UNITED STATES OF AMERICA
before the
SECURITIES AND EXCHANGE COMMISSION

SECURITIES EXCHANGE ACT OF 1934
Release No. 43862 / January 19, 2001

ACCOUNTING AND AUDITING ENFORCEMENT
Release No. 1360 / January 19, 2001

Admin. Proc. File No. 3-9500

In the Matter of KPMG PEAT MARWICK LLP c/o Michael Carroll, Esq. Davis Polk & Wardwell 450 Lexington Avenue New York, New York 10017

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OPINION OF THE COMMISSION

CEASE-AND-DESIST PROCEEDING

Ground for Remedial Action

Violation of Rules Governing Financial Statements
Causing Violations of Reporting Provisions

RULE 102(e) PROCEEDING

Ground for Remedial Action

Improper Professional Conduct

Accounting firm cannot be considered independent when it conducted audit of registrant's financial statements and issued audit report while loan from accounting firm to registrant's officer was outstanding and when accounting firm had the right to receivea fee contingent on the registrant's financial success. Accounting firm violated requirement that audit report accurately state that audit was made in accordance with Generally Accepted Auditing Standards. Accounting firm also caused registrant to violate reporting provisions, because the financial statements included as part of registrant's annual report, were not, as represented, audited by independent accountants. Held, it is in the public interest to order that accounting firm cease and desist from causing violations of Section 13(a) of the Securities Exchange Act of 1934 and Rule 13a-1 thereunder, or from committing violations of Rule 2-02(b) of Regulation S-X, by having any transactions, interests, or relationships that would impair its independence under Rule 2-01 of Regulation S-X or under Generally Accepted Auditing Standards. Because of the unique procedural posture of the proceeding, however, it cannot be concluded that accounting firm engaged in improper professional conduct within the meaning of Rule 102(e).

APPEARANCES:

Stephen J. Crimmins and Richard C. Sauer, for the Division of Enforcement and the Office of the Chief Accountant.

Michael P. Carroll and Joseph Warganz, of Davis Polk & Wardwell, Donald W. Rose, of KPMG LLP (of counsel), and Ronald S. Flagg, of Sidley & Austin (of counsel), for KPMG Peat Marwick LLP.

Appeal filed: February 11, 2000
Last brief filed: July 19, 2000
Oral argument held: September 28, 2000

I.

The Division of Enforcement and the Office of the Chief Accountant (together the "Division") appeal from the decision of an administrative law judge finding that KPMG Peat Marwick LLP ("Peat Marwick"), a Delaware limited liability partnership,¹ failed to adhere to standards of auditor independence in connection with its audit of Porta Systems Corp.'s ("PORTA") financial statements. The law judge concluded that Peat Marwick violated Rule 2-02 of Regulation S-X² and causedviolations of Section 13(a) of the Securities Exchange Act of 1934 and Rule 13a-1 thereunder.³ The law judge also concluded, however, that Peat Marwick did not engage in improper professional conduct within the meaning of Commission Rule of Practice 102(e).⁴ The law judge dismissed the proceeding insofar as it alleged that Peat Marwick engaged in improper professional conduct and denied the Division's request for entry of a cease-and-desist order against Peat Marwick pursuant to Section 21C of the Exchange Act.⁵ We base our findings on an independent review of the record.

II.

On September 29, 1994, L. Glenn Perry, a senior partner in Peat Marwick's Department of Professional Practice ("DPP"),⁶ met with staff members of the Commission's Office of the Chief Accountant ("OCA") for just over thirty minutes to discuss the contents of a "draft on an independence matter" he had sent to OCA via facsimile the previous afternoon.⁷ The draft described the creation of an entity -- KPMG Corporate Finance ("KPMGCF") - that would be involved in a "business relationship" with Peat Marwick and that would provide clients with financial advice and related services.⁸ The draft set forth, in very general terms, KPMGCF's proposed operations and briefly outlined the contours of the proposed relationship between Peat Marwick and KPMGCF. Accordingto the draft, Peat Marwick had concluded that it and KPMGCF would be "separate" entities and that the independence rules applicable to Peat Marwick would not constrain KPMGCF's activities. The draft solicited the staff's views on the matter.

During the meeting, Perry mentioned certain information addressed in the draft: 1) Peat Marwick would extend to KPMGCF a $5 million working capital loan; 2) Peat Marwick would license to KPMGCF the use of the "KPMG" initials; and 3) in return for the license Peat Marwick would receive a royalty from KPMGCF. Perry also responded to certain questions posed by OCA staff regarding the use of Peat Marwick's staff in KPMGCF engagements, another aspect of the proposed relationship mentioned in the draft. One of the items in the draft -- not discussed during the meeting --indicated that KPMGCF proposed to provide "services to troubled companies in the context of turnaround or bankruptcy."⁹ Perry was not prepared to discuss that point; he had "no specific understanding" as to its meaning, beyond what was said in the draft.

At the end of the meeting, the Deputy Chief Accountant, John Riley, advised Perry that he had not heard anything during the meeting that would cause the staff to raise questions about Peat Marwick's independence. Because the alliance was in the planning stages and details remained to be worked out, however, Riley anticipated that Peat Marwick would consult with OCA again as decisions about the contours of the alliance were refined and finalized. The staff also advised Perry that the activities of KPMGCF and its relationship with Peat Marwick raised a number of issues that Perry should discuss with staff of the Commission's Division of Market Regulation. The OCA staff advised Perry that another national accounting firm had previously abandoned a similar proposal when it became apparent that the Division of Market Regulation would view the accounting firm as acting in the capacity of a broker-dealer by virtue of the proposed affiliation.

Although Peat Marwick did not follow up with either OCA or the Division of Market Regulation, it nevertheless determined to proceed with the alliance. In January 1995, it entered into a license agreement with KPMG BayMark, LLC ("BayMark"), a Delaware limited liability company, and BayMark's two subsidiaries - KPMG BayMark Strategies, LLC ("Strategies"), a Delaware limited liability company, and KPMG BayMark Capital, LLC ("Capital"), a Delaware limited liability company (collectively the "BayMark parties"). The agreement described BayMark as "a newly formed limited liability company which [would] provide financial services" including "investment banking, corporate recovery, crisis management and other services under the direction of David Maughan, Mark Taffet, Edward Olson, and Dan Armel." Each of these persons were "Principals" of BayMark andeach held a 25% ownership interest in BayMark.¹⁰ BayMark was to conduct business through its subsidiaries. Strategies planned to engage in a corporate recovery, crisis management, and restructuring advisory business based in California and Virginia. Olson would serve as its Executive Managing Director.¹¹ BayMark owned 51% of the interests in the Strategies limited liability company, and Olson and Armel each owned 24.5%. Capital, based in New York, New York, was to engage in investment banking and other brokerage activities. BayMark owned 51% of the Capital limited liability company interests, and Maughan and Taffet each owned 24.5%.

Under its license agreement with the BayMark parties, Peat Marwick agreed to lend $100,000 to each of the four Principals on a non-recourse basis, to be used by the Principals as equity contributions to BayMark and its subsidiaries. Those equity interests in turn were pledged by the Principals to Peat Marwick as security for the loans. Thus, for example, Olson executed a promissory note and entered into a pledge agreement with Peat Marwick. Olson promised, among other things, to make a $99,000 capital contribution to Strategies and a $1,000 capital contribution to BayMark on receipt of the loan from Peat Marwick. He also pledged to Peat Marwick his equity interests in Strategies and BayMark as security for payment on the note.

