrie (Marrie) and Brian L. Berry (Berry), each a certified public accountant (CPA), engaged in improper professional conduct in that they "recklessly" violated the applicable professional standards when auditing the financial statements of a public company. The alleged audit failures occurred in connection with an annual financial report for California Micro Devices, Inc. (CMD) for the fiscal year ending June 30, 1994.
The OIP alleges that Respondents' audit of CMD's financial statements was not conducted in accordance with generally accepted auditing standards (GAAS). It further alleges that CMD's financial statements were not prepared in conformity with generally accepted accounting principles (GAAP) and were materially false and misleading.1 The Division of Enforcement and the Office of Chief Accountant (collectively, Division) argue that Respondents should be denied the privilege of appearing and practicing before the Commission.
In their answers to the OIP, Respondents denied that they failed to comply with the applicable professional standards during CMD's fiscal year 1994 audit. Respondents also raised several affirmative defenses. First, they argued that this proceeding is barred by the five-year limitation period in 28 U.S.C. § 2462. Second, they raised the doctrine of laches, contending that the Division unreasonably delayed the institution of this proceeding to their substantial prejudice. Third, they presented due process, ex post facto, and other constitutional challenges to Rule 102(e). They maintain that the OIP should be dismissed.
On August 30, 1999, Marrie and Berry also filed an action against the Commission in the U. S. District Court for the District of Arizona, seeking declaratory and injunctive relief. They challenged Rule 102(e) as unconstitutional and sought to enjoin the hearing in this matter. On February 18, 2000, Judge Earl H. Carroll issued an order dismissing the joint complaint for lack of subject matter jurisdiction. Among other things, Judge Carroll determined that Marrie and Berry were not challenging final agency action, that they had failed to exhaust their administrative remedies, and that the federal courts of appeals have exclusive jurisdiction to review final orders in Commission administrative proceedings.
I held a public hearing in Phoenix, Arizona, on February 28 through March 3, 2000, and in San Francisco, California, on March 6 through 9, 2000. One witness who had been subpoenaed by both sides did not testify at the hearing because he was recuperating from a surgical procedure. The parties took that witness's deposition on May 11, 2000. See Orders of March 14, 2000, April 27, 2000, and May 15, 2000. The parties have filed proposed findings of fact, conclusions of law, and briefs, and the matter is ready for decision.2 I base my findings and conclusions on the entire record and on the demeanor of the witnesses who testified at the hearing. I applied "preponderance of the evidence" as the applicable standard of proof. Steadman v. SEC, 450 U.S. 91, 97-104 (1981). I have considered and rejected all arguments, proposed findings, and conclusions that are inconsistent with this decision.
FINDINGS OF FACT
Respondents
Marrie and Berry acted as the engagement partner and engagement manager, respectively, for Coopers & Lybrand's (C&L's) audit of the financial statements of CMD for its fiscal year ended June 30, 1994 (1994 audit) (Tr. 15, 225). C&L issued an unqualified report dated August 25, 1994, with respect to those financial statements (JX 19 at 23).
At all relevant times, C&L was an international public accounting and consulting firm headquartered in New York, New York (Answers ¶ 8). C&L acted as independent auditors for CMD from 1990 until January 6, 1995 (Tr. 152, 514-15). The primary services C&L provided to CMD were annual audits and quarterly reviews of CMD's financial statements (Answers ¶ 8). C&L also prepared CMD's corporate income tax returns. Stan Johnson of C&L's office in Boise, Idaho, established the firm's business relationship with CMD (Tr. 14-15, 516; DX 83 at 1). After 1991, C&L performed its services for CMD from its Phoenix office. C&L resigned as CMD's auditors on January 6, 1995, and informed CMD it would not reissue its 1994 audit report (Answers ¶ 8; Tr. 152-53). In 1998, C&L combined with Price Waterhouse LLP to become PriceWaterhouseCoopers LLP.
Marrie, age fifty-three, is a CPA licensed in Arizona (active) and Ohio (inactive) (Marrie Answer ¶ 5; Tr. 10-11). He graduated from Youngstown State University in 1970, with a major in accounting and a minor in economics (DX 83 at 1). Marrie started his employment with C&L in 1970 in Cleveland, Ohio. He became a partner in 1981 and transferred to C&L's Phoenix office in 1985 (Tr. 11-12). Marrie served as the concurring reviewer for C&L's audits of CMD in 1990 and 1991, and as the engagement partner for C&L's audits of CMD in 1992, 1993, and 1994 (Tr. 14-15; DX 83 at 2). In 1994, Marrie spent approximately 30% to 50% of his time auditing clients who filed financial reports with the Commission (Tr. 12, 206). He was also the managing partner of C&L's Phoenix office in 1994 (Tr. 11).
Marrie resigned from C&L at the firm's request on September 30, 1995 (Tr. 12; DX 86). Thereafter, Marrie was a consultant to one of his former audit clients; eventually, he became the executive director of a Phoenix law firm (Tr. 13). He does not prepare or audit financial statements or participate in any business that the law firm may have before the Commission (Tr. 13-14, 168-69).
Berry, age forty, is a CPA licensed in Arizona (active) and Ohio (inactive) (Berry Answer ¶ 6; Tr. 208). He joined C&L's office in Columbus, Ohio, in 1983 and transferred to the Phoenix office in 1991 (Tr. 209-10). While at C&L, Berry advanced through the positions of associate and senior associate. He became a manager in late 1990 or early 1991 (Tr. 210). Berry participated in two or three CMD audits before the 1994 audit (Tr. 42, 156, 224-25; DX 84 at 1).
Berry resigned from C&L in August 1995 and began working as an independent consultant (Berry Answer ¶ 6; Tr. 197). After about a year, he joined Falcon Power, a privately owned company, as its corporate controller (Tr. 214). Since October 1998, Berry has been employed as the corporate controller at Pentegra Dental Group (Pentegra), a company whose securities are traded on the American Stock Exchange (Tr. 213-14, 216). Berry prepares the financial statements that Pentegra files with the Commission (Tr. 215).
CMD's Public Face: Booming Sales, Soaring Income, Only Minor Problems
CMD is a California corporation with principal executive offices in Milpitas, California (Tr. 15-16; JX 19). The company designs, develops, manufactures, and markets high performance integrated passive electronic circuits (IPECs) and certain semiconductor products (JX 19 at 1). CMD's manufacturing plants are located in Milpitas and in Tempe, Arizona, and its accounting offices are located in Tempe (Tr. 15-16, 516-17).
In fiscal year 1994, CMD's common stock was registered with the Commission pursuant to Section 12(g) of the Securities Exchange Act of 1934 (Exchange Act) and its stock prices were quoted on the NASDAQ National Market System (NASDAQ) (JX 19 at 1, 13). As of June 30, 1994, CMD had 269 full-time employees and approximately 3,000 shareholders of record (JX 19 at 11, 13). Chan M. Desaigoudar (Desaigoudar) was CMD's chief executive officer and chairman of the board of directors; Steven J. Henke (Henke) was CMD's vice president, treasurer, and chief financial officer; and Ronald A. Romito (Romito) was CMD's vice president and chief accounting officer (JX 19 at E&Y 1579). All management officials were located in Milpitas, except for Romito, who was located in Tempe (DX 15 at 25).
CMD's Forms 10-Q for the first three quarters of fiscal year 1994 presented a picture of booming sales and soaring income.3 CMD reported that its net income for the quarter ending September 30, 1993, had increased 120% and that its sales were up 23% from the same period in the prior year (First Quarter 10-Q). Net income for the quarter ending December 31, 1993, was reported to be up 135% and sales for the first six months of the fiscal year were reported to be up 24% from the comparable period in the prior year (Second Quarter 10-Q). Net income for the quarter ending March 31, 1994, was reported to be up 182% and sales were reported to be up 38% from the same period the prior year (Third Quarter 10-Q). CMD's Form 10-K for fiscal year 1994 also showed robust growth in sales and income. CMD's reported net sales increased from $33 million in fiscal year 1993 to $38.2 million in fiscal year 1994 (JX 19 at 25). Its reported net income increased from $2 million in fiscal year 1993 to $5 million in fiscal year 1994 (JX 19 at 25).
On March 15, 1994, CMD and Hitachi Metals, Ltd. (Hitachi Metals) agreed to a strategic alliance that expanded the market for CMD's thin film IPECs (JX 19 at 30). The agreement called for CMD to license its technology to Hitachi Metals. Under the terms of the agreement, Hitachi Metals would offer its own line of IPEC products through its direct sales force and would manufacture thin film technology products (JX 23). In return, Hitachi Metals agreed to purchase 880,000 newly issued shares of CMD common stock at $24 per share (JX 23). The transaction resulted in a total cash payment to CMD of over $21.1 million and Hitachi Metal's ownership of approximately 10% of CMD's common stock (JX 1 at 70, JX 19 at 30, JX 23). The agreement did not allocate the amounts paid by Hitachi Metals between the different segments of the contract.
The market price of CMD common stock was $14 per share on March 15, 1994 (JX 14). Following the announcement of the strategic alliance, CMD's stock price rose to $21.25 on March 16, 1994 (RX 402 at 2, JX 14). Trading volume of CMD's shares increased from 52,107 on March 15 to 2,333,561 on March 16 (JX 14). After the Hitachi Metals transaction closed on May 11, 1994, CMD actively worked with investment bankers and underwriters on a public stock offering to raise additional capital (Tr. 878; JX 19 at 30).
Not all of CMD's financial news during fiscal year 1994 was positive. CMD's reported balance of accounts receivable increased from $12.3 million in fiscal year 1993 to $16.9 million in fiscal year 1994 (JX 19 at 24). The reported balance of CMD's inventory increased from $12.9 million at the end of fiscal year 1993 to $13.9 million at the end of fiscal year 1994 (JX 19 at 24-25). Two factors contributed to these developments.
First, CMD's customer base changed. CMD's largest customer in fiscal year 1993 had been Apple Computer (Apple), accounting for 32% of CMD's total product sales (Tr. 517-18; DX 89, binder 1, tab 4 at 2, JX 19 at 16). In the first half of fiscal year 1994, CMD's sales to Apple amounted to only 6% of its total product sales (Tr. 517-18; DX 89, binder 1, tab 4 at 2). For all of fiscal year 1994, CMD's sales to Apple declined by $9.2 million (JX 19 at 15). Apple had paid its bills promptly (DX 89, binder 1, tab 4 at 2).
CMD reported that its net product sales to foreign customers had increased from 52% in fiscal year 1993 to 59% in fiscal year 1994 (JX 19 at 8). CMD's normal sales terms for foreign customers required payment in sixty days (DX 16 at 42). However, shipments to customers in the Far East involved lengthy transit times and some of those customers would not pay until they had received the product (JX 9 at 830C). CMD found it necessary to offer extended payment terms of ninety to 120 days or more to several customers located in the Far East (Tr. 910-12; DX 89, binder 1, tab 4 at 2, RX 401). Thus, the shift in CMD's customer base lengthened the collection time for its accounts receivable (Tr. 517-18; JX 9 at 832, 832A). The number of days of sales that trade accounts receivable were outstanding was 127 on December 31, 1993, and 126 on March 31, 1994, as compared to ninety-four days on June 30, 1993 (Second and Third Quarter 10-Qs).4
Second, CMD experienced problems maintaining revenue linearity. In the high technology industry, it is common for companies to report a significant percentage of their sales at the end of a quarter or year (Tr. 757-59, 912-13; RX 405 at 21).5 As long as cutoff dates between reporting periods are respected, however, there is nothing inherently improper with significant sales at the end of a reporting period (Tr. 758).6 CMD's revenue spikes were extreme: the company historically reported 70% to 90% of its sales in the third month of each quarter (DX 89, binder 1, tab 4 at 15, JX 9 at 830C). CMD invoiced and shipped approximately 70% of its revenue for the second quarter of fiscal year 1994 during the last week of December 1993 (DX 89, binder 1, tab 4 at 2, 14-15). Because CMD reported that its second quarter sales were $10.2 million, 70% of that figure implies that sales between Christmas Day 1993 and New Year's Day 1994 exceeded $7 million. CMD's reported sales during June 1994 were $12 million (31% of its reported sales for the entire fiscal year) (JX 10 at 1027-77). On June 30, 1994, the last day of the fiscal year, CMD's reported sales were $8 million (JX 10 at 1027-77).
CMD management acknowledged these problems in its quarterly reports, but suggested that matters were under control. The Second Quarter 10-Q stated, at 8:
The increase in accounts receivable was a result of increased sales levels, extended payment terms to selected Far East customers, and non-linearity of sales. In response to this increase, [CMD] is tightening its payment terms policy, stepping up its collection efforts and working on improving its sales linearity within the quarter.
Three months later, CMD management stated in the Third Quarter 10-Q, at 8:
The increase in accounts receivable was a result of increased sales levels, extended payment terms to selected customers (largely in the Far East), and non-linearity of sales for the quarter. [CMD] has increased its receivable reserves in conjunction with closely monitoring the payment trends and stepping up collection efforts while striving to improve linearity of its sales.
