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Initial Decision of an SEC Administrative Law JudgeIn the Matter of
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In the Matter of : CARROLL A. WALLACE, CPA |
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INITIAL DECISION
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APPEARANCES:
Robert M. Fusfeld for the Division of Enforcement, Securities and Exchange Commission.
George B. Curtis and James D. Goldsmith for Respondent Wallace.
BEFORE:
James T. Kelly, Administrative Law Judge
The Securities and Exchange Commission (Commission or SEC) instituted this proceeding on April 1, 1999, pursuant to Rule 102(e)(1)(ii) of its Rules of Practice, 17 C.F.R. § 201.102(e)(1)(ii). The Order Instituting Proceedings (OIP) charged that Carroll A. Wallace (Wallace or Respondent), a certified public accountant (CPA) in Denver, Colorado, engaged in improper professional conduct in that he "intentionally, knowingly, or recklessly" violated the applicable professional standards when auditing a public company. The alleged audit failures occurred in connection with two annual financial reports filed with the Commission by The Rockies Fund, Inc. (Rockies Fund or Fund), a closed-end investment company.
The OIP charges that Wallace's audits of the Fund's 1994 and 1995 financial statements were not conducted in accordance with generally accepted auditing standards (GAAS) and that he failed to assure that the Fund's financial statements were prepared in conformity with generally accepted accounting principles (GAAP).1 Financial statements for both years are alleged to have materially overstated the Fund's net assets. In 1994, Rockies Fund wrongly classified certain restricted securities in its investment portfolio as unrestricted. The Fund then valued those securities based on the bid price for unrestricted shares, even though the market was highly illiquid and management knew that it could not sell all its holdings at the bid price. Wallace is alleged to have acted recklessly, in that he failed to test management's classification of the securities in question, gave his approval to the Fund's valuation of those securities, and then issued an unqualified audit opinion.
The OIP further charges that, in 1995, the Fund again overvalued this restricted stock by using the closing bid price for unrestricted shares. It alleges that Wallace behaved recklessly by failing to test management's representations about valuation before issuing another unqualified audit opinion.
The Division of Enforcement (Division) contends that Wallace should be denied the privilege of appearing or practicing before the Commission as an accountant, although it would allow him to petition for reinstatement after three years. Wallace argues that his audit performances and his audit conclusions were reasonable. He maintains that the proceeding should be dismissed.
I held a public hearing in Denver on September 13-17, 1999. 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 and proposed findings and conclusions that are inconsistent with this decision.
FINDINGS OF FACT
Wallace, age fifty-one, is a CPA licensed in Colorado (Tr. 424-25). Since 1982, he has been an audit partner in the Denver office of KPMG LLP (KPMG) and its predecessor firms (Tr. 425, 674-75). From 1992 to 1996, Wallace was the partner-in-charge of the audit department of KPMG's Denver office. During those years, he performed several administrative duties for his firm while also continuing to audit clients on a regular basis (Tr. 675). Wallace spent one-third to one-half of his time auditing public companies in 1994 and 1995 (Tr. 558). Respondent has participated in audits of several hundred Commission registrants over his career (Tr. 433, 677-78). From 1991 through 1996, he was the audit engagement partner for KPMG's audits of Rockies Fund (Tr. 425-26, 678).
Rockies Fund
Rockies Fund was incorporated in Nevada in 1983. It makes venture capital investments in, and management assistance available to, developing companies located throughout the United States (Tr. 126-27, 283-84; CWX 108 at 1143U, JX 1 at 1374). The Fund's office is in Colorado Springs, Colorado, and it has six employees. The Fund has elected to be treated as a business development company (BDC) under Section 54(a) of the Investment Company Act of 1940 (Investment Company Act), and it has registered with the Commission under Section 12(g) of the Securities Exchange Act of 1934 (Exchange Act).3 Under Section 13(a)(2) of the Exchange Act, Rockies Fund is required to file annual reports with the Commission on Form 10-K, including financial statements certified by an independent public auditor (DXs 6, 10). It also files unaudited quarterly reports with the Commission on Form 10-Q (DXs 1-5, 7-9).
Stephen G. Calandrella (Calandrella) has managed Rockies Fund since February 1991. In 1994 and 1995, he was the Fund's president, chief executive officer, treasurer, and a director (Tr. 179; DX 6 at 19, DX 10 at 18). The Fund's other directors were Charles C. Powell (Powell) and Clifford C. Thygesen (Thygesen) (Tr. 341-42). At all relevant times, Calandrella owned over 30% of the Fund's common stock (Tr. 287; DX 6 at 25, DX 10 at 24, JX 3 at 2348). D.A. Davidson & Co., Inc. (Davidson), a broker-dealer based in Great Falls, Montana, owned over 36% of Rockies Fund's common stock, and it gave Calandrella power to vote its shares (DX 6 at 21, 25, JX 1 at 1579, JX 3 at 2348).
Bids and offers for the Fund's common stock were posted on the National Association of Securities Dealers, Inc.'s (NASD) electronic bulletin board (Tr. 286).4 With two-thirds of the Fund's common stock in the hands of two shareholders, public trading of the Fund's shares was limited (CWX 189 at Ex. 12). The Fund had 131 shareholders at the end of 1994 and 116 at the end of 1995 (DX 6 at 12, DX 10 at 11, JX 2 at 1836-47).
In February 1994, the Commission's staff commenced an unannounced examination of Rockies Fund's books and records (Tr. 810-11). This was the first such examination since Calandrella had taken over the Fund's management, and the results were not encouraging. The staff summarized its findings in a deficiency letter to the Fund's board in May 1994 (CWX 151). As here relevant, the staff identified several discrepancies in the Fund's journals and ledgers. It advised that separate ledger accounts should be maintained for each security in the Fund's portfolio of investments. It cautioned the Fund about the necessary journal entries, and specified: "Any portfolio security, the salability of which is conditioned, should be so noted" (CWX 151 at 2). The staff's examination also determined that the Fund had not held an annual shareholder meeting to elect directors since 1991, the Fund's board had not met in person since 1991, management had not obtained approval from the Fund's board for the retention of an independent accountant since 1991, management had not corresponded with the shareholders between late 1992 and early 1994, and the Fund had been late in filing a Form 10-K and several Forms 10-Q (CWX 151 at 6). Calandrella replied to the deficiency letter one month later, explaining how the Fund proposed to address the staff's concerns (CWX 152).
Some time later in 1994, the Commission's staff requested Rockies Fund voluntarily to provide information relating to an investigation of the securities trading activities by several of the Fund's principals, including Calandrella (JX 1 at 1501-02). The Commission opened a formal investigation of the Fund and others on April 18, 1995, six days after the Fund filed its 1994 annual report (DX 6, JX 3 at 2317-22).
Premier Concepts, Inc.
In 1994 and 1995, the securities of Premier Concepts, Inc. (Premier), became the most significant holding in Rockies Fund's portfolio of investments (Tr. 432-33). At the end of 1994, Premier securities were 28% of Rockies Fund's reported total assets and 40% of its reported securities portfolio. At the end of 1995, Premier securities were 12% of the Fund's reported total assets and 19% of its reported securities portfolio. Rockies Fund was an "affiliate" of Premier for both years (DX 6 at 26, DX 10 at 25, JX 2 at 1742-44, JX 4 at 2630-35).5
Premier, a Colorado corporation with headquarters in the Denver metropolitan area, is the successor entity to Silver State Casinos, Inc., and Silver State Holdings, Inc. (Silver State) (Tr. 285-86; DX 55, CWX 159, JX 5 at 96-97). Rockies Fund was one of the founding investors in Silver State, which was then involved in real estate and gaming investments (Tr. 286). In 1992, the Fund purchased 500 shares of unrestricted Silver State common stock from a brokerage firm (Tr. 303-04; CWX 171). Those shares generated a 50% stock dividend of 250 unrestricted shares in 1993.
Since March 1994, Premier's sole business has been the ownership and operation of a network of retail costume jewelry stores that sell reproduction or "faux" jewelry under the trademark "Impostors" (JX 5 at 128-29). In May 1994, Premier acquired three additional retail costume jewelry stores from Mirage Concepts, Inc. (Mirage) (JX 5 at 109).
John C. Power (Power), a venture capitalist, approached Calandrella in 1993 about acquiring the Impostors chain out of bankruptcy (Tr. 287). Calandrella determined that Premier, a public company that was then in the process of divesting all its real estate and gaming assets, would be a good vehicle for the transaction. Premier completed the Impostors acquisition in March 1994 through a private offering of restricted securities (DXs 26, 27).6
At the time of the Impostors private placement and for the remainder of the time period relevant to this proceeding, Premier's board of directors was composed of three people, one of whom was also a member of the board of Rockies Fund. Calandrella served on Premier's board until February 28, 1995, when Powell succeeded him (Tr. 279-80, 291; CWXs 175, 176). Calandrella was also president and chief executive officer of Premier until June 1994, when Sissel B. Greenberg (Greenberg) replaced him (Tr. 179-80; JX 5 at 95).
For the fiscal year ending December 31, 1994, Premier reported net losses of $823,942 on total revenues of $7,792,413 (DX 59 at F-5). Premier's auditors opined that the firm's continued existence was dependent on its ability to raise additional capital and achieve profitable operations. The auditors added a "going concern" qualification to their opinion (DX 59 at page after F-3, CWX 183 at 17, JX 5 at 106).7 In its next fiscal year (ending January 28, 1996), Premier improved its operations and revenue flow. It reported net income of $174,219 on total revenues of $9,069,840, and its auditors removed the "going concern" qualification from their opinion (DX 55 at F-2).
Both Greenberg and Calandrella were optimistic about Premier's future.8 Their plans for Impostors included renegotiating leases with the company's landlords, closing unprofitable stores, continuing to open retail stores in new markets, implementing a new merchandising strategy, obtaining additional financing, filing a registration statement with the Commission, and ultimately listing the company's stock on NASDAQ's SmallCap Market (Tr. 239; DX 55 at 6, CWX 159 at 3-4, JX 5 at 100).