Under the license agreement, Peat Marwick granted the BayMark parties rights to use "KPMG" as part of their names, provided, among other things, that the BayMark parties: (a) sought and received approval from Peat Marwick to use any advertising bearing the initials; (b) complied withcertain "professional and ethical policies and standards of practice" to which Peat Marwick adhered; and (c) used the phrase "A Strategic Alliance of KPMG Peat Marwick" in connection with the use of the "KPMG" initials.¹² In return for the license, each BayMark party agreed to pay Peat Marwick a license fee ("royalty fee") of five percent of its quarterly consolidated fee income, excluding certain revenues received from another BayMark party less certain fees. The royalty fees were to be paid to Peat Marwick quarterly, within thirty days after the close of each quarter.

In addition, Peat Marwick agreed to enter into revolving credit agreements with the BayMark subsidiaries under which Peat Marwick would lend the subsidiaries up to $2.3 million each.¹³ In return, Peat Marwick took a security interest in Strategies' and Capital's accounts receivable, contracts, licenses, intangibles, proceeds, and other properties. Peat Marwick also agreed to provide, for an hourly fee, financial analysis and other services to the BayMark parties in support of their engagements. The BayMark parties in turn agreed to assist in developing Peat Marwick's financial analysis and support services business through their "sources."¹⁴

The financial and trade press published news of the Peat Marwick/BayMark alliance in late August or early September 1995. When Michael Sutton, then the Commission's Chief Accountant, became aware of these articles, he directed his staff to gather more information. On September 29, 1995, Perry responded to staff inquiries by sending a letter reiterating, almost verbatim, the information set forth in his 1994 draft memorandum, together with a brief description of the ownership of BayMark and the background of its owners. Thus, for example, the letter described Olson's background as follows: "Thirty years of operational expertise, including 15 years of corporate turnaround consulting. Most recently, Ed was president of his own consulting company."

On October 19, 1995, Perry and Chris Trattou, a senior manager in Peat Marwick's DPP, met with OCA staff, including Sutton.¹⁵ Jerry Sullivan, Executive Director of the Public Oversight Board ("POB"), also attended the meeting.¹⁶ The purpose of the meeting was to address the staff's concerns and questions about Peat Marwick's relationship with BayMark. Among other things, OCA expressed concern that Peat Marwick could be found to be lacking in independence if Peat Marwick controlled BayMark and BayMark provided services to registrants audited by Peat Marwick. Specifically, the staff expressed concern about BayMark's use of the "KPMG" initials, the royalty fee arrangement, and BayMark's financing.¹⁷ The staff also indicated that Peat Marwick's independence might be adversely affected by the services it would provide BayMark's clients as a subcontractor. Accordingly, the staff informed Perry and Trattou that OCA would "not say `at this . . . time' that . . . [it did] not object to the strategic alliance." According to Perry's notes, Sutton ended the meeting by cautioning Perry: "If you have a significant SEC client, we suggest you consult with us before you use BayMark." Perry asked Sutton what he meant by "significant" SEC client, and Sutton responded, "A client you do not want to embarrass."¹⁸ As Van Brunt put it:

Despite this interchange, Perry and Trattou failed to indicate to OCA that just such a situation was about to occur. Between two and three weeks earlier, Strategies had submitted a letter agreement to PORTA under which Strategies would provide PORTA (a Syosset, New York telecommunications company that was experiencing losses from operations) with turnaround management services for fifteen months.¹⁹ PORTA had been Peat Marwick's audit client for a few years. Leonard Sturm, a partner in Peat Marwick's Long Island, New York office, was the engagement partner for PORTA's 1994 audit. Sometime in the early summer of 1995, in the course of a partners' meeting, Sturm learned that Peat Marwick had a strategic alliance with an entity called BayMark and that BayMark "provided turn-around services . . . and helped secure financing for companies." Later, when Sturm learned that PORTA's management was seeking assistance to turn the company around, Sturm contacted a colleague at Peat Marwick and, ultimately, Strategies was "introduced" to PORTA.²⁰

Under the agreement between PORTA and Strategies, which was executed on November 3, 1995, Olson was to assume the title of Chief Operating Officer ("COO") of the company and direct itsturnaround effort in exchange for a management fee of $250,000 and certain percentages of PORTA's earnings, disposed inventory, and restructured debt ("success fee").²¹ Strategies, through Olson, was given authority to put in place a management team that would lead the turnaround effort, establish control of the company's cash flow, "take whatever actions are necessary to enable [PORTA] to survive," restructure the company's business, develop reward and compensation systems, and seek out opportunities for "profitable growth." The work was to be performed "with a view toward the development of specific short term and long term business strategies" for PORTA. On November 9, 1995, PORTA's Board of Directors elected Olson president and COO of the company.²²

In October 1995, Sturm became aware that PORTA was going to engage BayMark (Strategies). Although he thought BayMark would provide only consulting services to PORTA, because he knew little about the alliance or BayMark, Sturm contacted the DPP to determine whether it was "okay for [BayMark] to provide services, consulting services, to an audit client." He was referred to Trattou, whom he understood to be "fielding questions on anything related to BayMark." Trattou let Sturm know that the situation was "okay" -- that "the way the alliance was set up . . . [BayMark] could provide services to an audit client." Trattou further stated that the alliance had been discussed with the "SEC" and it had no objection.

Sometime during the first few days of December, after Sturm became aware that Olson had assumed the positions of president and COO of PORTA and in anticipation of beginning an audit "down the road," Sturm again called Trattou to inquire about "a second potential independence question" - "[w]hether it was okay for Ed Olson to not only be performing consulting services . . . [but also to be] performing . . . COO-type functions at the company . . . [and to] ha[ve] the title[s] of COO and President."²³ Trattou "indicated that he needed to take a look at [the situation] and get back" to Sturm.

On December 5, 1995, Trattou forwarded to Thomas Vasquez²⁴ an e-mail Trattou had written concerning Sturm's inquiry. The forwarding header told Vasquez that Trattou would "try and work this out" with the partner in charge of the DPP, Michael Conway, and others "before [Vasquez] ha[d] to get involved." The forwarded message read:

The e-mail continued:

Trattou went on to state that he disagreed with Conway and Perry and believed that "this situation can work." He further opined that "[t]here must be a way to structure such engagements to make them work by using walls, proper representations and full disclosure concepts." He concluded:

Perry and Conway met with OCA staff and representatives of the POB on December 6, 1995, the day after this e-mail.²⁵ They did not, however, mention anything about Strategies' PORTA engagement. Instead, the discussion focused on the same concerns raised in the October 19 meeting. Thus, Sutton reiterated OCA's concern that the relationship between BayMark and Peat Marwick (including Peat Marwick's loans to BayMark's subsidiaries and its Principals, Peat Marwick's contractual right to a royalty, and BayMark's use of the "KPMG" initials) might compromise Peat Marwick's independence from audit clients that would engage BayMark. The staff also expressed reservations about whether Peat Marwick could provide services to audit clients as a BayMark subcontractor and maintain its independence. Focusing again on Capital's business, the staff warned that broker-dealer activities were not compatible with audit functions and that those activities raised separate issues for the Division of Market Regulation. As Conway's notes reflect, the POB representatives "basically side[d]" with OCA with respect to these issues. The meeting ended without any resolution of OCA's concerns but with an understanding that dialogue would continue.

Before the meeting drew to a close, Sutton again warned Perry and Conway that, if BayMark and Peat Marwick were viewed as one entity, "any services provided to an audit client by BayMark would have to be viewed as services provided by the combined entity." Based on his "working assumption" that Peat Marwick controlled BayMark, Sutton indicated, in substance, that Peat Marwick "can't audit SEC registrants who use BayMark if BayMark's services . . . are precluded for auditor."²⁶ As Burns' notes of the meeting state: "Problem if BM [BayMark] doing anything PM [Peat Marwick] can't do."