On May 25, 1994, Kidder, Peabody & Co. (Kidder Peabody) upgraded its rating of CMD's stock from "outperform" to "strong buy" (RX 401). Kidder Peabody, which was serving as the lead investment banker on CMD's proposed public offering, pointed to CMD's strong third quarter operating results, as well as the expected benefits of the Hitachi Metals transaction, as grounds for recommending the stock to the investing public. In relevant part, Kidder Peabody's research report also opined that CMD's reserves against bad accounts receivable were "more than adequate," that CMD took a "conservative accounting position on its revenue recognition," thereby understating earnings to a degree, and that CMD had "conservatively reserved against obsolete inventories" (RX 401 at 2600-01).7
The Auditors Knew Of CMD's Loss Of Sales To Apple And CMD's Problems With Revenue Linearity
During fiscal year 1994, Respondents conducted quarterly reviews at CMD (Tr. 17-18, 88-89, 314). Marrie knew that CMD's sales to Apple had decreased significantly. However, he took "a lot of comfort" from the strategic alliance with Hitachi Metals and did not give much thought to the loss of Apple's business (Tr. 163-64, 190).
CMD's revenue spikes at the end of a reporting period were of longstanding duration. Marrie had noted the phenomenon as early as the 1992 audit. He wrote in the 1992 Business Assurance Client Continuance Supplement that he had adjusted C&L's review and audit procedures to address the issue (DX 89, binder 1, tab 6 at 4, 7).
Marrie and Berry also knew that CMD had problems with revenue cutoff issues in 1992 and 1993 (Tr. 80-82, 102-03, 231-32; DX 84 at 2). CMD's stated policy was to recognize revenue for product sales only upon shipment to customers (JX 19 at 30 note 2). However, in the years prior to 1994, CMD's actual practice had been much more aggressive. According to Romito, the company had recognized sales revenue if the product was ready for shipment on the last day of a reporting period, even if the product was not shipped until later (Tr. 518-19).8 Berry found it unusually difficult to determine what had and had not been shipped (DX 84 at 3).
Romito and Mary Bridges (Bridges), a clerk in CMD's accounting department, each claimed that during the 1993 audit they advised C&L that approximately $400,000 in revenue recognized on shipments to customers should be reversed because the goods had not actually been shipped before the end of the year (Tr. 525-28, 1225-26). Marrie did not recall receiving such a tip, but he reversed the sales (Tr. 103-04, 580-82). On November 24, 1993, C&L wrote a comment letter to CMD management, summarizing the findings of the 1993 audit. In that letter, C&L specifically recommended that CMD only record sales when goods were shipped (DX 66 at 1130, JX 28 at 1789-92 item 8).
Preliminary Planning For The 1994 Audit
Marrie signed C&L's engagement letter for the 1994 audit on December 2, 1993 (Tr. 73-74; JX 1 at 119-25). The letter explained that Marrie and Berry would lead the engagement team and that C&L expected to deliver its report to CMD on or about September 10, 1994 (JX 1 at 119). The estimated fee for the audit was $89,000, plus expenses (JX 1 at 120). In the letter, Marrie stated that C&L would (JX 1 at 119):
[A]udit the financial statements of [CMD] as of and for the period ending June 30, 1994, in accordance with [GAAS]. The objective of an audit is the expression of our opinion concerning whether the financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows of [CMD] in conformity with [GAAP].
In explaining the limitations of the auditing process, the letter further stated (JX 1 at 121):
Our audit will include procedures designed to provide reasonable assurance of detecting errors and irregularities that are material to the financial statements. As you are aware, however, there are inherent limitations in the auditing process. For example, audits are based on the concept of selective testing of the data being examined and are, therefore, subject to the limitation that errors and irregularities, if they exist, may not be detected. Also, because of the characteristics of irregularities, including attempts at concealment through collusion and forgery, a properly designed and executed audit may not detect a material irregularity.
Similarly, in performing our audit we will be aware of the possibility that illegal acts may have occurred. However, it should be recognized that our audit provides no assurance that illegal acts generally will be detected, and only reasonable assurance that illegal acts having a direct and material effect on the determination of financial statement amounts will be detected. We will inform you with respect to material errors and irregularities, or illegal acts that come to our attention during the course of our audit.
The letter also called for CMD to provide C&L with a management representation letter at the conclusion of the engagement. Among other things, the representation letter would confirm that CMD's management and key employees had not been involved in any irregularities (JX 1 at 122).
Respondents attended CMD's audit committee meeting on April 29, 1994 (Tr. 25, 77, 227-33, 603-04; JX 1 at 215-18).9 CMD's officers and the members of CMD's board of directors were also present at the meeting. Marrie spoke to the audit committee and submitted C&L's written presentation (Tr. 77, 228; JX 28). Listed as factors influencing the 1994 audit were the adequacy of allowance for doubtful accounts, adequacy of product return reserve, adequacy of reserve for slow moving and obsolete inventory, and the progress of the magnetic head and thin film operations (JX 28 at 1782).10
During the meeting, Marrie also discussed the importance of revenue cutoff and he reaffirmed that sales could not be recognized as revenue unless CMD had actually shipped its product prior to the end of the reporting period (Tr. 80-81, 231, 603-04; JX 28 at 1792). Romito addressed the processes that CMD used to identify and review obsolete inventory (Tr. 62-63). Because CMD had eliminated its Magnetic Head Division in Milpitas during fiscal year 1994, the participants in the meeting also discussed what management intended to do with the equipment from the discontinued operations (Tr. 232, 315, 604; DX 13 at 2133, JX 1 at 62). CMD management specifically told Marrie and Berry that the equipment from the Magnetic Head Division was going to be used in the Thin Film Division (Tr. 604).
In January 1994, Romito had asked Marrie to reduce C&L's fee for the upcoming audit (Tr. 44, 252, 553-56; DX 64, JX 1 at 120). After discussion at the audit committee meeting, the fee remained at $89,000 plus expenses, the same amount that C&L had proposed in the engagement letter (Tr. 79, 553-56).11
Audit Staffing, Budgeting, And Scheduling
As managing partner, Marrie was responsible for generating business in C&L's Phoenix office. C&L's national management had been pushing Marrie to increase the firm's share of the Phoenix audit market for some time. The significance that C&L attached to that goal had been underscored in Marrie's 1992 and 1993 performance evaluations (Tr. 145-46; DX 87 at CLB 486, 490). By December 1993, Marrie knew that he had not met his 1993 goal and that C&L was going to reduce his partnership interest for 1994 from 650 shares to 600 shares as a result (Tr. 146-47; DX 87 at CLB 483-87). Marrie received his 1993 performance evaluation on June 10, 1994, confirming the reduction in shares. The written evaluation again emphasized the need for "immediate new business action and results" to replace the billable hours that the Phoenix office had lost on other engagements (DX 87 at CLB 486).
C&L had expended 1,408 hours on the 1993 CMD audit; its budget for the 1994 CMD audit was limited to 1,200 hours (JX 1 at 89, 142-44, 147). C&L had assigned two senior associates to the 1993 CMD audit; its budget for the 1994 CMD audit called for only one senior associate (Tr. 40-42; JX 1 at 89). The OIP alleges that the reduction in budgeted hours and the increased reliance on junior auditors represented corner-cutting by Marrie in reaction to C&L's emphasis on increasing profits in the Phoenix office.
The allegation is based on the assumption that the 1994 audit was the same as the 1993 audit. However, C&L did not audit CMD's 401(k) plan in 1994, as it had in past years, because there were too many unreconcilable discrepancies between CMD's records and those of the plan administrator (DX 84 at 2).
In any event, Respondents offer a much more benign interpretation. They explained that they were able to reduce the number of budgeted hours and the level of staffing for two reasons. First, they credited the firm's Total Engagement Quality program, which required them to spend less time on non-critical audit areas (Tr. 69-71, 257-58; JX 1 at 72-83, 89). Second, they maintained that CMD had hired new employees and had agreed to prepare more schedules in house (Tr. 159-60, 257-58).12 It is not important to resolve the conflict on this issue, in light of certain concessions made by the Division's expert witness at the hearing, as well as the case law discussed below.
The 1994 engagement team consisted of Marrie, who devoted sixty hours to the audit; Berry, who devoted 189 hours; Kristie Lynn Schindele (Schindele), a senior associate who spent 330 hours on the audit; Jeff Jenson (Jenson), an associate who spent 350 hours on the audit; and M. Johnson, an associate (otherwise unidentified), who spent 220 hours on the engagement (JX 1 at 145-47). There is little reliable testimony and no documentary evidence to support Respondents' claim that another senior associate, Brian Newman (Newman), also participated in the early stages of the 1994 engagement.13
Respondents were the principal liaisons between C&L and CMD management (Tr. 22, 28, 295-96, 309, 316). Marrie visited CMD's Tempe offices ten to twenty times during the audit and he met frequently with Romito (Tr. 21, 60-61). Marrie also spoke twice by telephone with Henke, CMD's treasurer and chief financial officer (Tr. 29). Marrie's only contact with Desaigoudar, CMD's chairman and chief executive officer, occurred at the audit committee meeting on April 29, 1994 (Tr. 27).
Schindele earned a bachelor of arts degree in accounting from Santa Clara University in the spring of 1992, and had passed all parts of the CPA examination by November 1992 (Tr. 416-17, 498, 507). She has been licensed as a CPA since 1995 (Tr. 416, 507). Schindele was employed at C&L's Phoenix office from September 1992 to June 1995. During that time, she was promoted from associate to senior associate (Tr. 412-13). Schindele participated very briefly in the 1993 CMD audit, but she had not been involved in any of the quarterly reviews at CMD during fiscal year 1994 (Tr. 42, 250, 413-14; JX 1 at 86).
Schindele was the accountant in charge of the 1994 CMD audit (Tr. 361). She prepared the audit budget and audit strategy memorandum, supervised Jenson and another associate, prepared customer confirmation requests, audited receivables, inventory, and equipment, and assembled a list of the matters for the attention of the engagement partner (Tr. 361, 417, 420, 425, 433, 473, 479-80). Schindele was in frequent contact with Respondents during the field work (Tr. 424-25, 473).
Jenson graduated from Brigham Young University in December 1993 with both bachelor of arts and master of arts degrees in accounting (Tr. 329, 360, 405). He was employed as a staff auditor in C&L's Phoenix office from January 1994 to October 1996 (Tr. 360, 405). The record does not state whether Jenson was licensed as a CPA. Jenson was the primary associate on the 1994 CMD engagement (Tr. 32). The assignment represented not only Jenson's first audit of a public company, but also his first audit of a high technology company (Tr. 44, 361). When the field work started, Jenson had been at C&L for approximately six months (Tr. 256). He had not participated in any of the 1994 quarterly reviews at CMD (Tr. 361).
Jenson devoted about two or three weeks to field work at CMD's Tempe office (Tr. 402). While he was on site, Jenson was in continuous contact with Schindele, his immediate supervisor (Tr. 377, 402, 477). Jenson also had access to Berry when Berry was on site (Tr. 403). Jenson's principal responsibilities were to perform the audit of inventory and to assist in sales cutoff testing (Tr. 361-63, 378-81).
A second associate who was junior to Jensen also assisted in the audit (Tr. 196). The record is silent as to that individual's credentials and experience.
A member of the engagement team observed CMD's inventory count at Tempe on July 5, 1994 (JX 10 at 1144B-54). Another member of the engagement team (purportedly, Newman) partially observed CMD's physical inventory at the Milpitas on July 5 and 6, 1994 (Tr. 241-42; JX 11 at 1206-08, JX 12 at 2366-76). Formal planning for the audit took place from July 14 through July 24, 1994 (Tr. 309, 421; JX 1 at 86-93). During the planning stage, the engagement team met several times to discuss the audit procedures that the auditors would follow (Tr. 34). Field work, the period of time during which the engagement team collected and evaluated evidence to support its audit conclusions, began on July 27 and ended on August 25, 1994 (Tr. 91-92, 95, 421-22; JX 1 at 73). Apart from the partial observation of inventory at Milpitas, all field work performed by C&L took place in Tempe (Tr. 71-72, 242, 490).
CMD's 1994 Financial Performance: What The Auditors Did Not Know
CMD management had recorded revenue on a number of 1994 transactions where there was no realistic prospect of collecting payment (Tr. 528-29). These receivables were uncollectible because the goods had never been shipped, the likelihood of timely payment was in doubt, or there were customer concerns about the quality of the goods (Tr. 528-29).
Every senior CMD officer who attended the audit committee meeting on April 29, 1994, was aware that, for the quarter ending March 31, 1994, CMD had recognized millions of dollars of revenue for products that had not been shipped (Tr. 586-89, 603-04). No one from CMD management revealed this fact to Respondents (Tr. 586-89, 603-04).
CMD management knew that if it did not "clean" the company's books before the end of the fiscal year, C&L was likely to discover the improper revenue recognition during the audit (Tr. 528-30, 588). Accordingly, management decided to issue approximately $12 million in credit memoranda to write off certain accounts receivable during the fourth quarter of fiscal year 1994 (Tr. 528-30, 537, 541-42; DX 13 at 2128).