Between 1994 and 1997, bids and offers for Premier's common stock were posted on NASD's electronic bulletin board (Tr. 286; DX 26 at 8404, JX 5 at 126). At the times relevant to this case, Premier had 166 stockholders of record and public trading of its shares was sporadic (DX 20, DX 55 at 11, DX 59 at 11). There were thirty-two trades with a volume of 465,500 shares in 1994 and seventeen trades with a volume of 133,416 shares in 1995 (DX 14).
Hanifen Imhoff, Inc. (Hanifen), a Denver area brokerage firm, was Premier's only active market maker in 1994 (Tr. 37-38; DX 14). At different times in 1995, there were three market makers: Paragon Capital Corporation (Paragon), William V. Frankel & Co., Inc. (Frankel), and Hanifen (Tr. 20-22, 38, 41-42; DX 14). The last reported trade in Premier during 1994 was on December 16, 1994, when Hanifen bought 1,500 shares for $1.875 per share (DX 20 at 3). There were five reported trades in Premier on December 29, 1995, totaling 31,000 shares, at prices ranging from $0.625 to $0.6875 per share (DX 14, DX 20 at 19).
Premier's goal of listing its common stock on NASDAQ's SmallCap Market proved elusive in the short run. First, NASDAQ raised the asset requirement for listing to a level that Premier could not match (Tr. 239-40). Second, Premier did not become current in filing its quarterly reports with the Commission until January 1995 (Tr. 240, 242-43; DX 60, CWX 182, JX 5 at 108, 147, 192). Third, with its severe cash flow difficulties and large operating losses, Premier could not cover the $30,000 to $50,000 estimated cost of registration until 1996 (JX 5 at 138-39).
Notwithstanding these difficulties, Premier's securities became the crown jewels in Rockies Fund's portfolio of investments in 1994 and 1995. The threshold issue in this proceeding is whether the valuations of these crown jewels by Rockies Fund management (with the blessing of Wallace, as independent auditor) were, like Impostors' counterfeit baubles themselves, "faux." To address that issue, it is appropriate to consider how Rockies Fund acquired its Premier securities and what it paid.
Rockies Fund Acquires Premier Securities In A Series Of Private Transactions
The Impostors private placement involved units. Each unit cost $2.00 and consisted of two shares of Premier common stock and one Class C warrant, with an exercise price of $2.00 and an expiration date of December 31, 1995 (Tr. 187-88, 241; DX 22 at 1, CWX 144). The stock was assigned a price of $1.00 per share in the offering and the warrants were assigned a price of zero (Tr. 187-88; DX 22, DX 26 at 8411).
Rockies Fund's purchase in the Impostors private placement consisted of 62,500 units (125,000 shares of Premier common stock and 62,500 Class C warrants) and cost Rockies Fund $125,000 (Tr. 184; DXs 21, 22). Unlike the 750 shares of Silver State that Rockies Fund acquired in 1992 and 1993, the Premier shares and warrants that Rockies Fund bought in the Impostors private placement were restricted (Tr. 194-95, 304; DX 22 at 3, DX 29).
Rockies Fund borrowed the money for its units in the Impostors private placement from Caribou Bridge Fund, LLC (Caribou). It paid Caribou a loan fee of 12,500 Premier shares (Tr. 184-85, 188-89; DX 23). Caribou also held the remaining 112,500 shares, owned by Rockies Fund, as collateral for the loan (DX 24). The Fund repaid the loan to Caribou on May 8, 1995 (Tr. 258-59, 748; DX 24, JX 4 at 2698-99). In October 1995, the Fund reclaimed the 112,500-share certificate that Caribou had been holding as collateral (CWX 127).
Kober Corporation (Kober), a Denver area brokerage firm, also purchased 25,000 units (50,000 restricted shares of Premier common stock and 25,000 restricted Class C warrants) in the Impostors private placement (DX 22, JX 5 at 98, JX 6 at 1199). In June 1994, Calandrella reached an oral agreement with Kober to buy half of the restricted Premier shares that Kober had purchased in the Impostors private placement for $1.10 per share (Tr. 196, 240, 259-60). Rockies Fund eventually paid $27,500 to Kober for 25,000 shares of Premier. The payments were made as follows: $7,500 on June 29, 1994; $5,000 on August 2, 1994; $5,000 on August 16, 1994; and $10,000 on January 27, 1995 (Tr. 259-60; DX 35, JX 6 at 1205). Rockies Fund did not receive its restricted certificate from Kober until December 1996 (Tr. 201, 203, 227-33; DX 51-52, CWX 134, JX 6 at 1211-12).
Mirage acquired 35,000 shares of restricted Premier stock in the Impostors private placement (Tr. 193, 205; DXs 22, 28). Raymond Stanz (Stanz) owned half of Mirage (Tr. 194, 204-06; JX 5 at 109). In May 1994, Premier agreed to acquire Mirage for 135,000 shares of restricted Premier stock and an equal number of warrants (Tr. 204-05; DX 36, JX 5 at 110). Stanz was hired as Premier's chief operating officer, with the expectation that he would become president. He severed his ties to Premier once Greenberg replaced Calandrella as president (Tr. 262-64). Stanz's resignation was effective July 24, 1994 (DX 39).
In the first half of 1994, Calandrella, on behalf of Rockies Fund, orally agreed to buy 85,000 shares of restricted Premier stock from Stanz for $1.00 per share (Tr. 207). The 85,000 shares represented Stanz's half of the 135,000 shares that Premier initially agreed to pay to acquire Mirage (67,500 shares) plus half of the 35,000 shares of Premier that Mirage had acquired in the Impostors private placement (17,500 shares) (Tr. 206, 240-41). The agreement was reduced to writing on October 13, 1994 (Tr. 207-09; DX 39, JX 5 at 113). Rockies Fund paid Stanz $85,000 in two installments in October and December 1994 (Tr. 207-08; DX 38). As related by Calandrella, the Fund was essentially buying back Stanz's shares at $1.00 per share-the price he paid for them in the Impostors private placement (Tr. 266).9 The certificates for the Premier common stock that Rockies Fund acquired from Stanz bore a restrictive legend (Tr. 229, 231; DX 51). Warrants were also involved in this transaction, but they were never exercised and expired worthless.
On December 5, 1994, Rockies Fund obtained 150,000 Class D warrants from Premier at no cost. Each warrant was convertible into a restricted share of Premier common stock with an exercise price of $1.125 and an expiration date of December 31, 1995 (Tr. 220-23, 268-72; DX 59 at F-11, CWX 144 at 3-4, CWX 174). The Class D warrants were consideration for loans that Rockies Fund had extended to Premier in 1994 and an additional stand-by commitment the Fund made to loan money to Premier in the future (Tr. 222-23, 270, 272, 600-04; DX 59 at F-11, CWX 144, JX 2 at 1714, 1775-76). The terms of the stand-by credit commitment were not definite on December 5, 1994. Such key matters as interest rate, fees, maturity, repayment, and collateral remained to be negotiated before the Fund would allow Premier to draw any funds (CWX 174).
At year-end 1994, the Fund held approximately 10.3% of the outstanding shares of Premier (223,250 out of 2,170,737 shares) (DX 59 at F-4, CWX 189 at 17). Calandrella owned additional shares.
Rockies Fund bought 8,500 shares of unrestricted Premier stock through Hanifen on September 27, 1995. It paid $6,375, or $0.75 per share (DX 12 at 328, DX 14, JX 4 at 2605).
In late 1995, Premier's board authorized another private placement of restricted securities (DXs 49, 50). The proceeds of the offering were used to pay the expenses associated with the new store openings completed in 1995 (Tr. 794-95; DX 55 at 5). On December 19, 1995, Rockies Fund purchased 200,000 restricted shares of Premier stock in the private placement for $0.25 per share (DX 47). The Fund paid Premier $45,000 in cash and cancelled $5,000 in debt that Premier owed the Fund (Tr. 224-25; DX 48).
At year-end 1995, the Fund held approximately 11.5% of the outstanding shares of Premier (431,750 out of 3,744,695 shares) (DX 13 at 5657, DX 55 at F-3, CWX 189 at 17). Calandrella owned additional shares.
Registration Rights
Purchasers of restricted securities sometimes acquire the right to demand that an issuer register the shares with the Commission. Such "demand registration rights" typically obligate the issuer to file a registration statement and to use its best efforts to have the registration statement declared effective within a fixed period of time after the closing of the private transaction. Once the demand is made and registration becomes effective, the securities are freely transferable. Cf. Kers & Co. v. ATC Communications Group, Inc., 9 F. Supp. 2d 1267 (D. Kan. 1998).
There were no demand registration rights associated with the Impostors offering, or any of the Premier stock and warrants Rockies Fund acquired from other sources during 1994 (Tr. 238-41; DXs 26, 27, 36, JX 1 at 1467, item 9(c), JX 5 at 119). Premier did promise to use its best efforts to register. However, Calandrella understood that Premier could not file a registration statement while it was delinquent in its periodic filings with the Commission (Tr. 242-43). In addition, Premier's financial condition in 1994 and 1995 left it unable to pay the substantial costs associated with registration (JX 5 at 124).
There is conflicting evidence as to whether the 200,000 shares of Premier stock that the Fund acquired in December 1995 carried any registration rights (Tr. 242). The subscription agreement for Rockies Fund's purchase of these shares did not provide for demand registration rights (DX 47, ¶¶ 5(f), 5(g), 17). The investment term sheet, which was incorporated by reference in the subscription agreement, said just the opposite (Tr. 273-74; DX 50) (within thirty days of the sale, Premier must prepare and file a registration statement at its expense). Calandrella claimed that he could have forced Premier to register the Fund's 200,000 shares of restricted stock because he was an officer or director of Premier (Tr. 242). That is inaccurate. Calandrella ceased being an officer of Premier in June 1994 and ceased being a director in February 1995 (Tr. 179-80, 279-80).