On December 8, 1995, Trattou called Sturm seeking information, to use in an upcoming meeting with OCA staff, about the services Sturm proposed to provide to PORTA.²⁷ He did not answer Sturm's earlier independence questions. He asked about the amount of the fee Sturm proposed to charge for conducting the audit of PORTA's financial statements. Sturm replied that he proposed to charge $150,000. Trattou inquired whether Sturm had yet commenced any audit procedures. Sturm replied that he had not. Trattou also asked whether Peat Marwick had providedany services to PORTA as a BayMark subcontractor and whether it intended to do so in the future. Sturm told him "no, we had not, and we did not intend to." After Sturm answered the questions, Trattou told Sturm, in essence, "not to worry . . . unless [Sturm] heard back" from Trattou and that, "if [Sturm] didn't hear anything prospectively, then assume that things are okay; otherwise [Trattou] . . . would call [Sturm] back." During the hearing, Sturm recalled that he and Trattou had a number of follow-up conversations that Sturm did not consider to have further resolved the independence question.

On December 18, 1995, Conway met again with OCA staff and other Commission employees.²⁸ The purpose of the meeting was to give Conway and Peat Marwick's attorneys the opportunity to demonstrate why the relationship between Peat Marwick and BayMark was not "a potentially independence impairing relationship." Although Conway and Harvey Pitt, an attorney representing Peat Marwick, argued at some length that the alliance did not raise independence concerns, those attending the meeting discussed no new issues.²⁹ There were no discussions of particular BayMark engagements with Peat Marwick audit clients, such as PORTA, although there was some "generic" discussion that BayMark had some ongoing relationships with audit clients and "generically" what they involved.³⁰ The focus was on Capital's business and Sutton's concern that certain aspects of the alliance would lead a "reasonably informed person . . . [to] consider [Peat Marwick to be] in [the] invest[ment] banking bus[iness] as well as auditing."

Sutton recalled that at this meeting he "definitely said" that, if BayMark was performing services that Peat Marwick could not itself perform, Peat Marwick's independence would be impaired. According to Burns' detailed notes, as the meeting drew to a close, Conway stated that, if OCA would "undertake to consider the[] issues" raised by suggestions as to ways in which the structure of the alliance might be modified, Conway would "undertake to place a moratorium" on BayMark performing services for Peat Marwick's public audit clients. Sutton responded by noting that the only alternative would be to consider the services provided to each client and to make a case-by-case assessment as to whether or not those services would impair Peat Marwick's independence from that client.

On December 26, 1995, Sutton and Conway met again. Sutton indicated that "in order to avoid staff objections to the structure" of the alliance, Peat Marwick needed to drop the "KPMG" initials from the BayMark parties' names, eliminate the royalty fee arrangement, and bring about the repayment of the $400,000 in loans made to the BayMark Principals.³¹ Sutton and Conway agreed to follow up this meeting with a telephone call to talk about "whatever was still pending." Accordingly, in a December 28, 1995 telephone call, Conway answered certain questions Sutton had posed on December 26 concerning Peat Marwick's revolving credit arrangements with BayMark's subsidiaries.³² In addition, the two men again discussed the ways in which Peat Marwick and BayMark's relationship needed to change. As a result of these conversations, Conway and Sutton came to an agreement that Peat Marwick would undertake negotiations with BayMark to end the BayMark parties' use of the "KPMG" initials, terminate the royalty fee arrangement, and have the BayMark Principals repay their loans.

During the course of these conversations, Sutton and Conway also discussed pending BayMark engagements.³³ Conway let Sutton know that eighteen engagements were "on hold" since the October 19 meeting and would stay on hold until OCA's concerns were resolved.³⁴ Conway then turned to other engagements that, as Sutton acknowledged he understood, were not on hold but rather "in progress." These engagements were dual engagements "contracted for [by] both BayMark and Peat Marwick" and had been identified because Conway had asked for such information and "someone" at Peat Marwick had gotten it for him. That person prepared a chart "identif[ying] six engagements where [Peat Marwick] w[as] auditor of record [and] . . . BayMark had contracts with . .. [and was] doing work for those particular clients."³⁵ Conway "needed to know one way or the other fairly soon whether we had to stop those engagements or if they could proceed."³⁶ He wanted, and we find that he sought, Sutton's "yea or nay as to whether or not [the six dual engagements] could go forward." 37

One of the six dual engagements involved Strategies' provision of turnaround management to PORTA.³⁸ Conway knew that "someone" from Strategies was acting as president of PORTA and that the "someone" was "running" PORTA. But Conway testified that he may not have known that the person was a BayMark Principal or a person to whom Peat Marwick had lent $100,000.³⁹ AsConway recognized, however, Peat Marwick "clearly" could not itself have provided the services he understood Strategies to be providing to PORTA because an audit firm cannot "have an audit client where [it] had someone in running the company."

According to Sutton's notes, Conway described the PORTA situation to Sutton as follows: "[S]trategies - assistance to troubled companies; work-out; top level management [KPMG could not do]" (second brackets in original).⁴⁰ Conway did not identify PORTA by name, did not indicate that Olson was the person who would provide the top level management, and did not mention that the person who would manage PORTA (Olson) was a BayMark Principal or a person to whom Peat Marwick had loaned $100,000. Nor did Conway mention that Strategies would earn a success fee⁴¹ or discuss precisely when Peat Marwick would be performing audit work for PORTA.⁴² According to Conway, Sutton expressed some "concern" about the PORTA situation. Conway recalled that Sutton "must've said . . . is this something that [Peat Marwick] could . . . do, and I said to him that Peat Marwick could not do what BayMark Strategies is doing."

The Division and Peat Marwick generally agree that there was consensus during these conversations that Peat Marwick would resolve OCA's independence concerns if it proceeded to modify the alliance in the three respects specified by OCA. They disagree sharply, however, as to whether the six dual engagements could proceed to completion before the changes to the alliance were implemented. We find that Sutton neither told Conway that he approved or disapproved of the six dual engagements nor asked that Peat Marwick take steps to discontinue any of them. On the other hand, Conway testified that he believed that there was agreement with OCA that the six engagements could go ahead while the resolution of the issues posed by the alliance went forward. The law judge, who observed the demeanor of all the witnesses, found credible Conway's testimony as to his belief, and we find no basis to overturn that determination.

Sometime before December 27, 1995, Trattou called Sturm with an answer to Sturm's earlier independence inquiries. Trattou's answer professed to reflect accurately the content of Conway's dialogue with Sutton. According to Sturm, Trattou told him that the "SEC" was "aware of the PORTA situation," that PORTA had been mentioned to the "SEC" by name, and that Sturm "should proceed with the audit unless [he] heard otherwise and that even if there was an issue . . . because everybody knew about [the PORTA situation], it would be grandfathered." Indeed, Trattou implied that the situation had been described as he and Sturm had discussed -- that "Ed Olson had [been] hired, had those titles, and BayMark was performing some services there." Trattou also indicated that there would be some changes to the strategic alliance, but he mentioned only that the "KPMG" initials would be dropped from BayMark's name. Trattou did not, in the course of this conversation (or during those that took place earlier), inform Sturm about the concerns voiced by Commission staff about the structure of the alliance. Nor did Trattou or anyone else in the DPP tell Sturm that Peat Marwick hadloaned money to Olson or that the BayMark subsidiaries were obligated to pay a five percent royalty to Peat Marwick for use of the "KPMG" initials.