In July 1994, Romito told Respondents that CMD expected to write off $12 million in accounts receivable (Tr. 116-17, 308). Marrie later told a special agent of the Federal Bureau of Investigation that he was "dumbfounded" by the size of the proposed write-off (DX 83 at 3).14 Marrie believed that the write-off was a positive step for CMD (Tr. 121-22). Meyercord felt the same way (Tr. 919).
In alerting Respondents to the upcoming write-off, CMD management was sharing only a fraction of the full story. Left unmentioned was the fact that CMD's sales, shipping, and accounting personnel, as well as CMD customers, created false shipping documents and invoices to disguise at least a portion of the improperly recorded sales (Tr. 605-06, 706-08, 1213-17). To keep track of the sales, accounting department personnel maintained documents that outlined the exact nature and scope of cash collection activities for accounts receivable (Tr. 571-75). Those documents were hidden from the C&L auditors.15 CMD's officers also lied to C&L in the management representation letter at the conclusion of the audit (Tr. 203, 570-75; JX 1 at 168-71).
C&L Reviews CMD's Valuation Of The Technology Transfer To Hitachi Metals
CMD's transaction with Hitachi Metals provided management with an opportunity to record non-sales revenue to offset the elimination of a large portion of its accounts receivable (Tr. 534-37). During the fourth quarter, CMD management worked simultaneously on determining which accounts receivable to write off and how much revenue to recognize from the technology sale to Hitachi Metals (Tr. 535-36, 541-42).
In mid-July, Romito gave Marrie management's proposal for recording as revenue $6.6 million of the $21.1 million paid by Hitachi Metals (Tr. 119, 536-37). Within a week, Romito told Marrie that CMD wanted to increase that amount to $7 million (Tr. 536-37). These sums represented $7.50 and $8.00 per share, respectively, of the $24.00 per share that Hitachi Metals had paid (JX 14 (Wierwille memorandum)). The reason for the increase was that the write-off of accounts receivable had increased (Tr. 536-37). Marrie characterized the Hitachi Metals transaction as complex and he brought in a C&L valuation specialist to review management's proposal (Tr. 117-18). The specialist determined that a proper valuation of the technology transfer would be $6.53 per fully diluted share (JX 14 (Wierwille memorandum)). The specialist further stated: "Although the above calculat[ion] is less than that which . . . has been determined by the client, it does not appear to represent a material difference, and accordingly, the client's analysis and the determination of the value related to the license and technology transfer appear not unreasonable" (JX 14 (Wierwille memorandum)).16
Marrie Reviews CMD's Allocation Of The Write-Off Of Accounts Receivable
Marrie and Romito had several meetings and discussions to review information and documents about the proposed write-off (Tr. 123, 540, 591). These discussions related to the allocation of the write-off to reversal of sales, sales returns, bad debt, and other categories (Tr. 126-28, 540-41). The issue was not academic: amounts written off for returned product would be deducted directly from reported revenues, while amounts written off as bad debt would be treated as expenses and therefore would not decrease reported revenues. Desaigoudar and Henke wanted CMD's reported revenues to be as high as possible to maintain the impression of growth (Tr. 535, 541-42).
CMD's initial proposal maximized the portion of the write-off allocated to bad debt expense and minimized the portion allocated to sales returns and reversals (Tr. 541-42). This would have had the least negative impact on CMD's reported revenues (Tr. 542). However, when Romito proposed that over $4 million be allocated to bad debt expense, Marrie balked and told Romito that the write-off would have to be reallocated (Tr. 126, 542, 591).
Marrie advised Romito to prepare an analysis setting forth CMD's reasons for writing off each specific receivable for each customer (Tr. 126). He also informed Romito that CMD had to make a determination on a line-by-line basis as to the proper accounting for each adjustment (Tr. 127, 542-44). In response, Romito prepared a schedule listing the receivables and allocating the write-off (Tr. 123-25, 127, 591). The schedule went through a number of changes as Marrie and Romito continued to discuss the allocation issues (Tr. 127-28).
Marrie received materials on the fourth quarter sales adjustments. When later asked to produce his file, Marrie could not do so (Tr. 124-26; DX 83 at 5). C&L's work papers for the 1994 audit do not contain any spreadsheets on the write-off (JX 1-JX 18). Marrie could not identify CMD's "Credit Memorandum Summary Journal Entry, June 1994" as a document he reviewed, although he recalled seeing a document similar in form (Tr. 128-29; JX 26). The Division asks me to infer that JX 26, CMD's "Credit Memo Summary Journal Entry, June 1994," is either the spreadsheet of the accounts receivable write-off that Marrie saw in 1994, or is sufficiently similar to serve as a substitute (Div. Prop. Find. # 60). I agree with the Division and make that inference.
Berry joined Marrie in discussing with Romito the procedures necessary to account for the write-off, but Berry never saw any of the resulting spreadsheets (Tr. 309-10; DX 84 at 3). Beyond reviewing the spreadsheets, Marrie did very little with the information he received on the proposed write-off. He reviewed the sampling criteria he had previously established for confirming CMD's accounts receivable, but ordered no changes in the level of confirmation testing (Tr. 195). He never instructed the engagement team to perform any additional audit procedures (Tr. 130-31, 312, 397).
CMD Reports Its Fourth Quarter Results
On August 3, 1994, during the second week of C&L's field work, Romito gave Respondents a draft of a press release announcing CMD's earnings for the fourth quarter and for fiscal year 1994 (Tr. 132-33, 310-11; DX 73). The draft stated that non-product sales for the quarter had been $7 million, reflecting the sale of technology to Hitachi Metals. The draft then made the following statement about the write-off of accounts receivable:
Offsetting non-product sales were product returns and related expense charges totaling [$8.3 million] for the quarter. [CMD] authorized selected Far East distributors, unable to pay for the product on a timely basis, to return the product [$5.3 million] and in certain cases, these distributor balances were written off to cost of sales [$1.7 million] or bad debt expense [$1.3 million].
Berry reviewed the draft, made sure the numbers that CMD proposed to report for prior periods were mathematically accurate, and then discussed the draft with Marrie (Tr. 311).
On August 4, 1994, CMD issued its press release, publicly disclosing its fourth quarter net income and earnings, as well as an $8.3 million write-off of accounts receivable (DX 39). The press release was unchanged from the prior day's draft, insofar as it announced $7 million in non-product sale of technology. With respect to the write-off, however, the press release stated (emphasis added):
Offsetting non-product sales were product returns and related expense charges totaling [$8.3 million] for the quarter. As a result of the success of establishing second source to thin film IPEC products, [CMD] decided to reduce its emphasis on certain distribution channels by terminating selected distributors. [CMD] authorized these terminated distributors and others who were unable to pay for product on a timely basis, to return the product [$5.3 million] and in certain cases, these distributor balances were written off to cost of sales [$1.7 million] or bad debt expense [$1.3 million].
The bolded language denotes the changes that CMD made after Respondents reviewed the draft (DX 39, DX 73). The identities of the "terminated distributors" were never disclosed to C&L or to anyone else (Tr. 124, 298, 856; Thomsen Dep. at 45; RX 405 at 15).
Respondents received a copy of CMD's August 4 press release, reviewed it, and initialed it (Tr. 143-45, 311-12). They could not recall if they compared the information in the press release to the information Romito previously gave them concerning the write-off, or if they directed the junior auditors to investigate any of the information in the press release (Tr. 136-37, 312).
In addition to issuing the press release, CMD announced its fourth quarter earnings in a telephone conference call to financial analysts on August 4, 1994 (Tr. 544-45; DX 78, DX 79). Romito invited Marrie to listen to the conference call, but Marrie elected not to do so (Tr. 552-53; DX 79). During the conference call, Desaigoudar made an opening presentation for CMD and then he and Henke responded to questions (DX 78, DX 79). Some of the questions raised during the conference call revealed that the financial analysts had a very negative reaction to CMD's write-off of its accounts receivable (Tr. 545-46; DX 79).
Following the press release and the conference call, CMD's stock, which had been trading at over $20 per share, dropped to the lower teens (Tr. 430-32). Kidder Peabody abandoned its efforts on the proposed public offering (Tr. 885-87, 899).17 Shareholder class action lawsuits alleging accounting improprieties followed. Respondents were aware of both the drop in CMD's stock price and the first of the shareholder lawsuits (Tr. 137; JX 1 at 234, JX 19 at 38 note 13). Although they had three weeks of field work remaining, Marrie and Berry did not make any adjustments to the audit plan in response to the write-off or the events of August 4, 1994 (Tr. 130, 312, 397).
C&L's Audit Report
As of June 30, 1994, CMD claimed total assets of $74.5 million on its balance sheet (JX 19 at 24). It included both its accounts receivable and its inventories as current assets. CMD reported its accounts receivable, less an allowance for doubtful accounts of $1.5 million, to be worth $16.9 million. It reported its inventories to be worth $13.9 million. CMD reported its net property and equipment as non-current assets worth $10.4 million. In its statement of operations for fiscal year 1994, CMD reported net income of $5 million on total revenues of $45.3 million (JX 19 at 25).
C&L presented its independent accountants report in a letter addressed to CMD's shareholders and directors. The letter was dated August 25, 1994, the last day of C&L's field work at CMD (JX 19 at 23). In relevant part, the report stated:
We conducted our audits in accordance with [GAAS]. . . . We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements . . . present fairly, in all material respects, the financial position of [CMD] as of June 30, 1994 and 1993, . . . in conformity with [GAAP]. In addition, in our opinion, the financial statement schedules . . . when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein.
Note 2 to the financial statements identified CMD's significant accounting policies. As here relevant, the note explained that CMD carried its inventories at the lower of cost or market, and that CMD stated its property and equipment at cost (JX 19 at 29).
Note 4 to the financial statements addressed the concentration of CMD's credit risk. In relevant part, the note stated that CMD had customers "who are located in foreign countries. [CMD] generally extends credit to these customers and, therefore, collection of receivables is affected by the [customers'] industries' economy. However, [CMD] monitors extensions of credit and, in the opinion of management, has provided adequate receivable reserves" (JX 19 at 31).
Note 13 to the financial statements addressed pending litigation. In relevant part, the note stated that "[CMD] has been named a defendant in three securities class action lawsuits. . . . [CMD] believes these suits to be without merit and intends to vigorously defend them. . . . Management believes that none of these matters will have a material adverse effect on [CMD's] financial position or results of operations" (JX 19 at 38).
Lastly, note 14 to the financial statements addressed segment information. In relevant part, the note stated (JX 19 at 38):
Foreign sales, primarily in Europe, Canada and Asia, aggregated approximately 59%, 52% and 42% of net product sales in fiscal 1994, 1993 and 1992 respectively. . . .
During fiscal 1994, no customer accounted for more than 10% of net product sales. During fiscal 1993 and 1992, one customer accounted for approximately 32% and 24% of net sales respectively.
Subsequent Developments At CMD
On September 29, 1994, CMD filed its Form 10-K for fiscal year 1994 with the Commission (JX 19). Included within its Form 10-K was the C&L report on the audited financial statements for that year (DX 89, binder 1, tab 3 at 23-38, JX 19 at 23-38). The next day, the Commission's staff requested that C&L produce documents, including work papers, related to CMD's quarterly and annual periods ending December 31, 1993, March 31, 1994, and June 30, 1994.18
Revenue recognition issues and accounts receivable issues persisted at CMD through the end of the first quarter of fiscal year 1995. In early October 1994, CMD retained the law firm of Howard, Rice, Nemerovski, Canady, Robertson, Falk & Rabkin (Howard Rice) to defend the company and its officers in the pending shareholder actions and in the Commission's investigation (Thomsen Dep. at 18-19; RX 374 at 628).
At an audit committee meeting on October 14, 1994, Howard Rice presented its preliminary findings, conclusions, and recommendations (RX 374 at 628, RX 405, Exhibit E, Audit Committee Meeting Document). Howard Rice reported that CMD personnel had been able to obtain false shipping documents from shippers, that CMD had been shipping merchandise to freight forwarders to hold until the merchandise could be shipped to customers, and that CMD personnel had shipped merchandise to false customers (DX 13 at 2128, RX 405, Exhibit E, Audit Committee Meeting Document). The audit committee promptly notified the Commission, NASDAQ, and the U. S. Department of Justice of these preliminary findings (Tr. 924).
On October 17, 1994, CMD announced that its board of directors had appointed a special committee of independent directors to investigate possible revenue recognition and other accounting irregularities that might affect the financial results for earlier periods, including fiscal year 1994 (Tr. 920-21, 924-25; JX 21 at 9). To assist its investigation, the special committee engaged Howard Rice as its counsel (Tr. 1238-39). In turn, Howard Rice retained the special services group of the accounting firm of Ernst & Young (E&Y) (Tr. 1238).