Rockies Fund's Form 10-K for 1995 stated with respect to Premier that "certain shares are free trading . . . as a result of demand registration rights held by the [Fund]" (DX 10, financial statements, at 7). However, neither Rockies Fund nor any of the other purchasers in the 1995 Premier private placement ever demanded that Premier register the stock they had bought (JX 5 at 124, 143).
Rockies Fund Had Several Conflicting Methodologies
For Valuing The Securities In Its Portfolio
The parties agree that the source documents that reflect the Fund's valuation methodology are the 1983 prospectus, the board-adopted policy statement used at year-end 1994 and 1995, and the 1994 and 1995 Forms 10-K. The parties differ on whether the documents conflict and reflect changes in valuation methodology. I find that the weight of the evidence supports the Division's claim that there were several inconsistent policies.
The Fund's original valuation methodology was described in its 1983 prospectus. That document disclosed the lack of liquidity of the Fund's portfolio investments in the following terms (DX 66 at 8):
It is anticipated that a substantial portion of the [Fund's] venture capital investments in portfolio companies will consist of securities that are subject to restrictions on sale by the [Fund] because they were acquired from the issuer or affiliates of the issuer in "private placement" transactions or because the [Fund] is deemed to be an affiliate of the issuer. Generally, the [Fund] cannot sell these securities publicly without the expense and time required to register the securities under the [Securities Act] or sell the securities under Rule 144 or other rules under the Securities Act which permit only limited sales under specified conditions. . . .[P]ractical limitations may inhibit the [Fund's] ability to sell or distribute its portfolio securities because . . . the [Fund] owns a relatively large percentage of the issuer's outstanding securities. The above limitations on liquidity of the [Fund's] portfolio investments could prevent a successful sale thereof, result in delay of any sale or reduce the amount of proceeds that might otherwise be realized. The [Fund] will reflect these restrictive factors in the valuation of its investments.
The prospectus also stated that the Fund's board, including a majority of the board's independent directors, would make portfolio valuation determinations at least quarterly (DX 66 at 19). The Fund's policy was to value investments either at market value or in good faith at fair value, whichever was appropriate under the circumstances. The prospectus described the fair value of a security as the amount the owner might expect to receive for it upon its current sale (DX 66 at 19). It then explained in some detail the general and specific factors the Fund's board would consider when it valued an individual security, and stated that the board would use one of four methods for valuation: the public market method, the private market method, the appraisal method, or the cost method (DX 66 at 19-20).
The prospectus explained that the public market method was the preferred method of valuation and would be used when there was an established public market for the portfolio company's securities. The bid price of the security on the date of valuation would be used to establish the fair market value. There was no specification as to what bid price would be used (high, low, mean, closing). If the Fund owned restricted securities of a public company, such securities would be valued at a discount from the fair market value of a similar class of publicly traded securities. The prospectus disclosed that the extent of the discount would vary with each security holding, depending on the extent of the restriction and the breadth of the market for the similar class of unrestricted securities (DX 66 at 20).
The prospectus stated that the cost method of valuation would be used only if none of the other methods of valuation was appropriate. The cost method was most likely to be used early in a portfolio company's existence. The prospectus also explained that if any significant events occurred in a portfolio company that would have a long-term effect on the company, the appraisal method and not the cost method would be used to value the investment (DX 66 at 20).
Although the prospectus was twelve years old at the times relevant to this case, Rockies Fund was still relying on it.10 During the 1994 audit, Calandrella represented to Wallace that the Fund had valued its portfolio securities "in accordance with the valuation method set forth in the current prospectus" (JX 1 at 1509). KPMG suggested the wording of that management representation letter (Tr. 170-71, 496-97).
A second valuation methodology is described in a policy statement the Fund's board adopted for use at year-end 1994 and 1995 (Tr. 181, 184, 295; DX 11 at 103, DX 13 at 103, CWX 118 at 1944). In the board's policy statement, unrestricted securities were defined as those that have "an available market price and are publicly traded on a stock exchange."11 Restricted securities were defined as those that are restricted as to sale, or those that do not have an available market price due to the small number of shares traded. The Fund's policy was to obtain a "current market price" from a broker in the case of unrestricted securities. Restricted securities would be held at cost until events or conditions like strong operations, a growing market share, proven competent management, or a third party transaction indicated appreciation in value. The policy statement noted that, in many instances, Rockies Fund board members were also directors for the portfolio companies, giving them additional insight into operating results, management abilities, financing needs, current technologies, and future plans regarding new markets (DX 11 at 103).
In its brief, the Division argues that there are obvious differences between the valuation methodologies set forth in the 1983 prospectus and those the board adopted for use in 1994 and 1995. For example, the board-approved policy stated that restricted securities would generally be valued at cost, while the prospectus stated that cost was the least preferred method for valuation. The Division also contends that the board-approved valuation policy committed the Fund to using the low bid to value unrestricted securities ("generally, if more than one valuation is documented, the board will use the lower, more conservative value"), whereas the prospectus valuation policy stated only that an undefined bid would be used. These claims will be considered below.
Calandrella testified that the board-approved procedures for 1994 and 1995 were "an attempt to clarify" the procedures in the prospectus, not to replace them (Tr. 235). He saw no conflict. Both Calandrella and the Fund's board asserted that they had been applying consistent valuation policies since 1991 (Tr. 307; CWX 118 at 1942, JX 3 at 2344). Wallace acknowledged that the board-approved valuation policies were not "word for word identical" to those in the prospectus, but he believed they were "generally consistent" or "generally similar" (Tr. 455-56).
Rockies Fund's 1994 Form 10-K included a discussion of four valuation methods: the public market method "used when there is an established public market for the portfolio company's securities"; the private market method "based on private transactions"; the appraisal method "reflecting a comparison between the portfolio company and other public or private companies engaged in the same or similar business activities"; and the cost method "based on the cost of the [Fund's] investments as adjusted to reflect significant developments" (DX 6 at 5). Unlike the prospectus, the 10-K did not indicate which of the final three methods would be preferred when valuing restricted securities. Unlike the prospectus, the 10-K permitted adjustments to reflect significant developments under the cost method, rather than the appraisal method. Wallace perceived no significant inconsistencies between the board valuation policy and the Fund's 1994 Form 10-K (Tr. 496).
The Fund's 1995 Form 10-K had the same disclosure of four valuation methods as the 1994 Form 10-K (DX 10 at 5). However, the 1995 Form 10-K went on to describe a third valuation methodology. In relevant part, it stated: "Investments in unrestricted securities and restricted securities with quoted market prices are valued at closing bid price" (DX 10, financial statements, at 13-14 note (1)(b)). The use of market prices to value restricted securities was contrary to, and not mentioned in, the 1983 prospectus, the board valuation policy statement, and the 1994 Form 10-K. The practice described in the note also conflicted with an earlier statement in the 1995 Form 10-K that public market prices will only be used when there is an established market (DX 10 at 5). Wallace drafted the language. He admitted that it was not particularly well-written (Tr. 474-75, 477-78, 766). There is no evidence that the independent directors on the Fund's board ever even saw the valuation policy expressed in the footnote until they signed the Form 10-K on April 12, 1996.
In a management representation letter executed in connection with the 1995 audit, Calandrella advised Wallace that the Fund had valued its portfolio securities "in accordance with the valuation method set forth in the Form 10-K" (JX 3 at 2340). Once again, KPMG had suggested the general language to be used in this management representation letter (Tr. 519). This 1995 letter differed from Calandrella's representation one year earlier that the Fund was following the valuation policy "in the current prospectus" (JX 1 at 1509). Calandrella claimed that the Fund used the same valuation methods in 1995 that it used in 1994 (Tr. 351). The weight of the evidence is clearly otherwise.
In his February 2, 1996, investigative testimony, Calandrella described yet another valuation policy, whereby restricted shares were discounted from the market price for shares of comparable unrestricted stock; the percentage of the discount depended upon the length of time the restriction would last (Tr. 237-38). I find that this was deliberately misleading testimony. Only one day earlier, Calandrella had signed a board consent resolution valuing the restricted shares of several portfolio companies at the market price of the unrestricted stock (DX 13 at 5653-58). At the hearing, Calandrella explained that his investigative testimony was not addressing the valuation policy of Rockies Fund, but was intended to educate the Commission's staff about general investment company policy on valuations (Tr. 278). Respondent observes that the views expressed by Calandrella on February 2, 1996, were never communicated to Rockies Fund investors or to KPMG. I agree that Calandrella's investigative testimony is not relevant to Wallace's culpability in this proceeding. Nonetheless, Calandrella's effort to explain away his investigative testimony was unpersuasive, and further diminished his credibility as a witness.
The Fund Board's Valuation Meetings
During the February 1994 inspection, Rockies Fund failed to provide the Commission's staff with the minutes of its board meetings. The Fund explained that the minutes were not maintained at its Colorado Springs headquarters, but rather at the Boulder, Colorado, office of its attorney, Clifford L. Neuman. Despite repeated promises that the minutes would be provided within a short period of time, the Fund did not produce a complete set of minutes until a later date (CWX 151, item 2). I note that the board consent resolutions valuing the Fund's portfolio of investments for the first, second, and third quarters of 1993 were not even created until February 22, 1994-after the staff had asked to see them (CWX 108). These three consent resolutions were not contemporaneously written to memorialize board actions; rather, they were after-the-fact window dressing, designed to get the Commission's staff off the Fund's back. The Fund's practice in this regard is significant, because it shows that the Fund was not above creating misleading documents when the circumstances made it expedient to do so.
In 1994 and 1995, the Fund's board held only two in-person meetings. The first was a special meeting, convened at Neuman's office in Boulder on June 29, 1994 (CWX 108 at 1143S). The second was a lunch meeting at the Westin Hotel in Denver on February 15, 1995 (CWX 118). There were also two annual shareholder meetings, held in Colorado Springs on September 30, 1994, and September 27, 1995, respectively (CWX 108 at 1143Y, JX 3 at 2360).