On December 29, 1995, Conway directed an e-mail to Vasquez and copied it to Perry, among others. The message -- which updated Vasquez on "where we stand with our latest discussions with Mike Sutton" -- summarized the structural changes to the strategic alliance that Conway had agreed to discuss with BayMark and noted that Sutton "again indicated that it was important that we resolve any problems" that the Division of Market Regulation might have with the alliance because certain of their determinations might affect OCA's conclusions about independence. The e-mail continued:

Mr. Sutton said that he was going to try to get the matter resolved on the basis that we discussed and that, if resolved quickly, he thought that Baymark would be able to complete the engagements in process without jeopardizing our independence with respect to our SEC audit clients. Mr. Sutton needed to discuss the matter with others before he came to a final conclusion . . . .⁴³

On January 3, 1996, Conway contacted Sutton to inform him that Peat Marwick was ready to begin negotiating the changes to the alliance but that Conway wanted to be sure that OCA was "satisfied before putting the lawyers to work." Sutton told Conway that OCA would get back to him. On January 5, Burns called Conway to say that "OCA was comfortable with the proposals he had made but . . . could not give him any approval or clearance until the Market Regulation issues were resolved." Conway understood this to mean that Peat Marwick's counsel was to begin discussions with the Division of Market Regulation and that the changes to the alliance could not be made until Market Regulation resolved its concerns about the alliance.

Sutton and Conway then exchanged letters purporting to reflect the outcome of their discussions. In a letter dated January 29, 1996, Conway summarized the proposed modifications to the structure of the strategic alliance and then stated that OCA had informed Peat Marwick "that the implementation of the foregoing revisions (which . . . remain subject to negotiation with BayMark) would resolve all issues that might be said to arise as a result of the strategic alliance under applicable independence rules." Two days later, Sutton replied in a letter correcting Conway's statement about the resolution of independence issues: Sutton's letter stated that all "independence issues raised by the OCA are, and will remain, open until all issues raised by the Division of Market Regulation have been resolved." On February 14, 1996, Conway replied to Sutton's letter and acknowledged that "[o]urrespective recollections [as to the discussions] are generally consistent." Nowhere in these letters is there a reference to the six ongoing dual engagements.

Again, the parties agree that "independence issues" remained open pending further action by the Division of Market Regulation. But the Division contends, in essence, that the "independence issues" included whether the six engagements could proceed, while Peat Marwick argues, in essence, that it was understood that the six engagements could proceed while the "independence issues" as to the overall structure of the alliance were being resolved. We believe that the December 29 e-mail and the subsequent correspondence can fairly be read as being consistent with either view. Accordingly, they do not lead us to overturn the law judge's determination to credit Conway's testimony concerning his belief that Peat Marwick and the BayMark subsidiaries were free to go forward with the pending engagements.

In the meantime, however, on December 27, 1995, PORTA signed Peat Marwick's engagement letter. Field work began sometime in January 1996. The audit team did not interact with Olson. Indeed, Olson deliberately stayed clear of the auditors. He was mindful that, at the outset of his dealings with Peat Marwick, Vasquez had told him that Peat Marwick wanted to maintain its independence from BayMark.⁴⁴

On the other hand, as PORTA's president, Olson signed the management representation letter on which the audit team relied in conducting the audit. As a consequence, Olson, along with the other officers and the director who signed the letter, took responsibility for "the fair presentation" in consolidated financial statements of PORTA's financial position, results of operations, and cash flows in conformity with generally accepted accounting principles ("GAAP"). Moreover, the fact that Olson, a person associated with Strategies, was managing PORTA was certainly not lost on the audit team. As Peat Marwick's workpapers reflect, the audit engagement team considered whether it "needed to reevaluate" its relationship with PORTA "due to man[agement] turnover." In determining not to do so, the team considered, among other things, that the "new COO, Ed Olson, is with BayMark Strategies [and] came highly recommended by [Peat Marwick's] corporate finance personnel."

On January 5, 1996, Catherine McGuire, Chief Counsel of the Division of Market Regulation, met with Burns of OCA to discuss the Peat Marwick/BayMark alliance. She had become concerned that the resolution of the auditor independence issues raised by the BayMark venture ought to be better coordinated with the resolution of the broker-dealer registration issues. She was optimistic, however, that the broker-dealer issues might be resolved quickly given Conway's demonstrated willingness toundertake structural modifications to the alliance. Accordingly, on January 17, 1996, counsel for Peat Marwick and BayMark met with staff of the Division of Market Regulation, including McGuire. McGuire expressed concern, in light of Peat Marwick's failure to initiate dialogue with Market Regulation, that Peat Marwick seemed to be ignoring the broker-dealer issues arising from its relationship with BayMark and Capital. McGuire wanted Peat Marwick to understand that those issues were "extremely difficult and . . . important" and had been "the show stopper" with respect to another accounting firm's attempt to establish an affiliation similar to that of Peat Marwick and the BayMark parties. Accordingly, while McGuire invited Peat Marwick to submit a formal no-action request with respect to whether Peat Marwick could provide certain services to Capital's clients without broker or dealer registration, she stated that the staff had "said no . . . [to] the last account[ing] firm that wanted to do this."

On February 12, 1996, McGuire again conferred with attorneys representing Peat Marwick and provided detailed guidance on how the firm might seek no-action relief. First, McGuire identified those aspects of the license agreement that raised concerns about whether Peat Marwick controlled BayMark. Next, McGuire specified the sorts of representations Peat Marwick should make concerning the services it intended to supply to Capital's customers. Two months later, on April 12, 1996, Peat Marwick submitted a discussion draft of a no-action request. In McGuire's view, the draft failed to make the "simple representations" that might warrant no-action relief. McGuire explained that, instead of addressing relevant issues, the letter argued that the services that Peat Marwick would provide BayMark (Capital) were proper accounting functions and therefore were not broker-dealer functions. After it submitted a revised June 13 draft, Peat Marwick did not proceed further with the request.

Before Peat Marwick submitted the first draft no-action request -- and before it had effected any structural changes to the alliance - Sturm and the rest of the audit team concluded the audit of PORTA's 1995 year-end financial statements and Peat Marwick issued its "Independent Auditors' Report." PORTA's consolidated statements of operations reported a net loss of over $31 million for 1995 and the audit report, dated March 22, 1996, expressed substantial doubt about PORTA's ability to continue as a going concern. PORTA included the report as part of its 1995 annual report on Form 10-K, filed with the Commission on April 1, 1996. The annual report listed Olson as the company's president and COO and noted that Olson "is also one of the principals of KPMG BayMark Strategies LLC." The report also stated that "Mr. Olson continues in this position while serving as President and Chief Operating Officer of the Company."⁴⁵ Olson signed the annual report as "President" of PORTA.

As Sturm was reviewing the draft Form 10-K, he noticed that it described BayMark (Strategies) as "KPMG BayMark." Because he had been told that the "KPMG" initials would be dropped from BayMark's name pursuant to Peat Marwick's agreement with OCA, he called Conway to inquire specifically about whether the name BayMark Strategies, LLC should appear in the Form 10-K with the "KPMG" initials and generally to "reconfirm that there were no independence issues." He (or another member of the audit team) also discussed the matter with Vasquez. Ultimately, Conway and Vasquez "reconfirmed that the SEC was aware that BayMark was performing the work at PORTA, our independence has not been impaired, and that, due to the SEC review, we should not accept any subcontracted work from BayMark . . .".⁴⁶

On May 6, 1996, OCA learned of the PORTA audit after Van Brunt and others in OCA ran a search on the Commission's Electronic Data Gathering and Retrieval System ("EDGAR") for filings in which the initials "KPMG" and the name "BayMark" appeared. The search disclosed that Peat Marwick had performed an audit of the financial statements of a public audit client, PORTA, while BayMark was providing, through its subsidiary, Strategies, and a BayMark Principal, Olson, management services to that client. Van Brunt and others told Sutton about the situation. Sutton directed them to talk with Peat Marwick and get the facts about the PORTA audit.

Approximately one week later, Burns mentioned to Conway that the staff was "looking at PORTA" and on May 20, 1996, Burns⁴⁷ informed Conway that, in the staff's view, Peat Marwick was not independent from PORTA for "at least two reasons." First, because the structural changes to the strategic alliance had not been implemented, the staff considered Peat Marwick and BayMark to have been one entity for independence purposes and "[o]ne entity cannot be both management and auditor of a registrant's financial statements." Second, loans to a company (BayMark) owned by Olson "would constitute a loan from the auditor to a member of management and violate the fact and appearance of Peat's audit independence." Burns also told Conway that OCA would not "take action" on this determination until Sutton returned to the office.