E&Y's mandate was to examine CMD's financial reporting practices and procedures and to advise about the possible restatement of the previously issued financial statements (DX 13 at 2127). This was a forensic accounting, a much more extensive examination than a routine audit (Tr. 1241-44). The special services group of E&Y began its work with the knowledge that C&L were the auditors of record, and the expectation that C&L would sign off on any necessary restatement (Tr. 1284; Thomsen Dep. at 47). E&Y was not hired to evaluate the adequacy or appropriateness of C&L's auditing procedures (Tr. 1269-70, 1277-78; DX 13 at 2127). As E&Y performed its forensic review, CMD employees assisted them and told them what to look for to uncover the accounting irregularities (Tr. 1270-71). E&Y submitted its findings and recommendations in December 1994 (DX 13). E&Y's report focused on sales and shipping issues (DX 13 at 2132). The areas of inventory reserve and the valuation of machinery and equipment, both of which are identified as audit failures in the OIP, were beyond the scope of E&Y's engagement (DX 13 at 2132).
The special committee also hired Carl A. Thomsen (Thomsen) as a consultant to address a wide range of issues (Tr. 925; Thomsen Dep. at 5, 19-20; DX 5). Before accepting the position, Thomsen already knew that there had been accounting irregularities at CMD (RX 374 at 615). He initially examined the publicly available documents and concluded that CMD's inventory was excessive relative to its sales and to the inventory levels of its competitors (Thomsen Dep. at 10-11; RX 374 at 645). After his first day on the job, Thomsen wrote in his diary: "[I]nventory has to be a problem as customers are complaining about delays in shipments despite the major inventory levels" (RX 374 at 618). While he could not identify the origin of these customer complaints, Thomsen concluded that CMD's accounts receivable were too high as a percentage of its reported revenues (Thomsen Dep. at 12-13, 71-73, 75; RX 374 at 651).
Thomsen reported his preliminary findings and recommendations on accounting irregularities to the special committee on October 28, 1994, only eleven days after he started (JX 24).19 Among other things, Thomsen advised the special committee that CMD's fiscal year 1994 accounts receivable were a significant problem and that certain revenue billings also appeared to be improper (JX 24 at 667-70). As Thomsen continued his work, he prepared detailed analyses and recommended significant additional inventory reserves (Thomsen Dep. at 35-36; DX 12, DX 92, JX 25). In December 1994, Thomsen proposed a new inventory valuation policy to be used on a "go forward" or prospective basis (Thomsen Dep. at 29, 62-64; JX 25).
Thomsen resigned his consulting position in January 1995, before CMD's new management restated the 1994 financials (Thomsen Dep. at 63).20 He did not know if his proposed valuation policy changes or his proposed inventory adjustments were ultimately included in CMD's Form 10-K/A (Thomsen Dep. at 62-63).
On January 6, 1995, C&L confirmed that it was terminating its auditing relationship with CMD and would not reissue its audit opinion on CMD's 1994 financial statements (Tr. 152; JX 20 at 50, JX 24 at 678). NASDAQ delisted CMD's stock on January 26, 1995, due to CMD's delinquency with respect to two filings with the Commission, and CMD's inability to meet certain other filing requirements (JX 21 at 11). On February 3, 1995, CMD reached an agreement for the appointment of E&Y as its new independent accountants.21
On February 6, 1995, CMD filed a report with the Commission on Form 10-K/A, restating its results for fiscal year 1994 (JX 20). Upon restatement, CMD reported a net loss of $15.2 million on total revenues of $30.1 million (JX 20 at 22, JX 21 at 12). CMD had previously reported earnings of $5 million on revenues of $45.3 million (JX 20 at 26, JX 21 at 9). The restated balance sheet reduced accounts receivable from $16.9 million to $6.3 million, inventories from $13.9 million to $5.1 million, and net property and equipment from $10.4 million to $7.4 million (JX 19 at 24, JX 20 at 21). The revised financial statements were unaudited.22 The Division presented no witnesses from CMD to explain the basis for the restatement.
The Division struggles to establish that E&Y eventually audited CMD's restated fiscal year 1994 balance sheet when it later audited CMD's financial statements for the nine-month period ending March 31, 1995 (Tr. 1252-53, 1265-66, 1279-81; Div. Reply Br. at 10 n.5). The weight of the evidence does not support this claim.23
Witness Credibility
Fact witnesses. I have addressed the credibility of the principal fact witnesses (Marrie, Berry, Jenson, Schindele, Romito, Kannapan, and Meyercord) throughout this decision. I did not personally observe Thomsen, who testified by deposition, and I have expressed no view as to his credibility. I found several other witnesses (Robert K. Crowe (Crowe), Martin Nachimson (Nachimson), Betty Jo Charles, Hal Schultz, and Manual Alvarez) to be generally credible. The same cannot be said for Guy Steve Hamm (Hamm) or Bridges.
Hamm was the managing partner for C&L's Los Angeles regional cluster in 1994 and 1995 (Tr. 1485). He was Marrie's immediate supervisor (Tr. 1487-89). Hamm testified that C&L's principal reason for requesting Marrie's resignation was that business revenues in the Phoenix office had been flat or declining for several years (Tr. 1497-98). Hamm nonetheless opined that CMD's annual audit fees of less than $100,000 were not significant to the revenues of C&L's Phoenix office or to the those of the Los Angeles regional cluster as a whole, and that C&L's loss of CMD as an audit client was not a factor in Marrie's separation from the firm (Tr. 1499).
Hamm also testified that he did not personally examine Marrie's technical auditing performance and had received only limited input from others on that subject (Tr. 1491, 1499-1500). However, when shown DX 86, Voluntary Withdrawal at the Firm's Request, Hamm recalled that there had been some technical issues dealing with revenue recognition on the CMD audit (Tr. 1493-94). Hamm insisted that these technical issues were the last of many factors he considered when recommending that Marrie withdraw from C&L (Tr. 1496-97). Hamm maintained that he was not aware of any litigation against C&L arising out of the CMD audit when he recommended Marrie's termination (Tr. 1504).
DX 86 stated: "Marrie is being asked to withdraw from the Firm based on his inability to successfully grow the Phoenix practice and a lack of evidence that he is continuing to grow professionally as a partner" (DX 86 at CLB 452). It also gave considerably more weight to Marrie's technical accounting deficiencies than Hamm's testimony acknowledged. For example, DX 86 stated that Marrie's "technical competence has come into question. . . . Mike failed to identify certain technical issues on [the CMD audit] . . . which resulted in our resigning from [the engagement]. Mike has had technical difficulties with other clients in the past . . . ." (DX 86 at CLB 453). DX 86 also recited: "Although Mike has been generally well-liked by his clients, reviewers have indicated that at times he assumes too strong an advocacy role for them and that this may cause him to lose some of his objectivity. He has not always pressed his clients strongly enough, especially when the client has needed to be challenged on technical matters" (DX 86 at CLB 455).
I give considerably more weight to the first three pages of DX 86 than I do to Hamm's testimony that Marrie was asked to resign from C&L only because he had failed to generate adequate business for the firm's Phoenix office.24 Hamm's claim that he was unaware of litigation against C&L, arising out of the CMD audit, was not credible.
While it would not be accurate to classify Hamm as a witness who was overtly hostile to the Division, his demeanor persuaded me that he was giving the Division as little as he possibly could. On cross-examination by Respondents, Hamm availed himself of the opportunity to soften any blows he had been forced to deliver against Marrie on direct examination.
Bridges was generally an untrustworthy witness. She testified falsely that she had no direct contact with the auditors during the 1994 audit (Tr. 1212, 1219-20; JX 9 at 820, 829, 838). In an apparent recantation of prior testimony, she only "vaguely recall[ed]" telling one of the auditors to look at a May invoice register detailing millions of dollars of revenue reversals (Tr. 1221). She could not even recall if her tippee was male or female (Tr. 1221). In contrast, Schindele testified credibly that no one from CMD had tipped her to such matters (Tr. 501-02). Bridges, like Romito, claimed credit for being the whistleblower who alerted the auditors to improper revenue recognition during the 1993 audit (Tr. 1225-26). When discussing misconduct by CMD officers and employees during 1994, Bridges resorted to the passive voice, thus obscuring the identity of the actors: airway bills were falsified, invoices were falsified and provided to the C&L auditors, incriminating documents were thrown away (Tr. 1216-17). In this manner, Bridges attempted to establish misconduct by others at CMD without implicating herself. However, I do credit Bridges's testimony that she did not specifically inform anyone from C&L that CMD was recognizing revenue for products that had not been shipped in 1994 (Tr. 1214).
Expert witnesses. D. Paul Regan (Regan), CPA, a forensic accountant with Hemming, Morse, Inc., of San Francisco, California, appeared for the Division as an expert in accounting matters. Regan's direct testimony is contained in a forty-page report (DX 89). He also testified on cross-examination and redirect examination for more than thirteen hours over three days. Of the 1,525-page transcript in this case, 454 pages (30%) were devoted to Regan.
Ernest L. Ten Eyck (Ten Eyck), CPA, testified as Respondents' expert on accounting issues. Ten Eyck is a director of Ten Eyck Associates, a consulting and litigation support firm in King of Prussia, Pennsylvania. He submitted his direct testimony in a thirty-two-page report (RX 405). He also testified on cross-examination and redirect examination for five hours on a single day (179 pages of transcript).
Both experts were well qualified. Cross-examination of Regan by Respondents was much more contentious than cross-examination of Ten Eyck by the Division. It is difficult to overstate the importance of Regan's testimony to the Division's case. It was thus quite surprising to see the Division's Posthearing Brief, at 3, state: "[W]hile opinions of qualified expert accountants may be helpful, in the last analysis the Commission must weigh the value of expert testimony against its own judgment of what is sound accounting practice." The Division cites Ernst & Ernst, 46 S.E.C. 1234, 1237 (1978), as authority for that proposition, but it ignores the Commission's statement elsewhere on the same page of that opinion. There, the Commission concluded that an Administrative Law Judge had erred in failing to give sufficient weight to expert testimony concerning accounting principles that were generally accepted during the period under consideration. Id. at 1237-38. This decision does not adopt the views of either expert in full, but it does rely on parts of the reports and testimony of each.
Related Cases
In addition to the present proceeding, the events at CMD during 1994 generated many other civil, administrative, and criminal cases. Several are relevant to the OIP's charge of pervasive financial reporting fraud at CMD, to Respondents' defense of laches, and to Respondents' claim that CMD management officials repeatedly deceived them. Of course, settlements are not proof that such fraud actually occurred or that CMD officials deceived the auditors, particularly when the parties involved neither admitted nor denied the allegations. The cases have been cited only to provide context for this proceeding.
Civil Injunctive Actions. On January 4, 1996, the Commission brought a civil action against Romito in the U.S. District Court for the Northern District of California. See SEC v. Romito, SEC Litig. Rel. No. 14776, 60 SEC Docket 3342 (Jan. 4, 1996). The Commission alleged that Romito, together with other officers and employees of CMD, fraudulently inflated CMD's reported revenue for fiscal year 1994 by knowingly recognizing revenue on products that had not been shipped or, in some cases, even manufactured. Id. The complaint charged that, in order to conceal the improper revenue recognition, Romito and others falsified CMD's books and records, overrode CMD's internal accounting controls, and misled CMD's outside auditors. The complaint further alleged that Romito engaged in illegal insider trading by selling CMD stock while in possession of material non-public information. Id.
On January 17, 1996, Romito consented to an order permanently enjoining him from future violations of the securities laws, directing him to disgorge an amount equal to the losses he avoided by insider trading, and prohibiting him from serving as an officer or director of a public company. Romito also consented to the entry of an order in a separate administrative proceeding that prohibited him from appearing or practicing before the Commission as an accountant. See Ronald A. Romito, CPA, 61 SEC Docket 656 (Feb. 1, 1996).
On September 26, 1996, the Commission brought a civil action in the Northern District of California against Surendra Gupta (Gupta), former president of CMD, Bhasker B. Rao (Rao), former vice president and general manager of CMD's Tempe plant operations, and R. Ramana Penumarty (Penumarty), former vice president and general manager of CMD's Milpitas plant operations. See SEC v. Gupta, Rao, and Penumarty, SEC Litig. Rel. No. 15097, 62 SEC Docket 2970 (Sept. 30, 1996). The complaint alleged that all three defendants artificially inflated CMD's publicly reported revenue for fiscal year 1994 by directing employees to falsify documents to create the appearance that certain goods had been shipped to customers when in fact the goods had not been shipped or, in most cases, manufactured. Id. Rao and Penumarty were also charged with engaging in illegal insider trading by selling CMD stock in 1994 while in possession of material non-public information. Id.
On March 25, 1998, without admitting or denying the allegations, Gupta, Rao, and Penumarty consented to permanent injunctions from future violations of the securities laws, to civil penalties, and to be barred from serving as officers or directors of public companies. Rao and Penumarty also consented to pay disgorgement for insider trading. See SEC v. Gupta, Rao, and Penumarty, SEC Litig. Rel. No. 15690, 66 SEC Docket 2768 (Mar. 31, 1998).
On September 30, 1998, the Commission filed a complaint in the Northern District of California against Desaigoudar and Henke. See SEC v. Henke and Desaigoudar, SEC Litig. Rel. No. 15919, 68 SEC Docket 533 (Sept. 30, 1998). The allegations (financial reporting fraud and illegal insider trading) and the relief sought (injunctions, disgorgement, civil penalties, and bars on service as officers and directors of public companies) were similar to those in the Romito, Gupta, Rao, and Penumarty cases described above. Id. at 533-34. The Commission's complaint against Desaigoudar and Henke is still pending.