With Thygesen living in Boulder, Powell in Denver, and Calandrella in Colorado Springs, the Fund's board conducted the remainder of its business by telephone (Tr. 343, 355-56; JX 3 at 2345, 2351). Calandrella held conference calls or seriatim telephone conversations with the other two board members (Tr. 320-21, 343, 355-56). Under Nevada law, board meetings conducted by conference calls are permissible, but board actions taken through seriatim telephone calls are not. See Section 78.315(3) of Nevada Revised Statutes Annotated, which permits board meetings to be conducted by telephone only if "all persons participating in the meeting can hear each other." The Nevada statute was dutifully cited in every board consent resolution. See William Fletcher, Cyclopedia of the Law of Private Corporations § 397.10 (1998) ("[W]here each member of the board is called individually to obtain unanimous approval, the action so taken fails to qualify as valid corporate action."); see also Fradkin v. Ernst, 571 F. Supp. 829, 844-46 (N.D. Ohio 1983) (same, applying Ohio corporate law).
Calandrella was unable to recall which "meetings" involved conference calls (and thus were legitimate under Nevada law) and which involved seriatim calls (and thus were ultra vires) (Tr. 321, 356). The consent resolutions are of no help in sorting out the issue.
The minutes of the meetings and the consent resolutions do not contain very much detail (DXs 11-13, CWX 108). The board did not list the factors that it considered and discussed when valuing portfolio securities. If Thygesen or Powell ever pressed Calandrella to justify a proposed valuation, or disagreed with a valuation recommended by Calandrella, there is no documentary evidence of it on this record. Neuman, the Fund's legal counsel, told the board that such written detail was unnecessary, and that the important thing was to document the action item and the fact that the action items were taken and properly authorized (Tr. 302-03, 831-32).
Wallace knew that the board's minutes and consent resolutions did not contain any discussion of the reasoning behind the board's valuation determinations (Tr. 441-42, 447-48, 452).
The Fund's Valuation Of Its Premier Shares As Of December 31, 1994
On January 11, 1995, Rockies Fund's board "ratified, adopted, and approved" a consent resolution valuing the Fund's investment portfolio as of December 31, 1994 (DX 11 at 96-103). The board attached a copy of its valuation policy statement to the consent resolution. Exhibit A to the consent resolution stated that Premier's common stock was "quoted" at $2.25 per share and that Premier's warrants were valued at the difference between their exercise price and "the quoted value of the shares" (DX 11 at 100). The consent resolution said nothing about any other factors the board may have used in valuing Premier (Tr. 347).
The wording of the January 11 consent resolution makes clear that the board took this action by telephone, and not at a face-to-face meeting. See DX 11 at 96 (the consent resolution has the same force and effect "as if" it had been adopted at a duly convened board meeting); DX 11 at 97 (facsimile signatures shall be binding "as if" they were originals).
The Fund's board also met in a restaurant at the Westin Hotel in Denver on February 15, 1995. Calandrella had general recollections of the meeting, but not "word for word" recollections (Tr. 243, 353-54, 358).12 Neuman could not remember the specifics of the conversation about Premier (Tr. 830-31, 862-63).
The restaurant meeting may well have taken place on the date and at the site identified. However, the record as a whole casts doubt on whether the Fund's board used the occasion to conduct the detailed discussion of valuation that Calandrella described. First, the need for the February 15, 1995, valuation meeting is unclear. Only one month earlier, on January 11, 1995, the board had already adopted a consent resolution valuing the Fund's portfolio as of December 31, 1994. Calandrella and Neuman offered no explanation as to why the Fund's board needed to perform the same task a second time. There is no suggestion that the valuations reached on February 15 differed in any way from those reached on January 11. The valuations appended to the January 11 consent resolution are the same ones that the Fund gave to the auditors in its preliminary financial statements (JX 2 at 1738-44) and (with minor modifications attributable to the auditors) the same ones that eventually appeared in the Fund's Form 10-K (DX 6 at 6-9). Second, the minutes of the February 15 meeting are incomplete. The minutes purport to incorporate by reference an attached schedule of investments and stock valuations. While there are three copies of the minutes in the record, none contains the referenced attachments (CWX 108 at 1143BB-DD, CWX 118, JX 3 at 2344-45).13 The attachments are the critical documents for understanding the board's valuation determinations. Without the attachments, the minutes alone are entitled to limited weight. Third, the notion that the Fund's board conducted a detailed discussion of highly confidential information in a public restaurant is difficult to accept. These factors persuade me that Calandrella's testimony about the meeting is incredible. Neuman's purported corroboration of Calandrella's account is vague and unreliable (Tr. 831, 862-64). I find that the February 15, 1995, minutes are no more than window dressing for the 1994 audit. I have given them minimal weight.
Although the auditors claimed that they reviewed the Fund's minutes and consent resolutions, there is no evidence that they saw the missing attachments to the February 15, 1995, minutes, or that they questioned Calandrella or Neuman about the need to discuss valuations at the February 15, 1995, meeting, in light of the valuations attached to the January 11, 1995, consent resolution.
The Fund's Valuation Of Its Premier Shares As Of December 31, 1995
In the preliminary financial statements the Fund submitted to KPMG for 1995, the board valued Premier at $0.75 per share (Tr. 308-09, 738-39; JX 4 at 2630). There is no documentation as to the reasoning or the thought processes behind the $0.75 valuation (Tr. 369). However, during the 1995 audit, the Fund told KPMG that the figure represented two things: the "3/4 last trade price" (JX 4 at 2643)14 and Premier's negotiations with an underwriter to conduct a secondary offering in the spring of 1996 in the range of $0.75 per share (Tr. 308-09, 311; JX 4 at 2643).15
Calandrella approached Wallace, who expressed discomfort with the proposed valuation of $0.75 per share (Tr. 738-39). Wallace was concerned that the prospective offering was structured as a best efforts underwriting rather than a firm underwriting, and he was not sure whether the offering could be completed. After discussions with Wallace, Calandrella modified the valuation of Premier to $0.625 per share. He characterized that figure as the bid price for an unrestricted share of Premier at year-end 1995 (Tr. 310-13, 359). According to Calandrella, "the board felt that [the lower figure] was fine" (Tr. 312-13, 324). In the Fund's 1995 Form 10-K, all the Fund's Premier shares were identified as restricted, and all were carried at the "quoted market value" of $0.63 per share (DX 10 at 8) (rounding up).
The Fund did not hold an in-person meeting to value its portfolio for year-end 1995, and there are no minutes. An attachment to the board's consent resolution of February 1, 1996 (erroneously dated February 1, 1995), stated that the Fund valued its Premier shares at $0.625 as of December 31, 1995 (DX 13 at 5657). The attachment did not discuss the initial valuation of Premier at $0.75 per share. According to Calandrella, that was because the consent resolution represented the "completion of the valuation process" (Tr. 368-69). As with the 1993 quarterly valuation consent resolutions and the February 15, 1995, minutes, the documentary evidence of board action on a significant issue is highly questionable.
Both Calandrella and Wallace explained that the Fund did not value its restricted Premier securities by the public market method, but rather at fair value, and that the end result just happened to equal the bid price of Premier's unrestricted shares (Tr. 297-300, 474-75, 511). However, Rockies Fund also held other restricted securities that it purportedly valued using fair value methods, and that it also valued at the bid price of the unrestricted shares at year-end 1995 (Tr. 511, 542, 555). The coincidence seriously undercuts Calandrella's and Wallace's claim that the board reached its valuation of Premier only after considering several factors that were unique to Premier.
Rockies Fund Sells Its Premier Shares Back To Premier In December 1996
Premier eventually filed a registration statement on May 23, 1996 (JX 5 at 108). Because of the Commission's ongoing investigation, NASD and the underwriter, Cohig & Associates, required Premier to repurchase its securities from Rockies Fund and others as a condition of listing the stock and going forward with the public offering (Tr. 329-30, 340; JX 5 at 179-80, 201).
Rockies Fund sold all of its Premier securities back to Premier in a private transaction on December 18, 1996, for $0.65 per share (Tr. 324-25, 329-31, 336-37; CWXs 155-57). The Fund received $303,396.69 for its Premier securities.
On April 20, 1997, Premier's common stock became eligible for posting on NASDAQ's SmallCap Market (JX 5 at 101, CWX 170 at 1). On April 21, 1997, Premier offered the public 1.1 million shares and Class A warrants for a price of $3.75 per share and $0.15 per warrant. The effective pre-split offering price of the shares was $0.75 per share (Tr. 340; CWX 170, JX 5 at 184).
Rockies Fund Is Charged With Fraud In June 1998
On June 1, 1998, the Commission commenced Administrative Proceeding No. 3-9615, Rockies Fund, Inc. The OIP in that proceeding alleges that the Fund, along with Calandrella, Powell, and Thygesen, defrauded investors by materially overstating its net assets between June 1994 and December 1995. The OIP also charges that Calandrella, along with Power, manipulated the market for Premier stock by engaging in matched orders, wash sales, and trading through nominee accounts between June and December 1994. Finally, the OIP asserts that the Fund, aided and abetted by Calandrella, Powell, and Thygesen, filed false and misleading annual and quarterly reports. The matter is pending before Chief Administrative Law Judge Brenda P. Murray.
The 1994 Audit
On December 31, 1994, Rockies Fund claimed total assets of $2,423,077, including a securities portfolio worth $1,699,582 (DX 6, financial statement, at 2). The Fund's Premier securities holdings consisted of 223,250 shares of Premier common stock, which the Fund's board valued at $2.25 per share (DX 6, financial statement, at 7, DX 11). Rockies Fund also held Class C warrants exercisable to acquire up to 62,500 shares of Premier common stock, which it valued at $0.25 per share, and Class D warrants exercisable to acquire up to 150,000 shares of Premier common stock, which it valued at $1.125 per share. The total claimed value of these Premier securities was $686,688 (DX 6, financial statement, at 7, DX 11). The Fund stated that all its Premier securities were unrestricted (Tr. 304-05, 473).