At Conway's request, Conway met with Sutton and other members of the OCA staff on June 20, 1996.⁴⁸ Counsel for Peat Marwick also attended the meeting. During the meeting, Sutton advised Conway that OCA did not consider Peat Marwick to have been independent from PORTA. Sutton further advised Conway that he had "difficulty" understanding how Peat Marwick "could cometo [the] conclusion" that it was "indep[endent] of [a] co[mpany] BM [BayMark] was managing . . . in view of our [1995] discussions." Although Conway insisted that he had "mentioned P/S [PORTA] as [a] man[agement] relationship," Sutton indicated that he had no recollection of that discussion.

By letter dated June 21, 1996, Sutton advised the Chairman of PORTA's Board of Directors, Warren Esanu, that "the existence of financial, operating, and other relationships among Mr. Olson, KPMG BayMark and KPMG Peat Marwick, adversely impacts KPMG Peat Marwick's independence with respect to Porta Systems." For that reason, the letter advised Esanu, the financial statements PORTA had included in its 1995 annual report would be considered unaudited and not in compliance with the federal securities laws. The letter also advised Esanu that PORTA should arrange for the immediate audit of its financial statements by an independent certified public accountant and should consider whether and how to notify public investors and others who might be relying on the then-current financial statements.49

III.

The capital formation process depends, in large part, on the availability of accurate and reliable financial information. As we have stated, "[a]n investor's willingness to commit his capital to an impersonal market is dependent on the availability of accurate, material and timely information regarding the corporations in which he has invested or proposes to invest."⁵⁰

The investing public must be able to rely on reports by "independent" public accountants concerning the financial statements included in filings with the Commission. These reports provide the assurance that outside experts have examined a filer's financial statements and have arrived at objective opinions about whether the filer's financial position, results of operations, and cash flows are presented fairly in conformity with GAAP. Independent audits thus improve the reliability of financial statements and enhance their credibility.

Although the independence of auditors does not alone assure reliable and credible financial reporting, its absence would certainly undermine public confidence in that reporting, and thereby harm the securities markets.⁵¹ Accountants and their firms must be -- and must reasonably be perceived to be -- free from influences that would impair objective, unbiased examinations, even when the results are contrary to management's interests. As we have consistently recognized, if an auditor "is predisposed, or even appears predisposed, to blindly validate management's work rather than subjecting it to careful scrutiny, the ultimate result will be a diminution of public confidence in the profession and the integrity of the securities markets."⁵²

In enacting the federal securities laws, Congress underscored the crucial function of independent auditors by requiring, or permitting the Commission to require, that "independent" public accountants certify financial statements filed with the Commission by public companies and others.⁵³ As the United States Supreme Court recognized in United States v. Arthur Young & Co., 465 U.S. 805, 817-818 (1984), these requirements place a special responsibility on accountants who audit the financial statements of public companies:

Congress did not define "independent;" instead it authorized the Commission to define "accounting, technical and trade" terms used in the federal securities laws.⁵⁵ We have adopted Rule 2-01 of Regulation S-X,⁵⁶ which provided, at all relevant times, in subsection (b) that the Commission "will not recognize any certified public accountant or public accountant as independentwho is not in fact independent." Based on the recognition that certain relationships between an auditor and a client are so likely to compromise an auditor's objectivity as to preclude a finding that an auditor is independent,⁵⁷ the rule gave examples of situations that gave rise to an accountant being "considered not independent."⁵⁸ The rule also stressed that, in determining whether an accountant is independent with respect to a particular person, the Commission would "give appropriate consideration to all relevant circumstances, including evidence bearing on all relationships between the accountant and that person or any affiliate thereof."⁵⁹

In our adjudicatory capacity, we have issued decisions over the last six decades finding impaired independence in a variety of factual situations.⁶⁰ Various releases in which we have proposed and adopted amendments to disclosure items and to Rule 2-01 itself also contain in-depthdiscussions of auditor independence issues.⁶¹ We also have issued extensive interpretations specifically designed to assist registrants and auditors in recognizing and evaluating independence questions.⁶²

In addition, Rule 2-02(b)(1) of Regulation S-X requires an auditor's report to state "whether the audit was made in accordance with generally accepted auditing standards [GAAS]." GAAS, in turn, requires that "[i]n all matters relating to the assignment, an independence in mental attitude is to be maintained by the auditor or auditors."⁶³ In keeping with this standard, the senior technical body of the American Institute of Certified Public Accountants ("AICPA")⁶⁴ issued Statement on Auditing Standards ("SAS") No.1, Section 220, providing that: "[i]t is of utmost importance to the profession that the general public maintain confidence in the independence of independent auditors."⁶⁵

The AICPA has developed a body of independence standards, set out in its Code of Professional Conduct, that applies to audits performed by its members.⁶⁶ Auditors look to thesestandards (and to the interpretations and ethics rulings concerning these standards) to determine whether they are independent for purposes of GAAS.⁶⁷ Ultimately, at least insofar as audits of financial statements of Commission registrants are concerned, however, the Commission retains the responsibility to ensure the development of an independence framework that serves the public interest and protects investors.

Independence traditionally has been understood by the profession to be a state of mind and a matter of character - subjective attributes of integrity, honesty, and objectivity.⁶⁸ Thus, an individual auditor is said to be "independent in fact" when he or she possesses a mental attitude giving rise to an ability to act with objectivity and integrity.⁶⁹ As we have recognized, however, "[s]ince objectivity exists only as a state of mind, [and] independence in fact, or the absence of it, is rarely susceptible to demonstrable proof . . . both the appearance and the fact of independence are equally important" under the securities laws.⁷⁰ In addition, because it is vital that audits not only produce more reliablefinancial information but also that investors believe that they do, it is critical that auditors appear free of biases and prejudices that may impair their objectivity.⁷¹ Indeed, as SAS No.1, Section 220,⁷²states:

As a consequence, both we and the AICPA have identified relationships and other circumstances so inherently compromising that they are judged necessarily to impugn independence. When, as a factual matter, such relationships are present, independence "shall be considered to be impaired" under GAAS,⁷³ and an accountant would "be considered not independent" under ourformer Rule 2-01.⁷⁴ Such relationships must be scrupulously avoided in order to preserve the credibility of audits.⁷⁵

The questions we address today turn on whether, on the basis of the record before us, there were any such relationships among Peat Marwick, Strategies, Strategies' owner, Olson, and Peat Marwick's audit client, PORTA. As discussed below, we conclude that there were at least two relationships that compromised Peat Marwick's independence. We discuss only relationships that were not the subject of discussion between Peat Marwick and OCA. We need not reach other relationships that are asserted to give rise to independence impairments, because even without reaching them, we conclude that Peat Marwick should be ordered to cease and desist from violating the securities laws.⁷⁶

IV.

A.

The first relationship we consider is Peat Marwick's debtor/creditor relationship with Olson. Peat Marwick's loan to Olson remained outstanding while Olson was PORTA's president and COO and Peat Marwick was auditing PORTA's financial statements and when Peat Marwick issued its audit report. Peat Marwick concedes that, as a result of this relationship, it was not independent from PORTA.