Criminal Cases. Romito pled guilty to one count of insider trading in CMD stock (Tr. 560). He agreed to cooperate with the government's ongoing investigation of the events at CMD.
Henke, Desaigoudar, and Gupta were indicted on criminal charges in September 1997. Gupta reached an agreement with the government in exchange for his testimony against Henke and Desaigoudar. In July 1998, after a five-week trial, a jury found Henke and Desaigoudar guilty of conspiracy to make false statements to the Commission, making false statements, securities fraud, and insider trading. See United States v. Desaigoudar and Henke, SEC Litig. Rel. No. 15846, 67 SEC Docket 2356 (Aug. 12, 1998). In December 1998, Henke and Desaigoudar were fined and sentenced to thirty-two months and thirty-six months incarceration, respectively.
In August 2000, the U. S. Court of Appeals for the Ninth Circuit reversed the convictions, vacated the sentences, and remanded for a new trial. United States v. Henke, 222 F.3d 633. The court agreed with the defendants that a new trial was necessary because their lawyers' ability to cross-examine Gupta, a key government witness, had been impaired by a conflict of interest arising from a joint defense agreement. According to the court, the joint defense agreement established an implied attorney-client relationship with the co-defendants' attorneys. The court also found reversible error in the admission of Meyercord's testimony that Henke, Desaigoudar, and others were terminated because they must have known about the revenue reporting scheme at CMD.
Shareholder Class Action Lawsuits. Following the August 4, 1994, write-off announcement, shareholders filed eleven class action lawsuits in the Northern District of California against CMD, its current and former officers and directors, C&L, and others. The principal allegation was that CMD and others violated the antifraud provisions of the securities laws by disseminating false and misleading financial statements and reports for fiscal years 1994 and 1993 (JX 21 at 9). The complaints sought damages and attorneys' fees, as well as other relief.
Judge Vaughn R. Walker denied the motions of certain plaintiffs and CMD for preliminary approval of a proposed settlement. He also denied the request of a law firm representing certain plaintiffs to be appointed class counsel. See In re California Micro Devices Sec. Litig., 168 F.R.D. 257, 269-71 (N.D. Cal. 1996) ("CMD I").
Judge Walker later approved a revised settlement proposal. In contrast to the earlier and rejected proposal, which consisted of $1 million in cash and $12 million of CMD stock, the revised proposal offered the class $6 million in cash and stock guaranteed to be worth at least $7 million. The revised proposal also cut attorney fees by over $1 million, and brought in additional cash from two new sources that had not been part of the original agreement.
C&L contributed $4 million in cash to the revised settlement agreement. Judge Walker found this to be "a substantial improvement for the class and . . . particularly impressive because it comes from outside accountants who may well have successfully claimed to have been duped" by CMD. See In re California Micro Devices Sec. Litig., 965 F. Supp. 1327, 1331 (N.D. Cal. 1997) ("CMD II").
DISCUSSION AND CONCLUSIONS
The OIP alleges that Respondents failed to exercise appropriate professional skepticism, obtain competent evidential matter, and properly supervise audit personnel as they audited CMD's property, inventory, and accounts receivable.
The most notable features of the OIP are its length and detail: fifteen single-spaced pages of very specific allegations about what was wrong with CMD's financial statements and how Respondents recklessly violated the applicable professional standards when auditing them. Because the charging document offers so much particularity, it is difficult to imagine that the Commission omitted anything that it considered important.
Nonetheless, the Division and/or its expert witness sought to bring in several fresh allegations that had not been identified in the OIP. The Division never moved to amend the OIP to encompass these new charges, and the time for doing so has expired. This Initial Decision refuses to consider these newly minted allegations. See supra note 16 and infra notes 42, 48, 49.
At the same time, the Division abandoned some of the allegations that are identified in the OIP. For example, the OIP claims that CMD's officers "engaged in a massive financial reporting fraud" (OIP ¶ II.D.4). The Division suggests that this charge is surplussage, and that it is there simply to provide background. I agree with the Division that it need not prove fraud by CMD's management in order to prevail on each of the OIP's allegations of improper professional conduct. The OIP is also brimming with allegations that CMD's audited financial statements contained material misstatements and failed to comply with GAAP (OIP ¶¶ II.A.2, II.A.3, II.A.4, II.D.4, II.D.13, II.D.28, II.D.39, and II.D.45). I agree with Respondents that the wording of the OIP requires the Division to prove each of these GAAP allegations to obtain the sanctions it seeks.
The OIP raises two types of GAAP-related claims: first, that CMD's financial statements contained material misstatements in violation of GAAP; and second, that Respondents recklessly violated GAAS because they lacked a sufficient basis to opine that the financial statements complied with GAAP. The Division specifically disavowed an intention to prove the former type of charge (Division's Designation of Expert Witness, dated Oct. 29, 1999 (omitting CMD's alleged violations of GAAP from the list of issues that Regan would address); Prehearing Conference of Nov. 12, 1999, at Tr. 22, 25-30; Resp. Prehearing Br. at 34-37; Tr. 1244-51, 1267-68; Resp. Prop. Find. # 9 n.10; Div. Reply Br. at 13 n.8). This decision finds that, by doing so, the Division has narrowed the scope of the practice sanction that is appropriate under Rule 102(f) if it prevails on the merits of the GAAS charges. See infra note 32 and associated text.
This decision rejects Respondents' claims that the proceeding is barred by the statute of limitations and/or by the doctrine of laches. It next examines the contours of recklessness under the applicable case law, and concludes that the Division cannot establish recklessness under Rule 102(e)(1)(iv)(A) by merely stringing together separate acts of auditing negligence that might have satisfied Rule 102(e)(1)(iv)(B)(2). It then reviews the term "applicable professional standards" in Rule 102(e)(1)(iv)(A) and concludes that C&L's internal policy and guidance manual is not part of the applicable professional standards for purposes of Rule 102(e).
The OIP focuses on Respondents' audit of three estimates made by CMD's management. These estimates are "soft" numbers; their reliability depends upon the quality of the assumptions on which they are based. The process of creating adequate reserves is inexact to begin with, and it is a daunting task for the Division to demonstrate that the audit of those estimates was reckless.
This decision finds that the weight of the evidence does not support the claims that Respondents recklessly violated GAAS in auditing CMD's estimates of the value of its property and equipment or the value of its obsolete inventory. In these two areas, this decision also finds that no GAAS violations were proven. It further finds that Respondents committed negligent, but not reckless, violations of GAAS when auditing CMD's sales revenues, accounts receivable, and estimate of sales returns. Finally, the decision finds that the weight of the evidence fails to sustain the charges that CMD's financial statements materially misstated its property and equipment, its obsolete inventory, and its revenues and accounts receivable in violation of GAAP.
Based on these findings and conclusions, the Initial Decision dismisses all the charges as to both Respondents.
1. This proceeding is not time-barred by 28 U.S.C. § 2462.
Respondents argue that 28 U.S.C. § 2462, the five-year limitation period for actions to enforce a penalty, bars this proceeding. They observe that much of the professional conduct at issue-including the audit planning, most of the field work, and the August 4, 1994, write-off that the Division contends should have alerted Marrie and Berry to CMD's fraud-occurred more than five years before the OIP was issued. In support of their request for dismissal, Respondents cite Johnson v. SEC, 87 F.3d 484, 488-90 (D.C. Cir. 1996), and 3M Co. v. Browner, 17 F.3d 1453, 1456-61 & n.14 (D.C. Cir. 1994).
The Division contends that 28 U.S.C. § 2462 does not apply because this proceeding is remedial in character, not punitive. See Johnson, 87 F.3d at 489 n.7 ("Where a licensing agency is only evaluating an individual's current competence, it is not clear that there would be a date at which the `claim first accrued' for purposes of § 2462."); cf. Janik Paving & Constr., Inc. v. Brock, 828 F.2d 84, 90-91 (2d Cir. 1987) (finding that debarment is not a penalty). In the alternative, the Division argues that the limitation period did not start to run until C&L "rendered" its audit report on September 27, 1994 (JX 1 at 75-77). Only then, the Division claims, did Respondents end their opportunity to take further corrective action with respect to the report.
The Commission has never explicitly held that 28 U.S.C. § 2462 governs Rule 102(e) disciplinary proceedings. See George Craig Stayner, CPA, 67 SEC Docket 425 (May 14, 1998) (dismissing a Rule 102(e) proceeding that had not been instituted until eight years after the alleged improper professional conduct occurred, without determining whether the rationale of Johnson applied); cf. Russell Ponce, 72 SEC Docket 442, 465-67 (Aug. 31, 2000) (finding in a mixed enforcement proceeding and Rule 102(e) disciplinary proceeding that the respondent had waived the statute of limitations argument, but observing in dicta that two of the four audited financial statements at issue had been prepared and filed within five years before the OIP).
However, the Commission has acquiesced in Johnson when resolving the aged administrative enforcement proceedings on its docket. See Terry T. Steen, 53 S.E.C. 618, 623-25 (1998) (holding that the Commission will look only to wrongful conduct within the five-year period before the OIP to establish liability, but stating that it may consider a respondent's earlier conduct, when relevant, to establish the respondent's motive, intent, or knowledge); Richard D. Chema, 53 S.E.C. 1049, 1052 n.8 (1998) (following Steen, but referring to "transactions" instead of "conduct"); Joseph J. Barbato, 53 S.E.C. 1259, 1278-79, 1281 (1999) (looking only to conduct within the five-year period to assess sanctions); Jacob Wonsover, 69 SEC Docket 694, 713-14, 716 (Mar. 1, 1999) (looking only to conduct within the five-year period to establish liability and assess sanctions).
The limitation period in 28 U.S.C. § 2462 is subject to equitable tolling if a continuing violation or ongoing conduct is involved. See Newell Recycling Co., Inc. v. EPA, 231 F.3d 204, 206-07 (5th Cir. 2000); InterAmericas Inv., Ltd. v. Bd. of Governors of the Fed. Reserve Sys., 111 F.3d 376, 382 (5th Cir. 1997). Respondents are wrong to focus on the date that a junior auditor completed a particular step during field work; the relevant date for commencing the running of the limitation period is when Marrie and Berry determined that all the procedures had been performed to their satisfaction. Had Respondents been dissatisfied with the work in a given area, they could have directed that additional work be performed. For that reason, I conclude that the audit involved a continuous course of conduct. As a result, the Commission's "claim first accrued" when Marrie certified C&L's unqualified audit report, thereby giving up the ability to take further corrective action.
Ponce is of limited assistance in determining when the limitation period should begin to run. Sections 12(b)(1)(J) and (K) of the Exchange Act require that an issuer's financial statements be "certified" by an independent public accountant. Commission Regulation S-X, 17 C.F.R. § 210.1-02(f), provides that financial statements are "certified" when an independent auditor completes an examination and issues a report expressing an opinion. AU § 530.01 states that the date of completion of field work is generally used as the date of the independent auditor's report. Under AU § 530.02, an auditor has no responsibility to make any inquiry or carry out any auditing procedures for the period after the date of his report. These provisions strongly suggest that the appropriate date to commence the running of any limitations period is the date the auditor certifies his report.
If an auditor certifies his report too early (before the field work has been completed), the Commission has not hesitated to charge improper professional conduct for violating AU § 530.01. See Lester Witte & Co., 47 S.E.C. 409, 419 (1981) (settled case); see also Indep. Accountants, Mandatory Peer Review, 37 SEC Docket 1825, 1836 n.53 (Apr. 10, 1987) (rulemaking proposal to amend the Regulation S-X definition of "certified" financial statements to require that such financial statements be examined by an independent accountant who has undergone a peer review within three years prior to the date of the completion of the examination, and using AU § 530.01 (the end of field work) as the date of the completion of the examination).25 If an auditor reopens the field work because he is not satisfied with the work already performed, AU § 530.05 contemplates that he will adjust his report date to reflect that fact.
Assuming that 28 U.S.C. § 2462 applies to Rule 102(e) disciplinary proceedings, I conclude that the limitation period began to run on August 25, 1994, the certification date on C&L's unqualified audit report.26 The limitation period had not expired when the OIP was issued on August 10, 1999.
2. There is no merit to Respondents' affirmative defense of laches.
Laches is an equitable doctrine by which a court denies relief to a claimant who has unreasonably delayed or been negligent in asserting a claim, when that delay or negligence has prejudiced the party against whom relief is sought. See Black's Law Dictionary 879 (7th ed. 1999). The doctrine is based on the maxim that equity aids the vigilant, not those who sleep on their rights. See Ikelionwu v. United States, 150 F.3d 233, 237 (2d Cir. 1998).
Respondents cannot use the doctrine of laches to shrink the limitations period they say is applicable to this proceeding. If there is a limitation period, and if the limitation period has been met, that is the end of the matter. See Holmberg v. Armbrecht, 327 U.S. 392, 395 (1946); Lyons P'ship, L.P. v. Morris Costumes, Inc., 243 F.3d 789, 797-98 (4th Cir. 2001) (holding that "separation of powers principles dictate that an equitable timeliness rule adopted by courts cannot bar claims that are brought within the legislatively-prescribed statute of limitations"); Patton v. Bearden, 8 F.3d 343, 348 (6th Cir. 1993) (holding that, absent compelling reasons, there is a strong presumption against applying the doctrine of laches where the statute of limitations has not expired).