Planning And Staffing The 1994 Audit
A critical audit area is one where the auditors believe there is a greater amount of judgment involved and, as a result, potentially a greater risk of misstatement in the financial statements. A significant audit area is one where the numbers involved might be significant to the financial statements as a whole, but there is not a large degree of judgment involved in identifying the procedures and in calculating the amounts (Tr. 127-28). The auditors knew that most of the securities held by the Fund were thinly traded (Tr. 56-57, 487, 489). Because of the judgment involved in determining the value of the securities held by the Fund and the lack of an available market price for those securities, KPMG identified investment valuation as a critical audit area (Tr. 50, 64, 127, 432; JX 1 at 1374). Based on the magnitude of the Fund's investments in comparison to the other items on its balance sheet, KPMG identified all other aspects of the Fund's investment portfolio as significant audit areas (JX 1 at 1378).
For the 1994 Rockies Fund audit, Wallace was responsible for the overall management of the engagement, including reviewing certain of the work papers, reviewing the financial statements, and signing the opinion on behalf of KPMG (Tr. 426-27). The engagement manager was Andrew Young, the in-charge accountant was Laurel Hammer, the staff accountant was Donna Mah, and the SEC and concurring review partner was LaVoy Robison.
Young had been assigned to KPMG's Denver office from KPMG's Wellington, New Zealand office as part of the firm's international rotation program. Since 1991, he has been a chartered accountant, which is the equivalent of a CPA in the United Kingdom, Australia, and New Zealand (Tr. 684-85; DX 148 at 9). Young worked in KPMG's Denver office from 1993 through April 1995 (Tr. 676-77, 683-84). When Young joined the Denver office, he attended various classes. These included a two-day "SEC School" program, explaining how a client might become a registrant, and discussing documents such as prospectuses and registration statements (DX 148 at 118-20). Wallace had been personally involved in approving Young's transfer from New Zealand to Denver. He also participated in Young's annual performance evaluations and offered Young career counseling (Tr. 684).
Young had been the in-charge accountant for KPMG's 1993 audit of Rockies Fund, working under the manager on that engagement (Tr. 683). Prior to the 1994 Rockies Fund audit, Wallace had supervised Young on at least three or four audits in addition to the 1993 Rockies Fund audit (Tr. 685). Young's responsibilities on the 1994 audit were to review the work papers prepared by the audit staff, to review Rockies Fund's financial statements and Form 10-K, and generally to manage the audit field work performed at Rockies Fund's offices, as well as work performed at KPMG's office (Tr. 427, 682).
Laurel Hammer had joined the Denver office of KPMG in November 1993, and was a senior manager at the time of the hearing (Tr. 47, 117-19). After graduating from college in August 1990, she was employed for three years in the internal audit department of Cargill, Inc. Prior to commencing the 1994 Rockies Fund audit, Hammer had received training from KPMG, including a three-day course covering the Commission's rules, regulations, and reporting requirements (Tr. 164-67; CWX 113). Hammer's responsibilities in the 1994 audit were to perform a substantial portion of the audit field work in Colorado Springs, to supervise Mah, and to review Rockies Fund's financial statements and Form 10-K (Tr. 682, 686).
Donna Mah was responsible for performing certain audit procedures under Hammer's direction (Tr. 683). The record contains no information about Mah's credentials or experience, and very little about the specific duties assigned to her.
LaVoy Robison was the concurring review partner, who gave a "second look" to Rockies Fund's financial statements after Wallace had approved them. As the SEC partner, he also reviewed the Fund's Form 10-K to provide reasonable assurance of its compliance with the applicable regulations (Tr. 427-29, 687). Wallace consulted with Robison during both the 1994 and the 1995 audits (Tr. 729). Robison was the most senior member of the audit partner group in KPMG's Denver office, and he retired in 1997 (Tr. 688-89).
As part of the planning for the 1994 audit, Wallace met with Young and Hammer to discuss the scope of the engagement, the accounting issues he believed to be important, as well as scheduling issues (Tr. 689-90). Wallace estimated that KPMG's audit fee would be $12,500, including expenses (JX 1 at 1392). KPMG calculated its materiality threshold, or audit gauge, at $33,000 (Tr. 702; JX 1 at 1397). The auditors also estimated the time they expected to allocate to each audit area (Tr. 707-08). They budgeted ninety hours for the 1994 audit, a significant reduction from the 134 hours they had spent on the engagement the prior year. By March 8, 1995, they had already spent 126 hours performing the 1994 audit (JX 1 at 1581). Hammer spent approximately eighty hours on the audit, including fifty to sixty hours at Rockies Fund's office (Tr. 116, 807). Wallace devoted about ten to twelve hours to the audit (Tr. 559).
Alleged Red Flags
The Division asserts that the auditors ignored several "red flags" that should have alerted them to likely problem areas in the 1994 audit. Wallace bristles at the term "red flag," on the ground that it does not appear in the accounting literature. He argues that the Division has not explained whether or how the existence of the so-called "red flags" modifies the standard of care to which all auditors are required to adhere during the course of an audit (CWX 191 at 18; Resp. Prop. Find. # 880-83). Respondent raises a valid point, which I consider in more detail below.
Five of the alleged red flags warrant discussion here.16 I agree with the Division that the auditors ignored one of them. The Division has not shown that Wallace had a duty under the applicable accounting literature to address the second or third alleged red flags. I agree with Wallace that the auditors responded appropriately to the fourth and fifth alleged red flags.
First, the auditors knew of the Commission's February 1994 examination of Rockies Fund's books and record and they reviewed the subsequent exchange of correspondence between the Commission's staff and Calandrella (Tr. 140-44). After discussions with Calandrella and Windy Haddad (Haddad), a Fund employee, Hammer concluded that the Fund "appear[ed]" to be making a "good faith" effort to remedy the deficiencies identified by the Commission's staff (Tr. 820; JX 1 at 1495). The work papers do not demonstrate that the audit tested management's representations in any way. Hammer's use of an equivocating term ("appear[ed]"), her failure to nail down whether the "good faith" effort had or had not been successful, and Wallace's failure to press Young and Hammer on the point persuade me that the auditors' response to this red flag was deficient.
Second, at the conclusion of the 1993 audit, KPMG had prepared a management comment letter for the Fund's board. In relevant part, the letter stated: "[d]uring the test work of investments, we noted that the documentation regarding the purchase of restricted securities could not be located and difficulties were encountered in determining the number of securities held by the [Fund]. . . .We recommend that the [Fund] review its control procedures for the maintenance of the restricted securities records" (Tr. 527-28; JX 3 at 2579). Although the letter was never issued, KPMG discussed its substance with the Fund verbally (Tr. 522, 566-67, 706). The auditors also filed a copy of this letter in their 1995 work papers (JX 3 at 2581). However, the letter does not appear in their 1994 work papers. There is no evidence the auditors were conscious of the draft letter before or during the 1994 audit, even though both Wallace and Young had worked on the 1993 audit.
Third, the auditors did not read any of the Fund's 1994 quarterly reports before or during the 1994 audit. They considered doing so, but concluded that it was not required because the Fund did not have to include interim financial information in its year-end financial statements (JX 1 at 1401, citing Item 302(a) of Commission Regulation S-K, 17 C.F.R. § 229.302(a)). Wallace further explained that it was unnecessary to read the quarterly reports because the preliminary year-end financial statements, containing the relevant information for the entire year, were already available when the audit began in February 1995 (Tr. 452-53). Each side's expert witness agreed that KPMG had not been engaged to review the Fund's interim financial information and, under the applicable accounting literature, the auditors were not required even to read the quarterly reports (Tr. 577-82; CWX 191 at 21).
Rockies Fund had filed amended quarterly reports twice during 1994, a fact that was unknown to Wallace (Tr. 452-54). Both amendments significantly reduced previously reported assets. For the quarter ending March 31, 1994, the amended report reduced the Fund's reported net assets and stockholder's equity from $2.8 million to $1.8 million and increased the Fund's total accumulated deficit from -$56,782 to -$1,077,107 (DX 1, 2). For the quarter ending September 30, 1994, the amended report reduced the Fund's reported total assets by $102,435, and reduced its reported investment assets by $93,435 (DX 4 at 4, DX 5 at 4).
In the quarter ending June 30, 1994, the Fund had valued Premier at $1.50 per share, allegedly a market quote, when the bids on the last day of the quarter were $1.25 and $1.375 (DX 3 at 18, DX 15 at 4626).
Section 311 of the Codification of Statements on Auditing Standards (AU § 311), published by the Auditing Standards Board of the American Institute of Certified Public Accountants (AICPA), discusses the auditor's duty to plan and supervise an audit.17 AU § 311.04 provides that an auditor "may consider" a number of procedures in planning an audit, including reviewing the prior year's work papers and correspondence files and reading the company's interim financial statements. The language is permissive, not mandatory, and it contrasts with AU § 311.03 (listing the matters an auditor "should consider" in planning an audit). With the benefit of hindsight, the Division's expert witness was able to opine that, had the auditors read the Fund's 1994 quarterly reports, they would have seen that further inquiry was needed (Tr. 581-83). But the Division's expert could not explain how the auditors should have been aware of the contents of the Fund's Forms 10-Q at the stage of determining whether to read them. The accounting literature did not compel Wallace to read the Fund's quarterly reports, as the Division's expert conceded (Tr. 577-82). The auditors unquestionably exhibited a lack of curiosity. However, the Division's expert did not discuss how it is "improper professional conduct" to fail to do that which the "applicable professional standards" makes optional.18 I find that the auditors cannot fairly be accused of ignoring the second and third alleged "red flags." Nevertheless, I find the unread quarterly reports are probative on the narrower issue of Wallace's lack of knowledge of his client's business.