Former rule 2-01 required auditors and their firms to avoid direct and material indirect business relationships with officers of clients, including borrowing or lending.⁷⁷ We have stated that these relationships engender a "mutuality or identity of interests with the client [that] would cause the accountant to lose the appearance of objectivity and impartiality . . . ".⁷⁸ This is so because a reasonable person, knowing that an auditor or his or her firm has a financial stake in the repayment of the loan and knowing that the repayment might be dependent, at least to some extent, on the audit client's continued operation and solvency, would harbor serious doubt about whether the auditor will objectively assess the client's financial condition.⁷⁹

GAAS is to the same effect. The AICPA Code of Professional Conduct, Interpretation 101-1, states that "[i]ndependence shall be considered to be impaired if, . . . [d]uring the period of a professional engagement or at the time of expressing an opinion," an auditor or his firm "[h]ad any loan to or from" an audit client, or any of its officers, directors or principal shareholders.⁸⁰ Thisinterpretation establishes what we have called an "absolute prohibition of loans."⁸¹ Peat Marwick's loan to Olson violated that prohibition.

Peat Marwick's witnesses admitted -- and on review Peat Marwick admits -- that the loan to Olson impaired Peat Marwick's independence under GAAS. Indeed, one of Peat Marwick's expert witnesses testified that in 25 years of auditing he had "not seen an audit up until this one where the audit firm had a loan to the client."⁸² Peat Marwick nevertheless attempts to minimize what one witness correctly characterized as "an absolute blatant out-and-out violation of the AICPA Code of Professional Conduct" by characterizing it as a "mistake."⁸³ We agree, but we stress that the "mistake" was serious and arose from Peat Marwick's failure to exercise ordinary care to maintain its independence.

B.

Another set of relationships between and among Peat Marwick, Strategies, and PORTA gave Peat Marwick the right to a fee attributable, in part, to PORTA's financial success. We also conclude that these relationships prevented Peat Marwick from being recognized as independent. As set out above, PORTA's turnaround agreement with Strategies required PORTA to pay Strategies a "success fee" of specified percentages of PORTA's quarterly earnings, disposed inventory, and restructured debt. The portion of the success fee attributable to earnings (five percent of the company's quarterly "earnings before interest taxes") was to be paid "at the end of each quarter during [the] engagement" and for three years thereafter. Strategies, in turn, was obligated to pay to Peat Marwick, on a fiscal quarterly basis in arrears, a royalty fee of five percent of its quarterly consolidated fee income.

Rule 302 of the AICPA's Code of Professional Conduct⁸⁴ prohibits arrangements under which an auditor has the right to receive a fee that is contingent on the financial success of an audit client. The rule flatly prohibits an auditor from "perfor[ming] for a contingent fee any professional services for, or receiv[ing] such a fee" from a client for whom the auditor performs an audit or review of a financial statement. Peat Marwick ran afoul of that prohibition by "receiving" such a fee within the meaning of the Rule.⁸⁵

Peat Marwick insists that it did not accept any royalties "once OCA raised a question" about the royalty fee arrangement, and that the success fee/royalty fee arrangements therefore do not support a finding of lack of independence. But, as Peat Marwick's own evidence shows, royalty fees due Peat Marwick for quarters ending after September 30, 1995, were deposited by BayMark in a "separate segregated account" established by BayMark, and the BayMark parties stood ready to make all required payments due under the terms of the license agreement once independence issues were resolved. In any event, whether Peat Marwick chose to avail itself of its right to share in the success fee is beside the point. Under AICPA Rule 302, as interpreted by ethics ruling 17, a contingent fee is deemed received when "the performance of the related services is complete and the fee . . . is determined."⁸⁶ Thus, it was the relationships between and among Peat Marwick, Strategies, andPORTA permitting Peat Marwick to receive a determinable fee, not the actual receipt of funds, that created the danger of clouding objectivity and impartiality in the audit.

C.

In the respects described above, Peat Marwick established and maintained relationships that impaired independence from its audit client, PORTA. By virtue of its debtor/creditor relationship with Olson, Peat Marwick cannot be recognized as independent from PORTA under former Rule 2-01. We also conclude that the loan to Olson and Peat Marwick's right to share in Strategies' success fee ran afoul of AICPA Code rules aimed at safeguarding independence. Accordingly, these relationships, whether considered individually or collectively, impaired Peat Marwick's independence under GAAS.

Concerning our findings under former Rule 2-01, Peat Marwick argues that the record shows that the audit team was independent "in fact" as evinced by, among other things, the quality of the audit report, the issuance of the going concern qualification, and the fact that the audit team itself had no knowledge of the loan to Olson or of the other features of the alliance structure.⁸⁷ Peat Marwick's argument misreads former Rule 2-01. Its argument essentially is that independence "in fact" -- the auditor's state of mind -- is to be determined by the outcome of the audit, and not by reference to those circumstances that have been designated by the Commission as inconsistent with independence. If the audit was properly performed, the argument goes, it must follow that the persons who performed it were independent.

This argument, in effect, calls upon us to replace the independence requirement with a "good audit" requirement. The argument assumes that, if the outcome of an audit was acceptable, it followsthat the auditors were objective. Of course, the absence of bias is not demonstrated by an adequate audit, just as an inadequate audit does not demonstrate that the auditor was biased. Rather, the independence requirement is designed to give investors the assurance that the persons examining a registrant's financial statements are capable of exercising objective and unbiased judgment. This assurance is at the core of the independence requirement, since investors are rarely in a position to judge whether, when financial statements are filed with the Commission, they have been subject to rigorous review and are accurate.⁸⁸

Peat Marwick's argument fails for an additional reason. The circumstances identified in former Rule 2-01(b) as impairing independence were those involving the accountant, "his firm, or a member of his firm." This phrase appeared in subsections (b)(1) and (2), which gave examples of situations in which an accountant would be "considered not independent." Indeed, the situation described in subsection (b)(1) was one in which the accountant's "firm had . . . any direct financial interest or any material indirect financial interest" in an audit client or its affiliates. The rule plainly did not make the question of whether an auditor's independence is impaired because of a relationship between the firm and the audit client depend on an inquiry into what each auditor in the firm knew.⁸⁹

Finally, it is apparent that some of the circumstances of the alliance did, in fact, have a significant effect on the audit at issue. As we have noted, the fact that Olson and Strategies would provide management services to PORTA was not lost on the audit team: in spite of significant management turnover, they decided not to reevaluate the audit relationship with PORTA, in part because Olson, the new COO, was "with BayMark Strategies" and "came highly recommended" by Peat Marwick's corporate finance personnel.

In another argument pertaining to former Rule 2-01, Peat Marwick contends that findings that its relationships adversely affected its independence would impose on it, without notice, new rules of conduct.⁹⁰ We disagree. Due process requires only that laws give a "person of ordinary intelligence a reasonable opportunity to know what is prohibited."⁹¹ The degree of required noticevaries according to the circumstances.⁹² In cases such as this one, regulations satisfy due process so long as they are sufficiently specific that a regulated entity "acting in good faith would be able to identify, with ascertainable certainty, the standards with which the agency expects" it to conform "by reviewing the regulations and other public statements issued by the agency."⁹³

We conclude that a reasonably prudent accounting firm would have had fair warning from the face of former Rule 2-01 that we would deem independence impaired when, during the period of an audit engagement, the firm maintained a debtor/creditor relationship with an officer of an audit client. Any doubt could have been resolved by recourse to, among other sources, our published decisions and our codification of financial reporting policies. In sum, our finding that Peat Marwick's relationship with Olson impaired its independence imposes no new rules of conduct.⁹⁴

We therefore conclude that, by virtue of its lack of independence from PORTA, Peat Marwick violated our Rule 2-02(b)(1)⁹⁵ by issuing an audit report stating that the audit was conducted in accordance with GAAS, when it was not.⁹⁶ We also conclude that, because Peat Marwick lacked independence (gauged both by GAAS and former Rule 2-01), PORTA violated Section 13(a) of the Exchange Act and Rule 13a-1, since the financial statements included as part of PORTA's 1995 annual report, were not, as represented, audited by independent accountants.⁹⁷ We note that each impairment we have found, considered on its own, compromised Peat Marwick's independence and each is sufficient, on its own, to support our finding of violations of Section 13(a) and Rule 13a-1. Similarly, each impairment is sufficient, standing alone, to compromise independence under GAAS and to support our finding of violation of Rule 2-02(b)(1).