Respondents' laches argument fails for an additional reason. Laches cannot be invoked against federal government agencies acting in a sovereign capacity to protect the public interest. See David Disner, 52 S.E.C. 1217, 1223 (1997); Kingsley, Jennison, McNulty & Morse, Inc., 51 S.E.C. 904, 911 n.30 (1993); Richard N. Cea, 44 S.E.C. 8, 21 (1969) and cases cited therein. The Commission has entertained laches defenses raised against non-governmental self-regulatory organizations. See Raphael Pinchas, 70 SEC Docket 1516, 1529-30 (Sept. 1, 1999); Stephen J. Gluckman, 70 SEC Docket 418, 431-32 (July 20, 1999). I am aware of no cases in which the Commission has found a laches defense to be meritorious.
As evidence of prejudice resulting from unreasonable delay, Respondents assert that original documents they sought to retrieve from CMD had been lost or destroyed and that they were unable to find a potential witness. They also find it galling that the Division repeatedly cites to the audit team's inability to recall the details of what it did during the audit as grounds to conclude that it did nothing.
I agree with Respondents that the delay in commencing this proceeding was regrettable and undesirable.27 However, I do not find that Respondents' legal rights have been prejudiced. The fact that original documents may have been missing from CMD headquarters was of no consequence because microfilmed copies of the documents were still available from CMD's attorneys at Howard Rice (Prehearing Conference of Jan. 13, 2000, at Tr. 6-8). The Division's prospective witness list provided a current address for Henke, the allegedly missing witness. Respondents could have pursued that lead if they wished to do so.
The failing recollections of various witnesses presents a closer issue. Certain witnesses' memories were clear when they were asked to recall events that could burnish their own reputations as whistleblowers. Thus, both Romito and Bridges took credit for tipping Marrie to revenue recognition problems during the 1993 audit (Tr. 525, 1225-26). These tips were one of the things that Marrie claimed not to recall (Tr. 103-04). Meyercord had little difficulty recalling his vehement disagreement with Romito at a February 1994 board meeting over management's decision to grant extended payment terms to Far East distributors (Tr. 910-12). However, other parts of Meyercord's testimony were sprinkled with "I don't recall" answers (Tr. 908, 914-16, 924). Other witnesses' memories were clear only when they had exculpatory information to offer. For example, Jenson had a precise recollection of the time Marrie stood up to Romito, refusing to direct the engagement team to work weekends after CMD had delayed in getting materials to the auditors (Tr. 401-02). On the other hand, Jenson was unable to remember the details of certain audit procedures he performed. Marrie had no difficulty recalling that he lost a client because he had too much integrity for the client's liking (Tr. 169-70). Marrie's ability to recall events closer to the heart of the case was much more limited. Thus, Marrie could not recall being "dumbfounded" when learning of the prospective write-off of $12 million in receivables. In contrast, Kannapan, a witness with a much more peripheral involvement in the case, had no difficulty remembering that he was shocked when he learned of the same information. I cannot find that Respondents have been unfairly prejudiced by the "I don't recall" testimony.
3. In attempting to show that Respondents were reckless, the Division has assumed a formidable burden of proof.
Rule 102(e) provides the Commission with a means to ensure that the professionals on whom it relies in executing its statutory duties perform their tasks diligently and with a reasonable degree of competence. The Commission has stated that it did not promulgate the rule to augment its enforcement arsenal, but simply to protect the integrity of its administrative processes from future harm that would result from continuing professional misconduct. See William R. Carter, 47 S.E.C. 471, 472-78 (1981) (discussing the background and operation of Rule 2(e), the predecessor of Rule 102(e)).28
Although there is no express statutory provision authorizing the Commission to discipline the professionals appearing before it, three reviewing courts have held that the rule was validly promulgated under the Commission's broad authority to adopt those rules and regulations necessary for carrying out its designated functions. See Sheldon v. SEC, 45 F.3d 1515, 1518 (11th Cir. 1995); Davy v. SEC, 792 F.2d 1418, 1421 (9th Cir. 1986); Touche Ross & Co. v. SEC, 609 F.2d 570, 577-82 (2d Cir. 1979).
Scienter And Rule 102(e)
The mental state required to violate the Commission's rule against improper professional conduct has been a point of considerable controversy. Representatives of the accounting profession, some prior Commissioners, and various legal commentators have argued that sanctioning an accountant for negligence extends beyond the realm of protective discipline and thrusts the Commission into substantive regulation over a professional's work-a function they view as reserved to the state boards of accountancy and professional organizations. Cf. SEC v. Pros Int'l, Inc., 994 F.2d 767, 769 (10th Cir. 1993) ("The SEC's authority does not extend to general regulation of the accounting profession . . . ."); SEC v. Arthur Young & Co., 590 F.2d 785, 788 (9th Cir. 1979). These critics have suggested that the text of Rule 102(e)(1)(ii) must be read in its entirety and that, just as an accountant cannot "negligently" be lacking in character or integrity or act unethically, so too, an accountant cannot "negligently" engage in improper professional conduct. They have contended that it is unfair for the Commission to apply a more stringent standard for accountants (sanctioning them for negligence) than for attorneys (sanctioning them only for recklessness or knowing misconduct).
In Davy, 792 F.2d at 1422, the U.S. Court of Appeals for the Ninth Circuit stated that "there may be cases where the SEC should not be empowered to determine the standards by which accountants, or attorneys for that matter, are to be judged," but it concluded that Davy's breaches of GAAP and GAAS were "so clear and so uncontroverted that any vagueness in the Rule is not at issue here."
In David J. Checkosky, 50 S.E.C. 1180 (1992), a majority of the Commission found that two accountants had engaged in improper professional conduct in violation of former Rule 2(e). It suspended them from practice for two years. The Commission stated that "a mental awareness greater than negligence is not required" to establish a violation of the rule, but it "noted" that the two accountants' conduct "did in fact rise to the level of recklessness." Id. at 1197.
In Checkosky v. SEC, 23 F.3d 452 (D.C. Cir. 1994) (Checkosky I), the court of appeals remanded the case to the Commission, holding that the agency had failed adequately to explain the standard of conduct it had applied under the rule. There was a very brief opinion of the court; each of the three judges also issued a separate expression of views. All three judges found substantial evidence to support the Commission's findings that the two accountants had failed properly to interpret GAAP and to act in accordance with GAAS. They differed on whether the violations of GAAP and GAAS constituted negligence or recklessness and whether negligence was sufficient for sanctions under the rule.
On remand, the Commission affirmed the suspensions. David J. Checkosky, 52 S.E.C. 1177 (1997). The majority opinion found that "improper professional conduct by accountants encompasses a range of conduct" and that the rule "does not mandate a particular mental state." Id. at 1190-91. It concluded that the accountants had behaved recklessly, but at the same time insisted that negligent deviations from GAAP or GAAS could violate Rule 102(e).
The two accountants again petitioned for judicial review, and again argued that the Commission had failed to articulate an intelligible standard for "improper professional conduct" under Rule 102(e). In Checkosky v. SEC, 139 F.3d 221 (D.C. Cir. 1998) (Checkosky II), the court of appeals again remanded. The court found that, notwithstanding the prior remand, the Commission had failed to offer an adequate explanation of the mental state that violated the rule. Citing the Commission's "persistent failure to explain itself" and "the extraordinary duration" of the proceedings, id. at 222, 227, the court determined that further proceedings would be futile. It instructed the Commission to dismiss the charges.
In response to Checkosky II, the Commission instituted a notice-and-comment rulemaking proceeding to "clarify" the standard of intent it would apply when determining whether accountants engage in improper professional conduct. Proposed Amendment to Rule 102(e) of the Commission's Rules of Practice, 67 SEC Docket 1006 (June 18, 1998) (Proposed Amendment). It adopted an amendment on October 19, 1998, and specified three types of conduct that would constitute improper professional conduct by an accountant under Rule 102(e)(1)(ii). Amendment to Rule 102(e) of the Commission's Rules of Practice, 68 SEC Docket 707 (Rule Amendment).
New Rule 102(e)(1)(iv)(A) defined "improper professional conduct" by an accountant to mean "[i]ntentional or knowing conduct, including reckless conduct, that results in a violation of applicable professional standards." In addition, new Rule 102(e)(1)(iv)(B) defined "improper professional conduct" by an accountant as "[e]ither of the following two types of negligent conduct: (1) A single instance of highly unreasonable conduct that results in a violation of applicable professional standards in circumstances in which an accountant knows, or should know, that heightened scrutiny is warranted[; or] (2) Repeated instances of unreasonable conduct, each resulting in a violation of applicable professional standards, that indicate a lack of competence to practice before the Commission." Rule Amendment, 68 SEC Docket at 709.
The notice of proposed rulemaking requested the public to comment on what definition of "recklessness" would be appropriate. Proposed Amendment, 67 SEC Docket at 1009. Several commenters suggested the definition of "recklessness" used in cases brought under Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. In adopting the Rule Amendment, the Commission agreed: "Although the standards of professional practice are not fraud based," for purposes of consistency, "recklessness" in the amended rule "should mean the same thing as courts have defined `recklessness' to mean under the antifraud provisions." Rule Amendment, 68 SEC Docket at 710.
Retroactive Application Of Rule 102(e)(1)(iv)(A)
Respondents argue that the Commission is estopped from retroactively applying Rule 102(e)(1)(iv)(A) to professional conduct that occurred in 1994 (Answers at 14; Resp. Br. at 35-37). They believe that the Commission must measure their 1994 professional conduct against the pre-1998 version of Rule 102(e)(1), the version the Commission has stated "does not mandate a particular mental state."
In promulgating the amended rule, the Commission stated that the purpose it served and the relief it provided are forward-looking. For those reasons, it said that it would use the clarified standard "in all cases considered after the amendment's effective date . . . regardless of when the conduct in question occurred." Rule Amendment, 68 SEC Docket at 708. The Commission did not specifically state that the amended version of the rule would be applied retroactively, but only that the clarified "standard" would be used "regardless of when the conduct in question occurred."
Paragraphs II.D.14 and II.D.48 of the OIP charge that Respondents "recklessly" violated applicable professional standards, while Paragraph II.D.48 specifically invokes Rule 102(e)(1)(iv)(A).29 Clearly, the 1998 rule amendment is being applied to pre-1998 conduct.
Application of a statute to conduct that occurred before its issuance is disfavored, but it is permissible if the provision simply embodies the law in existence at the time of the conduct and thus does not attach new legal consequences to events completed before its enactment. See Landgraf v. USI Film Prods., 511 U.S. 244, 269-70 (1994); SEC v. First Pac. Bancorp, 142 F.3d 1186, 1193 n.8 (9th Cir. 1998). Where the intervening statute authorizes or affects the propriety of prospective relief, application of the new provision is not retroactive. See Landgraf, 511 U.S. at 273.
However, absent clear Congressional intent, an agency may not give retroactive effect to statutes or rules that impair rights a party possessed when he acted, increase a party's liability for past conduct, or impose new duties with respect to transactions already completed. See id. at 280; see also Koch v. SEC, 177 F.3d 784, 789 (9th Cir. 1999) (holding that the Remedies Act did not authorize the Commission to impose a penny stock bar on an individual whose alleged misconduct predated the enactment of that statute); Upton v. SEC, 75 F.3d 92, 98 (2d Cir. 1996) (stating that because there was "substantial uncertainty" in the Commission's interpretation of a rule, the respondent did not have reasonable notice that his conduct might violate the rule); Carter, 47 S.E.C. at 508 (declining to find "improper professional conduct" by two attorneys because the applicable standards "have not been so firmly and unambiguously established that we believe all practicing lawyers can be held to an awareness of generally recognized norms" and because "the Commission has never articulated or endorsed any such standards").
In the three years since it adopted the rule amendment, the Commission has held that the clarified standard of intentional or knowing conduct by an accountant, including reckless conduct, "is not novel and was not created by the amendment to Rule 102(e). Rather, it is a standard that we have used in proceedings that predate both the Checkosky opinion and [the respondent's] own 1995 conduct." Albert Glenn Yesner, CPA, 70 SEC Docket 2743, 2748 (Oct. 19, 1999); Ponce, 73 SEC Docket at 465 n.52, 467 n.57; see also Potts v. SEC, 151 F.3d 810, 812-13 (8th Cir. 1998), cert. denied, 526 U.S. 1097 (1999) (recklessness by a concurring review partner). But see Checkosky II, 139 F.2d at 225-26 ("[T]he Commission had to make a choice. There is no justification for the government depriving citizens of the opportunity to practice their profession without revealing the standard they have been found to violate."); Yesner, 70 SEC Docket at 2752 (Johnson, Comm'r, dissenting) (criticizing the Commission's majority for treating the relevant version of Rule 102(e)-the one that existed prior to the October 1998 amendment-as if it had a severable "recklessness" element that survived Checkosky II); but cf. Natl. Mining Assn. v. U.S. Dept. of the Interior, 177 F.3d 1, 18-19 (D.C. Cir. 1999).