I agree with Wallace that the auditors responded appropriately to the fourth and fifth "red flags." The auditors became aware of the Commission's investigation of securities trading by the Fund's principals through conversations with Calandrella (Tr. 695-98). They contacted Neuman, the attorney who represented Calandrella, Premier, and the Fund, to understand the nature of the allegations involved. Neuman informed the auditors in writing that the Commission's request for information did not necessarily imply that any securities law violations had occurred, and that, in his judgment, no violations had occurred (Tr. 597; JX 1 at 1502). The auditors documented their inquiries in the work papers and disclosed the Commission's investigation in the Fund's 1994 Form 10-K (Tr. 700; DX 6, financial statements, at 16, JX 1 at 1628). The same is true of litigation involving BioSource International, Inc., which the Fund settled for $19,460. The auditors considered Neuman's written explanation of the settlement, and fully disclosed the matter in the Fund's 1994 Form 10-K (Tr. 637-39, 700-02; DX 6 at 10-11, JX 1 at 1501-02). No more was required under AU § 337, which provides guidance on inquiries of an audit client's lawyer concerning litigation, claims, and assessments.
The 1994 Audit Failed To Test Rockies Fund's Representation
That Its Holdings Of Premier Securities Were Unrestricted
Rockies Fund's internal accounting system used ledger cards to track its investments (Tr. 304). The cards contained additional information about all acquisitions and dispositions, including whether the securities involved were restricted or unrestricted.
Rockies Fund created a ledger card reflecting its 1992 acquisition of 500 shares of Silver State. The shares were accurately listed on the ledger card as unrestricted. The Fund also accurately entered on the Silver State ledger card the 250 unrestricted shares of Silver State that it acquired as a dividend in 1993 (Tr. 304). The Fund listed the Premier shares that it acquired in the Impostors private placement on the Silver State ledger card with the 750 unrestricted Silver State shares that it had acquired previously. However, the listing erroneously identified the shares as unrestricted (Tr. 304). As Rockies Fund acquired additional restricted shares of Premier, it erroneously listed them as unrestricted (Tr. 304). Calandrella did not learn of the discrepancy until late in 1995 (Tr. 304-05).
I cannot credit Calandrella's explanation that the misclassification was merely an innocent and excusable clerical error. KPMG had discussed its management comment letter with the Fund after the 1993 audit, and the topics included the faulty documentation of restricted securities (Tr. 522; JX 3 at 2579-81). In addition, the Commission staff's deficiency letter had specifically warned the Fund of the need keep accurate ledger accounts for each portfolio security, and to note any conditions on the sale of a portfolio security (CWX 151). Calandrella's response to the deficiency letter, as well as an internal Fund memorandum, and the hearing testimony by a Fund employee, all gave hollow assurances that the staff's admonition had been taken to heart and the problem corrected (Tr. 812-14, 817-18; CWXs 152, 153).
For year-end 1994, the audit approach document required the auditors to "review client classification of securities for appropriateness" (JX 1 at 1379). The auditors mistakenly believed that TrustCorp, an affiliate of Davidson in Great Falls, Montana, would have custody of all restricted stock certificates owned by Rockies Fund (JX 2 at 1735). The auditors sent a confirmation request to TrustCorp, asking among other things whether the securities it held for Rockies Fund were restricted or not (Tr. 67; JX 1 at 1529). TrustCorp confirmed that it held 750 shares of Premier (listed as Silver State on the reply) and that those 750 shares were not restricted (Tr. 107, 464; JX 2 at 1753-54). Apart from this one confirmation, however, the 1994 auditors relied on management's representation about whether the Fund's holdings of Premier securities were properly classified as unrestricted. They performed no audit steps to test this management representation.
In addition to TrustCorp, Hammer wrote and telephoned several other parties to verify the existence of certain Premier securities that Rockies Fund claimed to own, but she never asked these parties whether the securities were restricted or unrestricted (Tr. 58-59, 65-68, 70-76, 78-79, 83, 105-07, 175; JX 1 at 1411, 1559, JX 2 at 1736-37, 1742). Young could not even explain what a restricted security is, and could not recall if he performed any audit steps to test the classification of Premier securities as restricted or unrestricted (DX 148 at 25-30, 76-77, 85).
Wallace admitted that the work papers for the audit do not document any steps performed to test whether the Fund's Premier securities were restricted, other than the correspondence with TrustCorp (Tr. 479-81, 780-83). Wallace simply assumed that Young, Hammer, and Mah had confirmed with third parties whether the Premier stock was restricted or not (Tr. 479-80, 499-500, 712). However, there is no evidence of conversations between Wallace, on the one hand, and Young, Hammer, or Mah, on the other hand, to justify this assumption (Tr. 65-68, 480). Wallace, like Hammer, knew that Rockies Fund had purchased significant blocks of Premier securities directly from the issuer or in other private transactions (Tr. 79, 486, 501-02; DX 11 at 79, 94, 101-02, JX 2 at 1710-13). Wallace acknowledged that such information should have alerted him to the restricted status of the securities (Tr. 781-82).
The custodial requirements of Section 17(f) of the Investment Company Act apply to BDCs under Section 59 of the Investment Company Act. The fact that the presumed primary custodian did not have the bulk of the Premier shares that Rockies Fund claimed to own, coupled with the fact that Fund management claimed that its Premier securities were unrestricted, should have caused the auditors to take special care concerning the remaining Premier securities. I find that, following receipt of TrustCorp's response, the auditors' approach to the confirmation of the restricted status of the Fund's Premier securities was poorly designed, poorly executed, and poorly evaluated.
The 1994 Audit Did Not Test The
Fund's Valuation Of Premier At $2.25 Per Share
Rockies Fund valued its Premier shares at $2.25 as of year end 1994. An attachment to the board's consent resolution stated that this figure represented the "quoted market value" (Tr. 298, 321; DX 6 at 8).
The auditors confirmed from two sources that $2.25 was in fact the bid price for a share of unrestricted Premier stock on December 30, 1994. The auditors corresponded with Hanifen and followed up with a telephone call to that firm's director of compliance. They learned that $2.25 was the bid price in the National Quotation Bureau, Inc.'s "pink sheets" (JX 2 at 1757). As a separate matter, the auditors checked with TrustCorp, which advised that the "market value" of the 750 shares of Silver State it held was $1,687.50 as of year end 1994-a figure which equates to $2.25 per share (Tr. 95-96; JX 2 at 1754). Evidence presented at the hearing was to the same effect. Pink sheet quotations provided by the National Quotation Bureau confirmed that the bid price for Premier on December 30, 1994, was $2¼ per share and that the ask price on that day was $3 per share (DX 17).19
There, however, the auditors stopped. The 1994 work papers indicate that no testing was done of the nature of the markets for securities such as Premier that were valued based on prices provided by Hanifen or TrustCorp. See JX 2 at 1737, tick mark 2 ("[t]o determine 12/31/94 market valuation, KPMG agreed the description and market value to the TrustCorp confirmation or the Hanifen confirmation, without material exception. Market value appears to be properly stated at 12/31/94. Further test work [not considered necessary]"). The auditors never inquired as to the number of market makers (Tr. 55-57, 487). They did not ask about the quantity of shares the $2.25 bid price represented (Tr. 494-95). They made no effort to determine Premier's trading volume or the prices at which trades had occurred (Tr. 60-62, 487, 489).
The board minutes and consent resolutions do not identify the documents the Fund's board purportedly consulted when valuing its portfolio. The work papers do not identify the materials the auditors purportedly reviewed during the field work. Hammer nonetheless wrote: "KPMG examined the support used by the [Fund's board] in determining their valuations as considered necessary and as available" (JX 1 at 1496). Once again, Hammer composed an audit note that obscured rather than clarified an important point. The statement tells the reader little about what she "considered necessary" and less about what was "available."
The testimony on this significant issue was either vague or unbelievable. In response to leading questions, Hammer confirmed that she "performed that procedure" (Tr. 157-58) and Wallace confirmed his understanding that the junior auditors had "access" to the underlying documentation of valuation (Tr. 703-04). Wallace did not know what, if anything, the junior auditors actually read. Haddad also testified in generalities. The most she could say was that the junior auditors asked her for "that type" of document, referring to Forms 10-Q and 10-K for the portfolio companies (Tr. 810, 824-25). Young exhibited a very faulty memory when questioned on this issue, and he offered numerous "I don't recall" answers (DX 148 at 68-70, 101). His testimony was not even remotely credible. Calandrella admitted that the Fund's board knew there was no possibility of selling its entire Premier portfolio into the market at the bid price (Tr. 358, 375-76).
The Class D warrants, which Rockies Fund had acquired less than four weeks before the end of 1994 at no cost, authorized the Fund to purchase 150,000 shares of Premier stock at approximately 50% of the year-end bid. The Fund valued these warrants on its financial statements at $168,750. That was 7% of its assets and 10% of its securities portfolio, and was well in excess of the audit gauge of $33,000. This was a most unusual transaction: warrants are rarely issued by themselves, but rather, as "sweeteners" to make some other security a more attractive investment. Even though the Fund and Premier were affiliates, the auditors gave minimal scrutiny to this transaction (JX 2 at 1714, 1775-76).20
The 1994 Audit Report
KPMG issued its independent auditors' report, addressed to Rockies Fund's shareholders and directors, on March 20, 1995 (DX 6). Wallace signed the report on behalf of KPMG. With respect to the Fund's statement of assets and liabilities, and its schedules of investments as of December 31, 1994, the auditors reported (DX 6, financial statements, at 1):
In our opinion, the financial statements and schedules referred to above present fairly, in all material respects, the financial position of [the Fund] as of December 31, 1994 and 1993, and the results of its operations, its cash flows, and changes in its net assets for the years then ended in conformity with [GAAP].
As discussed in Note 1, the financial statements and schedules include investments valued at $867,724 and $781,148 at December 31, 1994 and 1993, respectively, whose values have been estimated by the [Fund's board] in the absence of readily ascertainable market values. We have reviewed the procedures used by the [Fund's board] in arriving at its estimate of value of such investments and have inspected underlying documentation and, in the circumstances, we believe the procedures are reasonable and the documentation appropriate. However, because of the inherent uncertainty of valuation, those estimated values may differ significantly from the values that would have been used had a ready market for the investments existed, and the differences could be material.