V.

We now address whether Peat Marwick should be sanctioned for the conduct we have found. Under Exchange Act Section 21C(a), we may order a person to cease and desist from certain conduct if the person "is violating, has violated, or is about to violate" any provision of the Exchange Act, or anyrule or regulation thereunder.⁹⁸ The section also authorizes us to order a person to cease and desist from certain conduct if the person "is, was or would be a cause of [a] violation [of the Exchange Act or the rules and regulations thereunder], due to an act or omission the person knew or should have known would contribute to such violation." As we conclude below, Peat Marwick acted negligently, and its conduct resulted both in its primary violation of Rule 2-02 and in its being the "cause" of PORTA's violations of Section 13(a) of the Exchange Act and Rule 13a-1. Because of the unique procedural posture of this case, however, negligence is not sufficient to warrant a conclusion that Peat Marwick engaged in "improper professional conduct" within the meaning of our Rule 102(e). Instead, Peat Marwick engaged in improper professional conduct only if it acted intentionally, knowingly, or recklessly.⁹⁹

A.

We hold today that negligence is sufficient to establish "causing" liability under Exchange Act Section 21C(a), at least in cases in which a person is alleged to "cause" a primary violation that does not require scienter.¹⁰⁰ Therefore, if Peat Marwick acted at least negligently with respect to whether its conduct would contribute to PORTA's violations, Peat Marwick is liable under Section 21C(a) as a cause of those violations.

Ordinarily, the phrase "should have known" used in Section 21C(a) is classic negligence language.¹⁰¹ On the other hand, the meaning of the phrase is flexible and can vary depending on the context.¹⁰² Where, as here, the primary violations do not require culpability beyond negligence, we see no reason not to give the phrase its ordinary meaning¹⁰³ and much that compels us to adhere to that meaning. As we discuss infra pp. 47-49, the legislative history of Section 21C and its parallel provisions shows that it was designed to provide a flexible remedy against persons who commit isolated infractions and present less threat to investors than do persons against whom injunctive relief is sought.¹⁰⁴

We also find support for our holding in the construction of an analogous provision of the Exchange Act, Section 15(c)(4).¹⁰⁵ Section 15(c)(4) permits us to proceed administratively against a person who is "a cause of [another person's] failure to comply [with certain provisions of the Exchange Act or rules and regulations thereunder] due to an act or omission the person knew or should have known would contribute to the failure." In George C. Kern, Jr., [1988-1989 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶84,342, at 89,591-92 (Nov. 14, 1988), aff'd in part and vacated in part on other grounds, 50 S.E.C. 596 (1991), then-Chief Administrative Law Judge Warren Blair, taking into consideration the language of the section, its legislative history, and its "disclosure philosophy," among other things, held that a negligence standard governs "causing" liability under Section 15(c)(4). A number of commentators suggest that Section 21C's formulation for "causing" liability appears to be derived from Section 15(c)(4).¹⁰⁶

B.

Based on our review of the record, we conclude that Peat Marwick acted negligently, but not recklessly, in concluding that it was independent from PORTA. It was unreasonable for Peat Marwick, in the person of Conway, to overlook how the terms of the Strategies engagement with PORTA compromised Peat Marwick's independence. As the head of Peat Marwick's DPP, Conway was in charge of a "group of experts" to whom Peat Marwick professionals were directed to turn for guidance on questions about independence. Specifically, the DPP was charged with dealing with, among otherthings, independence questions that might arise "in the field."¹⁰⁷ As Sturm explained, when he had questions of this sort, he would turn first to "the professional literature" and, if he could not ascertain the answer on his own, he would contact the DPP. It was because he could not, on his own, ascertain the answers to his concerns about Olson's relationship with Peat Marwick and PORTA that Sturm repeatedly contacted the DPP. In early December, for example, Sturm asked Trattou whether Peat Marwick's independence would be impaired if, in addition to performing consulting services for PORTA, Olson functioned as its COO and bore the titles of president and COO of the company. As a result of this inquiry, Conway had reasons to be - and initially was - concerned about Peat Marwick's independence from PORTA. As a consequence, he should have taken the steps necessary to resolve Sturm's inquiry appropriately. He did not do so.

As Trattou's December 5 e-mail indicates, Conway was informed about Sturm's December inquiry shortly after Sturm called Trattou. Although it is not clear from the e-mail what Conway was told about the inquiry in particular, or the PORTA situation in general, it is clear that, based on what he did know, Conway "believed" that the "situation [was] not appropriate." On its face, this e-mail demonstrates that Conway was aware that the PORTA situation raised concerns about independence. Indeed, Peat Marwick's close identification with BayMark and its subsidiaries, the subject of ongoing discussion with OCA, rendered the PORTA situation particularly problematic from an independence standpoint, because Strategies would actively manage PORTA and therefore "indirectly [provide] `representations'" to the audit team.¹⁰⁸

Because he had these concerns, and because he was the head of Peat Marwick's DPP, Conway had a duty to inquire carefully about the specifics of Strategies' PORTA engagement and to assess diligently whether the audit could proceed. But he did not do so. Instead, Conway simplyasked someone at Peat Marwick to gather information¹⁰⁹ about dual engagements and proceeded with his independence assessment on the basis of a skeletal description of the PORTA situation set forth in a brief chart. That chart included only information on the client's name, year-end date, and assets; a summary description of the services Strategies would provide; and an incomplete description of the fees Strategies would earn. The chart was lacking in basic information -- such as the identity of the Strategies employee who would provide the management services.¹¹⁰

Thus, as Conway himself has admitted, he may well not have known many of the critical specifics of the PORTA situation. He should have. Had he known these facts, along with other facts he did know, he would have known that Peat Marwick's independence was impaired. For example, Conway knew that Peat Marwick had loaned money to the BayMark Principals. That fact, with the fact that a BayMark Principal would serve as PORTA's president (a fact Conway should, but may not, have known), would have given rise to immediate and obvious independence concerns.¹¹¹ Conway did not know these specifics because he was satisfied with an incomplete account of the PORTA situation.

Conway had ready access to multiple sources of information about the PORTA situation - e.g., Vasquez,¹¹² Trattou, and Sturm. Conway failed, however, to elicit material facts from his colleagues,even though he knew that they possessed information pertinent to the independence inquiries he was obligated to resolve. Despite his responsibility to make independence determinations for Peat Marwick, and despite his concerns, Conway simply never thought through the issues in meaningful detail. Conway's conduct, of course, is attributed to Peat Marwick for purposes of this proceeding.

Conway was not the only Peat Marwick employee whose conduct was negligent. For example, although Sturm was responsible for compliance with GAAS in the conduct of the PORTA engagement,¹¹³ Sturm failed to take reasonable steps to assure himself that Peat Marwick was independent from PORTA. Although he knew that he did not know enough about Peat Marwick's relationship with BayMark to assess whether it was "okay" for Olson to perform "COO-type" functions for a Peat Marwick audit client, he attempted to discharge his responsibilities under GAAS by relying without question on DPP's and Vasquez' conclusory assurances that independence had not been impaired. From all that appears in the record, Sturm made no inquiry into the specifics of the Peat Marwick/BayMark alliance, even though he had reason to know that Trattou and Vasquez had access to those facts. Had he made any specific inquiry, he would have learned, for example, that Olson, the person performing the "COO-type" functions for PORTA, had a loan outstanding from Peat Marwick. Instead, he simply relied on the blanket assurances of others that the structure of the alliance was such that it obviated independence issues and that the matter had been discussed with the Commission.