The Commission opinions in Yesner and Ponce stand for the proposition that intentional, knowing, or reckless conduct that did not comply with the applicable professional standards was "improper professional conduct" under Rule 102(e) before and after the Rule Amendment. Both opinions state that the "recklessness" standard was "not novel." Those opinions are binding on Administrative Law Judges, and are followed here. If Respondents contend that they had no idea, prior to October 19, 1998, that reckless violations of professional auditing standards would be treated as "improper professional conduct," or if they believe that Checkosky II, Koch, Upton, or Carter compel a different result on the retroactivity or fair notice issues, or on any of their other constitutional challenges, they must ask the Commission to reconsider its position.
Scienter And Auditing Under The Federal Securities Laws
The term "scienter" refers to "a mental state embracing intent to deceive, manipulate, or defraud." Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 n.12 (1976). The Division can establish scienter by proving either actual knowledge or recklessness. See Disner, 52 S.E.C. at 1222 & n.20; cf. In re Software Toolworks, Inc., Sec. Litig., 50 F.3d 615, 628 (9th Cir. 1994); In re Phar-Mor, Inc., Sec. Litig., 892 F. Supp. 676, 685 (W.D. Pa. 1995). Recklessness is narrowly defined. It involves not merely simple, or even inexcusable negligence, but an extreme departure from the standard of ordinary care and which presents a danger of misleading buyers or sellers that is either known to the actor or is so obvious that the actor must have been aware of it. See SEC v. Steadman, 967 F.2d 636, 641 (D.C. Cir. 1992); Hollinger v. Titan Capital Corp., 914 F.2d 1564, 1569-70 & n.7 (9th Cir. 1990) (en banc); Hackbart v. Holmes, 675 F.2d 1114, 1117-18 (10th Cir. 1982); Sundstrand Corp. v. Sun Chem. Corp., 553 F.2d 1033, 1044-45 (7th Cir. 1977).30 Recklessness is a lesser form of intent, not a greater degree of ordinary negligence. It is not just different from negligence in degree, but also in kind. See Sanders v. John Nuveen & Co., 554 F.2d 790, 793 (7th Cir. 1977).
The contours of auditing recklessness are particularly troublesome because an audit by nature involves considerable estimation and judgment exercised against materials prepared by others. See Bily v. Arthur Young & Co., 834 P.2d 745, 762 (Cal. 1992) ("An auditor is a watchdog, not a bloodhound. As a matter of commercial reality, audits are performed in a client-controlled environment.").
The type of recklessness that is actionable against an outside auditor must approximate an actual intent to aid in the fraud being perpetrated by the audited company. See Decker v. Massey-Ferguson, Ltd., 681 F.2d 111, 120-21 (2d Cir. 1982). Scienter requires more than evidence that an outside auditor has misapplied accounting principles. The Division must prove that the accounting practices were so deficient that the audit amounted to no audit at all, or an egregious refusal to see the obvious, or to investigate the doubtful, or that the accounting judgments which were made were such that no reasonable accountant would have made the same decisions if confronted with the same facts. See SEC v. Price Waterhouse, 797 F. Supp. 1217, 1240 (S.D.N.Y. 1992). If a respondent shows that his accounting decisions were reasonable, he negates the Division's attempt to establish scienter. See In re Worlds of Wonder Sec. Litig., 35 F.3d 1407, 1426 (9th Cir. 1994).
The case law is clear about what is not sufficient to establish scienter.31 First, violations of GAAP, by themselves, do not constitute circumstantial evidence of scienter. See Chill v. Gen. Elec. Co., 101 F.3d 263, 270 (2d Cir. 1996); Lovelace v. Software Spectrum Inc., 78 F.3d 1015, 1020-21 (5th Cir. 1996); Software Toolworks, 50 F.3d at 626-27; Worlds of Wonder, 35 F.3d at 1426; Serabian v. Amoskeag Bank Shares, Inc., 24 F.3d 357, 362 (1st Cir. 1994). The same is true for violations of GAAS, standing alone. See Danis v. USN Communications, Inc., 73 F. Supp. 2d 923, 941 (N.D. Ill. 1999); Marksman Partners, L.P. v. Chantal Pharm. Corp., 46 F. Supp. 2d 1042, 1049 n.5 (C.D. Cal. 1999), aff'd, 2000 U.S. App. LEXIS 21708 (9th Cir. Aug. 22, 2000) (unpublished table decision); In re Health Mgmt., Inc. Sec. Litig., 970 F. Supp. 192, 203 (E.D.N.Y. 1997). Second, it is not enough for the Division to show that a reasonable accountant "would, might, or should have handled the matter differently." Price Waterhouse, 797 F. Supp. at 1241. Third, an accountant's scienter may not be inferred solely from the magnitude of the client's fraud. See Reiger v. Price Waterhouse Coopers, LLP, 117 F. Supp. 2d 1003, 1013 (S.D. Cal. 2000); In re Livent, Inc., Sec. Litig., 78 F. Supp. 2d 194, 217 (S.D.N.Y. 1999). Fourth, an auditor's desire to receive professional fees, or to profit from a continuing relationship with a client, does not suffice as evidence of scienter. See Melder v. Morris, 27 F.3d 1097, 1103 (5th Cir. 1994); DiLeo v. Ernst & Young, 901 F.2d 624, 629 (7th Cir. 1990); Health Mgmt., 970 F. Supp. at 202; Price Waterhouse, 797 F. Supp. at 1242 & n.60. Fifth, scienter is not established by demonstrating an auditor's lack of curiosity, or by using hindsight. See Chill, 101 F.3d at 270; Software Toolworks, 50 F.3d at 627; DiLeo, 901 F.2d at 628.
In contrast, the courts have been willing to infer scienter when GAAP or GAAS violations are combined with other circumstantial evidence of recklessness. First, scienter will exist when an auditor ignores multiple "red flags" that should have heightened his professional skepticism. See Danis, 73 F. Supp. 2d at 941-42; Miller v. Material Sci. Corp., 9 F. Supp. 2d 925, 928-29 (N.D. Ill. 1998); Health Mgmt., 970 F. Supp. at 203; Van de Velde v. Coopers & Lybrand, 899 F. Supp. 731, 737 (D. Mass. 1995); In re Leslie Fay Cos., Inc. Sec. Litig., 871 F. Supp. 686, 699 (S.D.N.Y. 1995), modified on other grounds, 918 F. Supp. 749 (S.D.N.Y. 1996). Second, scienter may be based on the magnitude of the reporting errors, if the accused was in a position to detect the errors. See Chu v. Sabratek Corp., 100 F. Supp. 2d 815, 824 (N.D. Ill. 2000); Chalverus v. Pegasystems, Inc., 59 F. Supp. 2d 226, 234 (D. Mass. 1999) (collecting cases); In re Miller Indus., Inc. Sec. Litig., 12 F. Supp. 2d 1323, 1332 (N.D. Ga. 1998); In re Leslie Fay Cos., Inc. Sec. Litig., 835 F. Supp. 167, 175 (S.D.N.Y. 1993) (holding that "tidal waves of accounting fraud" raise an inference of scienter for an accountant). The magnitude of an underlying fraud will also support an inference of scienter if it enhanced the auditor's suspicion of specific transactions or made the overall fraud glaringly conspicuous. See Reiger, 117 F. Supp. 2d at 1013. Third, scienter may be found if unusual transactions have been completed at or near the end of an accounting period, or if the audited company has violated its own internal policies in a way that violated GAAP. See Provenz v. Miller, 102 F.3d 1478, 1490 (9th Cir. 1996); In re Ikon Office Solutions, Inc. Sec. Litig., 66 F. Supp. 2d 622, 630-31 (E.D. Pa. 1999) (Ikon I); Chalverus, 59 F. Supp. 2d at 234-35; In re Cirrus Logic Sec. Litig., 946 F. Supp. 1446, 1458 n.10 (N.D. Cal. 1996); Van de Velde, 899 F. Supp. at 734-36. Fourth, scienter may be found if there is evidence that the accused participated in drafting misleading documents. See Software Toolworks, 50 F.3d at 629.
Materiality, GAAS, GAAP, And Scienter
The cases cited above, holding that scienter may be inferred in part from the magnitude of the reporting errors, offer judicial recognition of the close relationship between materiality and scienter under the antifraud provisions of the securities laws. The converse is equally true: immaterial errors will not support an inference of scienter. See Coates v. Heartland Wireless Communications, Inc., 55 F. Supp. 2d 628, 638 (N.D. Tx. 1999) ("It cannot be strongly inferred that a person who conceals immaterial information acts with intent to defraud."); Geiger v. Solomon-Page Group, Ltd., 933 F. Supp. 1180, 1191 (S.D.N.Y. 1996) (holding that it cannot be conscious misbehavior or recklessness for a defendant to fail to disclose information in a prospectus that is not material). In fact, because materiality is an element of an offense under Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, the courts often will not even consider the thorny issue of scienter if the materiality of an alleged misstatement or omission has not been established. See Press v. Quick & Reilly, Inc., 218 F.3d 121, 130 (2d Cir. 2000); Grossman v. Novell, Inc., 120 F.3d 1112, 1125 (10th Cir. 1997).
The Commission has rejected a suggestion that the filing of a materially false or misleading document should always be a threshold requirement for a finding of improper professional conduct by an accountant under Rule 102(e). In so ruling, the Commission reasoned:
[A]n accountant can demonstrate a lack of competence even if his conduct did not result in the filing of a false or misleading document. An auditor who fails to audit properly under GAAS-whether recklessly or highly unreasonably-should not be shielded [from a Rule 102(e) proceeding] because the audited financial statements fortuitously turned out to be accurate or not materially misleading.
Rule Amendment, 68 SEC Docket at 711. According to Respondents, this shows that the Commission is not simply interested in protecting the integrity of its processes, but is attempting to engage in the general regulation of the accounting profession. Absent evidence of GAAP violations and material misstatements in financial statements that could harm investors, Respondents claim that the Commission should stay its hand.
GAAS consists of three general standards, three standards of field work, and four standards of reporting. Certain activities subject to GAAS concern matters other than submitting documents. Thus, materiality is simply not relevant to such GAAS issues as the auditor's technical training and proficiency, or the auditor's need to maintain an independent mental attitude. Regan offered an additional hypothetical example of a GAAS violation without a corresponding GAAP violation: a client could have prepared a fair statement of its assets, liabilities, income, expenses, and the like, with all the appropriate footnotes, yet the auditor could have failed to perform any audit at all (Tr. 1109). In Regan's judgment, such circumstances would involve an audit that failed to comply with GAAS, although the client's financial statements complied with GAAP.
In other situations, however, whether "materiality" is an "element of the offense" will depend on whether it is an element of the specific professional standard alleged to have been violated. See Robert D. Potts, CPA, 65 SEC Docket 1376, 1385-87 (Sept. 24, 1997), aff'd, 151 F.3d 810 (8th Cir. 1998); see also Greebel v. FTP Software, Inc., 194 F.3d 185, 205 (1st Cir. 1999) (GAAP violations); In re Segue Software, Inc., Sec. Litig., 106 F. Supp. 2d 161, 169-71 (D. Mass. 2000) (GAAP violations); Ponce, 73 SEC Docket at 460-61 (GAAP violations).
The applicable professional literature is to the same effect. The statements interpreting GAAS recognize that materiality "underlie[s] the application of all [GAAS], particularly the standards of field work and reporting." AU § 150.03; see also AU § 150.04 ("The concept of materiality is inherent in the work of the independent auditor."); AU § 312.03 ("The concept of materiality recognizes that some matters, either individually or in the aggregate, are important for fair presentation of financial statements in conformity with [GAAP], while other matters are not important."); AU § 312.08 ("The auditor should consider audit risk and materiality both in (a) planning the audit and designing auditing procedures and (b) evaluating whether the financial statements taken as a whole are presented fairly, in all material respects, in conformity with [GAAP]."); AU §§ 312.13, 326.23, 411.06, 420.02, 431.02, 508.08. Accordingly, to prove improper professional conduct where the allegation is the expression of a faulty opinion on the client's financial statements taken as a whole, the Division must demonstrate materiality.
Should the Division prove that Marrie and Berry recklessly violated GAAS, yet fail to prove that CMD's audited financial statements were materially misstated in violation of GAAP, remedial sanctions would be limited to the particular deficiencies proven on the record. The Division professes to be aghast at this prospect, even going so far as to argue that Administrative Law Judges and the Commission lack the power to tailor the scope of a practice sanction under Rule 102(f)(2), 17 C.F.R. § 201.102(f)(2), to anything less than its full breadth (Posthearing Conference of Aug. 30, 2000, at Tr. 31-33). In advocating this extreme position, the Division fails to consider that it bears the burden of proof as the proponent of an order imposing sanctions. See 5 U.S.C. § 556(d) ("Except as otherwise provided by statute, the proponent of a rule or order has the burden of proof."). The Division also fails to explain why there is no merit to the recommendations of the American Bar Association's Section of Business Law, Committee on Federal Regulation of Securities, Task Force on Rule 102(e) Proceedings.32 The Task Force Report stated:
A respondent who understands GAAP but has an inadequate appreciation of GAAS . . . should not be precluded from participating in the preparation of financial statements as, for example, a member of the finance and accounting department of a public company, as opposed to having ultimate responsibility for the application of the auditing standards to those financial statements.