Footnote 1(b) to the report stated, in pertinent part (DX 6, financial statements, at 13):
Investments in restricted securities are carried at estimated fair value as determined in good faith by the [Fund's board]. Estimated fair value of restricted securities at December 31, 1994 and 1993 totaled $867,724 and $781,148, respectively. Investments in unrestricted securities are valued at the last sale price, or in the absence of sales, at values based on the closing bid price.
Wallace Did Not Require The Fund To Restate And Did Not
Withdraw KPMG's Opinion After Learning Of The Misclassification21
Neuman eventually caught the Fund's misclassification of Premier securities. He notified Calandrella, who immediately alerted the Fund's board (Tr. 305). Wallace's expert witness assumed that Rockies Fund disclosed the restricted classification of its Premier holdings in its September 30, 1995, Form 10-Q, but that is only half right (Tr. 892-94). In fact, that quarterly report made contradictory and confusing claims about whether Rockies Fund's Premier securities were restricted or not (DX 9 at 7, 16).
According to Calandrella, the Fund's board determined that a discount of the fair value of the Premier shares was not appropriate following the discovery of the misclassification (Tr. 306). The reasons for this conclusion were that Premier was worth more as a private company than it was in the public market; Rockies Fund owned a large position in Premier and could control its destiny; Premier stock was illiquid; Premier had held discussions about combining with a competitor, so that Premier could benefit from the competitor's higher market capitalization; and Rockies Fund knew that outside investment groups had expressed interest in acquiring Rockies Fund's position in Premier during 1995 (Tr. 306). In Calandrella's and the board's judgment, the misclassification was not material. As a result, the board maintained its prior valuation of the Fund's Premier securities (Tr. 306).
Premier had undergone a one-for-four reverse stock split in March 1994, and it was planning another one-for-five reverse stock split as part of its proposed public offering (Tr. 336; DX 55 at F-13, F-15). Reverse stock splits are often a tacit admission by management that a stock's price is unlikely to appreciate on its own. Managements use reverse stock splits to boost the stock price to meet the minimum price for exchange trading eligibility, and to make the stock appear more attractive to analysts and investors. Calandrella did not mention if the Fund's board took this evidence of corporate pessimism into account when deciding not to revalue Premier for year-end 1994.
Wallace learned of the misclassification late in 1995 (Tr. 531, 730). When asked if the discovery rendered footnote 1(b) of the 1994 audit opinion materially inaccurate as to the value of the Fund's restricted securities, Wallace delicately acknowledged "that particular number was no longer applicable" (Tr. 491). Wallace testified that he "challenged" Calandrella as to why the Fund should not change its valuation of Premier securities (Tr. 531). As the two men reviewed the situation, Wallace "became comfortable that the value used by the Fund's board at 12/31/94 was within the range of fair value for those securities that would be reasonable" (Tr. 531). In Wallace's view, there was not much difference between the value of restricted or unrestricted securities in a very thinly traded and illiquid market. For that reason, he believed the position of the Fund's board was reasonable and that restatement of the Fund's 1994 financial statements was not warranted (Tr. 531).
Wallace and Calandrella discussed "at length" the possibility of restating the 1994 financial reports (Tr. 532, 730). Wallace also raised the issue with Robison, his partner at KPMG. According to Wallace, Robison did not object to the manner of proceeding that Wallace had determined (Tr. 689, 730).22 Wallace confined his inquiries on this subject to Calandrella and Robison. He never approached the two independent members of the Fund's board, even though valuation decisions required the approval of a majority of the independent directors. Wallace never saw any documentation from the Fund's board (Tr. 532). Nor did he perform even minimal audit procedures on his own, such as reviewing the 1994 work papers (Tr. 537-38). Despite the fact that Wallace was considering the need for the Fund to revise its financial statements in a critical audit area, he did not memorialize in writing his conversations with Calandrella or Robison. Nor did he cause anything to be put in the 1995 work papers on the subject (Tr. 798-99). In his investigative testimony in June 1996, given only a few months after his conversation with Calandrella, Wallace never mentioned the litany of factors Calandrella identified at the hearing as justifying the decision not to restate the 1994 financials or withdraw the opinion (compare Tr. 306 with Tr. 537-40).
The explanation offered by Calandrella and Wallace depends entirely on the dubious credibility of these two witnesses. Calandrella's testimony about the rationale for declining to change the valuation of Premier's securities undoubtedly reflected Calandrella's thinking at the time of the hearing; however, there is no documentary evidence that it reflected the thinking of the Fund's board when the misclassification was discovered in late 1995. The reasons identified by Calandrella were not described in any contemporaneous board resolutions. Nor were they memorialized in the minutes of any board meetings. In addition, Calandrella's practice was to bypass the other two directors: recall that he never asked the other members of the board to ratify his selection of outside auditors until the Commission's staff examination compelled him to do so.
The testimony of Calandrella and Wallace leaves the impression that Wallace's decision not to require the Fund to revise its 1994 financial statements was made entirely on its accounting merits, and without regard for the professional fees a revision would incur. The record is silent as to how much a revision would have cost the Fund, and whether the Fund was willing to pay that amount. There is no evidence that Wallace expressed a willingness to donate KPMG's services to such an endeavor during his lengthy discussions with Calandrella.
The 1995 Audit
On December 31, 1995, Rockies Fund claimed total assets of $2,186,787, including a securities portfolio worth $1,400,374 (DX 10, financial statement, at 2). The Fund's Premier securities holdings consisted of 431,750 shares of common stock, which the Fund's board ultimately valued at $0.625 per share (DX 13 at 5657). All warrants had either expired or were below the exercise price. The total claimed value of these Premier securities was $269,845 (DX 10, financial statement, at 5). The Fund classified all its Premier securities as restricted (Tr. 508).
Planning And Staffing The 1995 Audit
In their 1995 planning memorandum, the auditors identified three critical audit areas: investment valuation, the Commission's investigation, and going concern issues (JX 3 at 2171). Investment valuation was deemed critical because of the subjectivity involved in determining the value of the Fund's investments, the lack of available market prices for those investments, and the materiality of the investment valuations to the financial statements. The Commission's investigation was considered critical due to the potential impact to the financial statements and the Fund if charges were to be filed. Because the Fund had net operating losses, negative cash flow from operations, and accumulated deficit in the current and prior years, and because a significant portion of the Fund's securities were restricted and not currently salable, the auditors also considered it critical to review a management-prepared analysis which substantiated the Fund's ability to continue as a going concern. The planning memorandum also identified investments as a significant audit area, given their materiality to the financial statements (JX 3 at 2172).
Wallace was again the engagement partner on the 1995 audit and Robison was again the SEC and concurring review partner (Tr. 425, 728-29). Tanya Terrion was the audit manager and Wendy Traiger was the accountant-in-charge. Brian Campbell was the staff accountant (JX 3 at 2173).
Wallace estimated that KPMG's audit fee for 1995 would be $14,500, including expenses (JX 3 at 2182). The audit gauge was $30,000 (JX 3 at 2170). The auditors budgeted 126 hours for the 1995 audit, matching the time they had spent the previous year. However, by March 18, 1996, they had spent 162 hours on the engagement. Traiger spent 120 hours on the audit and Campbell spent forty hours (Tr. 963-64; JX 3 at 2465). The work papers do not document the time Terrion and Wallace devoted to the engagement, but Wallace testified that he spent ten to twelve hours on the audit (Tr. 559).
Two Of The Three Critical Audit Areas
From The 1995 Audit Are Not Challenged
As in 1994, the auditors again conducted a going concern review and concluded that Rockies Fund would be able to generate cash and continue to operate (Tr. 726-27; JX 1 at 1494, JX 3 at 2202, 2298). They also added a "liquidity footnote" to the 1995 financial statements (DX 10, financial statements, at 13, note (1)(a)):
As shown in the accompanying financial statements, the [Fund] incurred net investments losses and had a net use of cash from operations in 1995 and 1994. The [Fund] may be required to liquidate investments and obtain debt or equity financing to fund operations in the future.
The Division does not challenge the procedures or conclusions in connection with the auditors' going concern analysis (Tr. 600).
The auditors contacted two law firms with respect to the ongoing Commission investigation of the Fund, and obtained from each a letter discussing the status of the investigation (Tr. 698-700; JX 3 at 2310-14, 2317-22, 2324-31). In addition, the auditors received and reviewed a copy of the Commission's order of investigation. With the assistance of the Fund's attorneys, the auditors then drafted a footnote for the financial statements to disclose the status of the investigation (DX 10, financial statements, at 17, note 5):
During 1995, the [Fund] received requests for information from the [SEC] related to an investigation begun by the SEC during 1994 into various matters, including the administrative and record keeping practices of the [Fund], its securities trading activities and those of one of its officers. As of March 15, 1996, neither management of the [Fund] nor the [Fund's] legal counsel have been informed of the results, if any, of the SEC's investigation or of any timetable for the SEC to complete its investigation. There can be no assurance as to the outcome of this matter or the ultimate effect on the [Fund's] financial position.
The Division does not take issue with the auditors' handling of this critical audit area (Tr. 599-600).
More Alleged Red Flags: Inconsistent Quarterly Valuations
Rockies Fund used inconsistent methods to value its Premier stock in 1995. In the quarters ending March 31, 1995, and June 30, 1995, the Fund valued Premier at $1.50 per share, allegedly a market quote, when the bids on the valuation dates were only $1.00 (DX 7 at 16, DX 8 at 16, DX 16, DX 17). For the quarter ending September 30, 1995, the Fund valued its Premier shares based on a purported market quote of $0.875 per share, when in fact the three bids on the valuation date were $0.25, $0.375, and $0.75 (DX 9 at 16, DX 16, 17). The board consent resolutions gave no reasons for these departures from the board-adopted valuation policy statement (DX 12). Had the auditors read the quarterly reports, the discrepancies would have alerted them to the fact that the Fund was not following any of its several different valuation methodologies. However, as discussed above, the Division has not established that the auditors had a duty to read these interim reports.