Peat Marwick attempts to minimize the seriousness of its employees' negligence by relying on Conway's discourse with Sutton. In our view, Conway's interactions with Sutton support, rather than undermine, our conclusion that Conway (and hence Peat Marwick) acted unreasonably. Although we have accepted the law judge's finding that Conway concluded his conversations with Suttonbelieving that OCA would not assert that Peat Marwick's independence was impaired with respect to the six overlapping engagements, OCA's position was plainly based on the facts as Conway presented them. But Conway did not tell OCA that Olson would be acting as PORTA's president and COO, nor did he tell OCA that PORTA had promised to pay Strategies a success fee under certain contingencies. Conway could not reasonably have believed that OCA was giving Peat Marwick a "free pass" on any and all independence issues that might arise in the course of the six engagements including issues arising from matters that were never discussed with OCA.

Even when Conway and Sturm had the opportunity to reconsider the PORTA situation, in the context of Sturm's call to Conway as the PORTA audit was nearing completion, neither man asked the other enough to elicit the facts each man claims he did not know, even though Sturm knew, for example, that Olson was providing COO services to PORTA, and Conway knew or was on notice that Olson was a Principal of BayMark. Instead, both men simply fell back on Conway's conversation with Sutton and "reconfirmed that the SEC was aware that BayMark was performing the work at PORTA" and hence that Peat Marwick's independence had not been impaired.

In an attempt to explain why he did not "put the pieces together," Conway observed that "all of my focus was on the relationship with BayMark. I mean, I spent all of my time, virtually all of [it] certainly, talking to [Sutton] about the basic relationship with BayMark. I just never focused on the loan." Although this is certainly an accurate description of Conway's interactions with OCA, it hardly excuses his failure to gather, assess, and impart facts about the specific engagement. Conway was concerned enough about the PORTA situation to seek OCA's guidance; he had the obligation to learn and disclose the salient facts about that situation. His failure to do so cannot be justified by his focus on structural issues or on his perception of views expressed by OCA. Without focusing on all the salient engagement-specific facts, Conway was negligent in concluding that Peat Marwick was independent from PORTA.

At the same time, although it is a close question, we are unable to conclude that Conway or Sturm acted recklessly. Conway talked repeatedly with OCA about independence issues raised by the BayMark alliance. Indeed, he put eighteen engagements on hold while he discussed those issues with OCA. There is no direct evidence that Conway was aware of the material facts that he did not raise with OCA, nor is there evidence that he sought to avoid learning them. When he did consider all the facts, Conway "used a four letter word to [himself] saying that [he] was disappointed in [himself] that [he] didn't realize this before." Conway was alarmingly careless in not learning what he needed to know and in not appreciating the significance of what he knew. But his misconduct, we conclude, fell short of recklessness. Similarly, we do not conclude that Sturm was reckless in relying on DPP's assurances. We particularly note that Sturm may have been misled by Trattou into believing that the PORTA situation had been discussed with OCA as Trattou and Sturm had discussed it, e.g., including information that Olson was performing the management functions at PORTA.

We find that Conway and Sturm negligently failed to inform themselves about facts material to specific issues about independence attending the PORTA situation - when both had questions or concerns about the propriety of the audit and had ready access to relevant information. We therefore conclude that Peat Marwick, through Conway and Sturm, necessarily should have known that its conduct would render false its representation that its audit was in accordance with GAAS, thereby violating Rule 2-02(b)(1). We further conclude that Peat Marwick, through Conway and Sturm, also should have known that its conduct would contribute to PORTA's violations of the securities laws within the meaning of Exchange Act Section 21C(a). Because of the unique posture of this proceeding (see supra note 99), however, we are constrained to conclude that Peat Marwick did not engage in improper professional conduct within the meaning of Rule 102(e).

VI.

In determining whether to issue a cease-and-desist order against Peat Marwick, the law judge considered: the egregiousness of the defendant's actions, the isolated or recurrent nature of the infraction, the degree of scienter involved, the sincerity of the defendant's assurances against future violations, the defendant's recognition of the wrongful nature of his conduct, and the likelihood that his occupation will present opportunities for future violations.¹¹⁴

These factors are used by courts in determining whether the Commission has shown a reasonable likelihood of future violation warranting injunctive relief.¹¹⁵ Since we were given cease-and-desist authority in the Securities Enforcement Remedies and Penny Stock Reform Act of 1990 ("RemediesAct"),¹¹⁶ we have not determined whether the Division must show a likelihood of future violations to warrant cease-and-desist relief.¹¹⁷

Our decision to impose any remedial sanction is governed by certain general principles. Within the context of our statutory authority, we have broad discretion in choosing a sanction.¹¹⁸ All that is required is that the remedy we select have a "reasonable relation" to the record before us and to the violations we have found.¹¹⁹ In imposing sanctions, we traditionally have balanced a variety of mitigating and aggravating circumstances, such as the harm caused by the violations, the seriousness of the violations, the extent of the wrongdoer's unjust enrichment, and the wrongdoer's disciplinary record. The questions this case poses are whether, as a matter either of statutory command or in the exercise of our broad discretion, we will require some showing of likelihood of future violations before issuing a cease-and-desist order, and how that showing may be made.

We believe that there must be some likelihood of future violations whenever we issue a cease-and-desist order. The nature of the cease-and-desist remedy almost by definition looks in part to the future. The remedy requires that a wrongdoer "cease" his unlawful conduct and "desist" from such conduct in the future. The forward-looking aspect of the remedy is further evidenced by the authority the statute gives us to impose conditions in cease-and-desist orders to assure future compliance.¹²⁰ If there is no possible risk of future violation, it is difficult to see the remedial purpose of a cease-and-desist order.¹²¹

Though "some" risk is necessary, it need not be very great to warrant issuing a cease-and-desist order. Absent evidence to the contrary, a finding of violation raises a sufficient risk of future violation. To put it another way, evidence showing that a respondent violated the law once probably also shows a risk of repetition that merits our ordering him to cease and desist. Our conclusion is suggested, though not compelled, by the statutory language. The statute specifies that we may impose a cease-and-desist order on a person who "has violated" the securities laws. This contrasts with our authority to seek injunctive relief in those instances when a person "is engaged or about to engage" in violative conduct.¹²²

The public discussion that ultimately resulted in the enactment of our cease-and-desist authority, as well as the legislative history of the Remedies Act, shows that this authority was designed to provide the Commission with a remedy that could be based on a finding of past violation. As far as we are aware, cease-and-desist authority for the Commission was first suggested in 1972 by the late Arthur F. Mathews in a letter to the Commission's Advisory Committee on Enforcement Policies and Practices ("Wells Committee").¹²³ Mathews suggested that a cease-and-desist order remedy similar to that employed by state securities regulators would be a useful remedy "where there does not exist any reasonable likelihood that the person will commit statutory violations in the future."¹²⁴ The Wells Committee did not adopt Mathews' suggestion.¹²⁵

A decade later, then-Commissioner Bevis Longstreth, suggested asking Congress for cease-and-desist authority in insider trading cases¹²⁶ and in 1983, the Commission launched a formal review to study whether it should seek authority to impose administratively a greater range of remedies, including cease-and-desist orders.¹²⁷ The issue of cease-and-desist authority was again raised in October 1987 by the National Commission on Fraudulent Financial Reporting ("Treadway Commission").¹²⁸ The Treadway Commission recommended, among other things, that the Commission be authorized "to issue cease-and-desist orders when it finds a securities law violation."¹²⁹ The Treadway Commission found that cease-and-desist power "would provide increaseddeterrence in . . . financial reporting cases . . . in which the SEC lacks sufficient evidence to demonstrate a reasonable likelihood of future violations."¹³⁰

On February 1, 1990, then-Chairman Richard Breeden appeared before a Senate committee considering enforcement remedies and requested legislation that would give the Commission authority to issue temporary and permanent cease-and-desist orders. In support of this cease-and-desist power, Chairman Breeden stated that,