Scienter Cannot Properly Be Inferred From Evidence Of Nothing More Than Repeated Auditing Negligence
As stated in Sanders, 554 F.2d at 793, recklessness is a lesser form of intent, not a greater degree of ordinary negligence, and it differs from negligence not only in degree, but also in kind. See McLean v. Alexander, 599 F.2d 1190, 1198 (3d Cir. 1979) ("[N]egligence, whether gross, grave or inexcusable cannot serve as [a] substitute for scienter."); Reiger, 117 F. Supp. 2d at 1014 ("[N]o degree of negligence can satisfy the substantive element of scienter, or raise a strong inference of scienter under the [PSLRA.]").
Although the Commission assesses an auditor's performance in light of the "total audit environment," see Ernst & Ernst, 46 S.E.C. at 1262, the OIP does not challenge the CMD audit in its entirety. Rather, the OIP focuses on three specific aspects of the audit: accounts receivable, obsolete inventory, and discontinued equipment. Of course, it is theoretically possible that the more negligent acts an auditor commits during a given interval, the likelier it may be that the auditor knew he was creating risk of a greater degree and a different kind. But the courts have not been receptive to such hair-splitting. Cf. Wells v. Monarch Capital Corp., [1998 Supp.] Fed. Sec. L. Rep. (CCH) ¶ 90,110 at 90,152 (1st Cir. 1997) (holding that the fact that the outside auditors made "many mistakes" did not support a finding of scienter). Given Checkosky I and Checkosky II and the Commission's determination not to wade into this swamp in the 1998 rulemaking,33 the Division cannot bootstrap its way to victory in an auditing recklessness case by stringing together separate acts of auditing negligence.
The OIP does not allege auditing negligence. If the evidence shows nothing more than auditing negligence, dismissal would be appropriate. In these circumstances, the Division cannot pursue a Rule 102(e)(1)(iv)(A) recklessness theory based on nothing more than evidence of multiple Rule 102(e)(1)(iv)(B)(2)-type negligence. If that is what the Commission had intended to allow in its 1998 rulemaking, it would have said so explicitly. To the extent that the Division's evidence proves only negligence, even repeated instances of negligence, I have not considered that evidence as probative on the question of whether Respondents were reckless.
Not All Missed Audit Clues Are "Red Flags" That Demonstrate "Recklessness"
The Division cannot establish scienter by labeling every missed audit clue, no matter how slight, as a separate "red flag." The courts have required considerably more precision than that. See Reiger, 117 F. Supp. 2d at 1012 (holding that purported "red flags" consisted of documents which, if properly reviewed pursuant to GAAP or GAAS, would have raised an inference of gross negligence, but not fraud); In re MicroStrategy Sec. Litig., 115 F. Supp. 2d 620, 653-54 (E.D. Va. 2000) (holding that "the probative value of allegations that an auditor ignored `red flags' is a function of the nature and number of such flags"); Cheney v. Cyberguard Corp., 2000 U.S. Dist. LEXIS 16351, at *43-44 (S.D. Fla. July 31, 2000) (finding alleged "red flags" insufficient to support a strong inference of scienter). As explained in Reiger, 117 F. Supp. 2d at 1012 (footnote and citations omitted):
Plaintiffs rely on several decisions handed down by district courts . . . that found a strong inference of scienter by combining accounting improprieties with an accountant's alleged disregard of "red flags." . . . The warning signs in these cases more closely resembled "smoking guns" than "red flags." Each case included specific facts suggesting the independent accountant consciously entertained doubts about the veracity of its client's financial disclosures, either from a client or third party informing the accountant of the client's fraud, or from contemporaneous statements made by the accountant.
4. The C&L Accounting and Auditing Manual is not part of the applicable professional standards for purposes of Rule 102(e).
C&L prepared a policy and guidance manual known as the C&L Accounting and Auditing Manual (C&LAAM) (DX 43, DX 89, binder 1, tab 1 at 55-63 and binder 3, tab 1). C&LAAM includes the firm's interpretations of authoritative accounting and auditing literature, discussions of C&L's audit approach, and discussions of engagement conduct and administration. The Division contends that C&LAAM "operationalizes" GAAS, providing guidance to C&L employees in implementing GAAS on particular engagements (Div. Prehearing Br. at 5, 7; Tr. 713-15, 1106-08; DX 89, binder 1, tab 1 at 4-5).
At the early stages of this case, the Division and its expert witness took the unequivocal position that C&LAAM is one of the applicable professional standards (Div. Prehearing Br. at 5,7; DX 89, binder 1, tab 1 at 40-53). After Respondents hit back hard on this issue, the Division retreated to the position that C&LAAM is simply relevant to whether Respondents violated the applicable professional standards (Div. Reply Br. at 3, 18 n.16). This last-minute attempt to shift theories is fundamentally unfair to Respondents.
The OIP does not identify C&LAAM by name. However, paragraphs II.A.4, II.D.4, and II.D.19 of the OIP allege that Marrie should have increased the intensity of the audit after his supervisor completed the Business Assurance Client's Continuance Form, recommending CMD for addition to C&L's special attention list.34 The special attention list was a creation of C&LAAM (DX 43 at §§ 51310-314).
Additionally, paragraphs II.D.23, II.D.26, and II.D.28 of the OIP allege that Respondents' acceptance of initials or signatures of junior associates on audit program steps without additional documentation of the work performed was also an audit failure. C&LAAM requires such documentation (DX 43 at § 34205). GAAS requires something less (Tr. 843).35 The Division argues that the absence of additional documentation permits an inference that the auditors gave no particular consideration to these transactions and events, and that Respondents therefore lacked an adequate basis for their audit opinion.36 In these and other areas, C&LAAM violations are a key part of the Division's case.
I agree with Respondents that internal auditing manuals do not establish the standards against which auditors' conduct is to be judged under Rule 102(e). First, the case law predating the OIP is against the Division. See In re Mid American Waste Sys., Inc., Sec. Litig., 1997 U.S. Dist. LEXIS 22752, *4-10 (D.N.J. Dec. 9, 1997); Gohler v. Wood, 162 F.R.D. 691, 694-96 (D. Utah 1995); Tonnemacher v. Sasak, 155 F.R.D. 193, 195 (D. Ariz. 1994); In re Worlds of Wonder Sec. Litig., 147 F.R.D. 214, 215-17 (N.D. Cal. 1992); In re ContiCommodity Serv., Inc., Sec. Litig., 1988 U.S. Dist LEXIS 4812, *2-5 (N.D. Ill. May 23, 1988).37 These cases recognize that an accounting firm's internal manuals are not publicly available. They hold that such manuals do not and cannot create industry-wide norms, or alter a firm's obligations to follow GAAP or GAAS. They recognize that it would not be fair to punish a firm's auditors if the firm imposes standards upon itself that may be stricter than the industry-wide standards. Missing from the Division's presentation was testimony that C&LAAM's requirements are no more demanding on C&L auditors than GAAS are on auditors from firms without internal manuals, or than other firms' internal manuals are on their employees. As a result, the Division's reliance on C&LAAM creates a double standard: while one auditor could be held reckless for failing to follow his firm's internal procedures, another auditor whose firm's internal manuals did not set similar standards could be exonerated for the same conduct.
If there were any doubt on the subject, it has been put to rest by the recent opinion in SEC v. GLT Dain Rauscher, Inc., 254 F.3d 852, 858 (9th Cir. 2001) ("GAAS guidelines establish accounting standards that are explicitly defined in authoritative, publicly available pronouncements issued by recognized sources and utilized throughout the accounting profession.").
The Division observes that AU § 161.02 requires auditing firms to establish quality control policies and procedures to provide it with reasonable assurance of conforming to GAAS in its audit engagements. The Division reasons that, if an auditing firm must implement quality control policies, then logically the firm's members and employees should not be free to disregard those policies (Div. Reply Br. at 3). The argument makes sense insofar as it recognizes that an auditor who disregards his employer's policies will likely face disciplinary action by the employer. The argument is rejected insofar as it suggests that the Commission should enforce the employer's policies in a Rule 102(e) disciplinary proceeding. AU § 161.02 recognizes that the nature and extent of a firm's quality control policies and procedures depend on factors such as the firm's size, the degree of operating autonomy allowed its personnel and its practice offices, the nature of its practice, its organization, and appropriate cost-benefit considerations. For those reasons, acceptance of the Division's argument (and reliance on such internal policies and procedures) would inject uncertainty, not clarity, into Rule 102(e) proceedings.
Second, the Division's expansive interpretation of Rule 102(e)'s term "applicable professional standards" fails to provide Respondents with fair notice of sanctionable conduct. The Commission did not identify accounting firms' internal manuals when it reviewed the types of materials that comprise the applicable professional standards for a Rule 102(e) proceeding. In the preamble to the October 19, 1998, Rule Amendment, the Commission stated that it would look "primarily" to GAAP, GAAS, the AICPA Code of Professional Conduct, and its own regulations when determining what constitutes the applicable professional standards for an auditor. See Rule Amendment, 68 SEC Docket at 709. It continued: "Also included are generally accepted standards routinely used by accountants in the preparation of statements, opinions, or other papers filed with the Commission." Id. The Commission found that the term "applicable professional standards" was broad enough to accommodate changes to the body of professional guidance in the future, such as international accounting standards (should they be adopted) or pronouncements of the Independence Standards Board or "other bodies yet to be established." Id. It stated that such provisions "would become" or "would come to form" the applicable professional standards in the future. Id.
If the Commission had intended to treat accounting firms' internal manuals as "generally accepted" by the accounting profession, it would have said so in the preamble to the Rule Amendment. It was then, and remains now, the Commission's practice to look at brokerage firms' compliance manuals and supervisory manuals when considering allegations of failure to supervise under the safe harbor provisions of Section 15(b)(4)(E) of the Exchange Act. In light of that practice and the existence of contrary case law involving reliance on internal accounting manuals (such as Mid American, Gohler, Tonnemacher, Worlds of Wonder, and Conti) the Commission's determination to omit all mention of accounting firms' internal manuals when describing the applicable professional standards could not have been inadvertent.
Third, the testimony of the expert witnesses provided virtually no support for the Division's position. Ten Eyck emphasized that the notion of "special attention" was C&L's nomenclature, not GAAS (RX 405 at 10-11). Regan testified that C&L's special attention list did not mandate a change in the way that an audit should be conducted, although in his judgment, it would have been wise for Marrie and Berry to design an audit program with the client's special attention status in mind (Tr. 762-64). The Division must show that Respondents were reckless, not just that a different approach was perhaps wiser. Regan also testified that, when an auditor signs off on an audit step, he assumes the auditor performed the step, even without documentary backup, unless there is evidence to the contrary (Tr. 933). I consider that testimony by the Division's expert to be tantamount to a concession that C&L's requirement for additional documentation in the work papers exceeded what was "generally accepted" by the accounting profession.
Where a duty arises only as a result of an accounting firm's internal policy, as opposed to a generally accepted national standard, conduct violating that duty falls outside the jurisdiction of a Rule 102(e) proceeding. Of course, internal accounting firm policies and generally accepted national auditing standards may coincide in some instances, but ultimately, the proper frame of reference in setting the standard of conduct to be applied will be the national standard. Cf. In re Ikon Office Solutions, Inc. Sec. Litig., 131 F. Supp. 2d 680, 699-702 (E.D. Pa. 2001) (Ikon II) (rejecting plaintiff's claim that Ikon's internal accounting practices were substantially equivalent to GAAP and that, therefore, deviations from Ikon's internal accounting practices were also deviations from GAAP; holding that, even if such deviations from GAAP were established, they would not provide evidence of scienter).
5. The weight of the evidence fails to show that Respondents were reckless in auditing CMD's estimate of the value of its property and equipment. The weight of the evidence also fails to show that CMD materially misstated the value of its property and equipment in violation of GAAP.
Allegations. It is undisputed that CMD discontinued its Magnetic Head Division operations during fiscal year 1994, yet included $3 million of the Magnetic Head Division's property and equipment on its fiscal year 1994 balance sheet. It is also undisputed that when new management restated CMD's 1994 financials on February 6, 1995, it reduced that amount to zero. The OIP alleges that Marrie and Berry recklessly failed to follow GAAS when auditing CMD's property and equipment (OIP ¶ II.A.4). The OIP also charges that CMD's failure to write off the $3 million resulted in a material overstatement of its net income, that the valuation of property and equipment on CMD's financial statements was materially false and misleading and violated GAAP, and that new management's restatement of property and equipment was "highly material" (OIP ¶¶ II.A.2, II.A.3, II.D.45).
Audit procedures performed. Based on the 1993 audit, the quarterly reviews during fiscal year 1994, and the 1994 audit planning, Marrie and Berry were well aware that the carrying value of the equipment used