The 1995 Audit Did Not Test The Fund's Valuation Of Premier At
$0.625 Per Share And The Auditors Did Not Know What That Figure Represented
The rationale for the $0.625 per share valuation of Premier at year-end 1995 is perhaps the single murkiest factual issue in the case. Calandrella thought that $0.625 was the closing bid on the last trading day of the year (Tr. 311, 313, 359-60, 364). Wallace also assumed, but took no steps to verify, that the figure was the year-end closing bid (Tr. 514-15; JX 4 at 2643). The auditors asked Hanifen to provide an unidentified "market price" for the Fund's portfolio securities as of year-end 1995 (JX 3 at 2428-29). The handwritten reply from Hanifen merely stated that, as to Premier, the "year end price" was 5/8 (or $0.625) (JX 4 at 2644). Hanifen's confirmation did not explain what that price represented (Tr. 516-17). As a separate matter, the auditors also confirmed that TrustCorp was holding 138,688 shares of Premier. TrustCorp reported a "market price" for those shares of $86,680, which equated to $0.625 per share (JX 4 at 2646). At this juncture, however, the auditors ended their inquiry.
Cecelia Fiske, a NASD compliance examiner, opined that there were two published bids for Premier on December 29, 1995: one from Frankel at $0.375 and another from Paragon at $0.25 (Tr. 9, 22-23; DX 16 at 4664). Each of those bids was firm only for 5,000 shares. According to Fiske, there never was an actual bid of $0.625 on December 29, 1995, although an "inside bid" at that level was erroneously published by NASD.23
To understand the events of December 29, 1995, it is important to consider NASD's quote report overview (DX 16) in the context of NASD's trade report overview (DX 14) and NASD's inside quote and detail trade audit trail (DX 20 at 19).24 The Division did not ask Fiske to harmonize these documents.
I agree with Respondent that DX 16 is confusing. For example, DX 16 leaves the impression that Frankel opened the day with a bid of $0.375 and never budged from that level for the rest of the trading day. That was not the case. At 1:25 p.m., Frankel, acting as principal, bought 5,000 shares of Premier at $0.625 from Canacord Capital Corporation, acting as agent (DX 14). At 1:31 p.m., Frankel, acting as principal, sold 5,000 shares of Premier at $0.65625 to Paragon, acting as agent (DX 14).
December 29, 1995, was an unusually active day for over-the-counter trading in unrestricted Premier common stock. Between 1:25 p.m. and 1:51 p.m. Eastern time, 31,000 shares changed hands in five separate transactions (DX 14, DX 20 at 19). The last trade of the day-and of the year-took place at 1:51 p.m., when Paragon, acting as principal, bought 8,000 shares of Premier at $0.625 per share from J.W. Charles Securities, Inc., acting as agent (DX 14, DX 20 at 19). Following that trade, at 1:53 p.m., Paragon scaled back its bid to $0.25 per share (DX 16 at 4664). I note that DX 16 is silent as to Frankel's position in the market after the 1:31 p.m. trade. There is no evidence that Frankel restated its opening bid of $0.375, in the same way that Paragon later restated its opening bid of $0.25 (DX 16 at 4664). I find that Frankel withdrew entirely after its 1:31 p.m. trade, leaving Paragon as the only firm making a market in Premier. I further find that the reported inside bid of $0.375 at and after 1:53 p.m. is entitled to limited weight because there is no corresponding market maker.
I find from these facts that the last trade at 1:51 p.m. served as the basis for the Fund's year-end valuation of Premier. The closing bid on December 29, 1995, had nothing to do with the chosen valuation. I further find that, from 1:53 p.m. onward, Paragon's bid of $0.25 per share should not be characterized as the low bid, but as the only bid.
After reviewing all three documents, I find that the last sale price of $0.625 was one of several possible legitimate measures of the value of up to 31,000 shares of unrestricted Premier stock on December 29, 1995. However, it was not the valuation that the Fund had described in any of its written valuation methodologies. Nor was it the valuation that Calandrella insisted the Fund's board would apply under the circumstances presented (Tr. 322-23). I also find that the auditors did not understand the basis for the valuation (JX 4 at 2642). The $0.25 closing bid for 5,000 unrestricted shares of Premier should have represented the start of the valuation process for the Fund's 431,750 restricted shares of Premier. The same is true for the audit that was supposed to test management's valuation methodology.
Other Audit Failures
First, the Fund consummated the purchase of 200,000 shares of restricted Premier stock on December 19, 1995, at $0.25 per share. At year-end 1995, the Fund valued these securities at $0.625 per share. The auditors did nothing to scrutinize this instant appreciation of $75,000 in only twelve days.
Second, Wallace explained that he did not consider the purported demand registration rights attached to these 200,000 shares to be significant to the value of the shares (Tr. 505-07). He made no effort to determine if in fact there were any demand registration rights. Nonetheless, a footnote to the schedule of investments in the Fund's 1995 Form 10-K stated with respect to Premier that certain shares were free trading as a result of such demand registration rights (DX 10, financial statements, at 7).
Third, the auditors maintained that, in testing the value of restricted securities, they discussed valuations with the client and analyzed the financial statements and other operating information for the portfolio companies (JX 3 at 2203). However, neither Wallace nor Haddad knew what specific Premier documents the auditors had reviewed during the field work (Tr. 450, 778-79, 824-25). The 1995 work papers are silent. Both sides identified two prospective witnesses who could have shed light on the subject-Traiger and Terrion. Wallace also named Campbell as a prospective witness. However, the parties elected not to call any of these witnesses to testify.
The 1995 Audit Report
KPMG issued its independent auditors' report, addressed to Rockies Fund shareholders and directors, on March 15, 1996 (DX 10).25 Wallace again signed the report for KPMG. With respect to the Fund's statement of assets and liabilities, and its schedule of investments as of December 31, 1995, the auditors reported (DX 10, financial statements, at 1):
In our opinion, the financial statements and schedules referred to above present fairly, in all material respects, the financial position of [the Fund] as of December 31, 1995 and 1994, and the results of its operations, its cash flows, and changes in its net assets for the years then ended in conformity with [GAAP].
Footnote 1(b) to the report stated, in pertinent part (DX 10, financial statements, at 13-14):
In the absence of readily ascertainable market values, investments in restricted securities without quoted market prices are carried at estimated fair value as determined by the [board]. Due to the inherent uncertainty of valuation, those estimated values may differ significantly from the values that would have been used had a ready market for the investments existed, and the differences could be material. Investments in unrestricted securities and restricted securities with quoted market prices are valued at closing bid price . . . . Estimated fair value of restricted securities at December 31, 1995 and 1994 totaled $1,215,965 and $1,551,466, respectively.
The explanatory language that had appeared in the text of the 1994 audit report moved to the footnote in the 1995 audit report because of a change in applicable accounting guidelines (Tr. 635-36, 704-05). The change in location is not significant for purposes of this case.
The statement that estimated fair value of restricted securities at December 31, 1994, totaled $1,551,466 was not accurate. The corresponding figure reported in footnote 1(b) to the financial statements in the 1994 Form 10-K was $867,724 (DX 6, financial statements, at 13). Most of the difference-but not all-came from the reclassification of Premier shares as restricted for 1995.
The 1995 Management Comment Letter
On March 15, 1996, the auditors also issued a management comment letter in connection with the 1995 audit and directed it to Rockies Fund's board (JX 3 at 2388-90). Such letters are not required by GAAS but are provided as a client service (Tr. 706). In the 1995 management comment letter, the auditors noted that during their analysis of investment valuation they had encountered an instance where the Fund's investment valuation policy was not followed and where a year-end adjustment was required to value the investment in a manner consistent with the Fund's policies (JX 3 at 2388). The sentence referred to the Fund's initial valuation of Premier at $0.75 per share, which Wallace suggested that the Fund's board decrease to $0.625 per share (Tr. 522, 738). In the management comment letter, KPMG recommended that Rockies Fund "continually review and update [its] investment valuation policies to establish consistency from year to year" and that "all amendments to the investment valuation policy should be reviewed and approved by the Board of Directors" (JX 3 at 2388). According to Wallace, the letter was a prospective recommendation and did not indicate that the auditors had found that an amendment had been made to the investment valuation policy that had not been approved by the Fund's board (Tr. 523).
Expert Witnesses
Jerome L. Duffy, CPA, appeared for the Division as an expert on securities valuation (DX 144). Duffy's professional experience includes nine years with Arthur Young & Co., Inc., and twenty-five years with Kemper Financial Services, Inc. (Kemper). At Kemper, he supervised a staff of sixty, and served as treasurer and chief accounting officer for eighty-six mutual funds with combined assets of over $49 billion (Tr. 381-82). Duffy has experience as a member of the committee that revised the AICPA Audit and Accounting Guide: Audits of Investment Companies (1994) (AICPA Audits of Investment Companies). He was also a member of an Investment Company Institute task force concerning the valuation of securities.
In Duffy's judgment, restricted securities should always be valued at less than the unrestricted shares of the same issuer, unless both are valued at zero, or unless there is a firm commitment to sell the restricted shares in the near future at a price equal to or higher than the value of the unrestricted (Tr. 383, 413-15). Duffy did not address the issue of whether the Fund's $2.25 valuation was appropriate for its 750 unrestricted shares of Premier at year-end 1994. Nor did he identify a specific discount from the bid for an unrestricted share that he considered applicable to the Fund's holdings of Premier in either 1994 or 1995. Instead, he opined that Rockies Fund's valuation of restricted Premier shares at $2.25 for year-end 1994 was inappropriate, and that restricted Premier shares should have been valued at cost. Among the factors he cited were Premier's large operating losses in 1994, the thin and illiquid market for its shares, and the fact that there were no tender offers or merger proposals (DX 144 at 3-5).
Duffy opined that the Fund's valuation of restricted Premier shares at $0.625 for year-end 1995 was also improper. He noted that the trading market for Premier shares remained thin and illiquid, with Rockies Fund's restricted holdings more than triple the entire year's trading volume. He also cited the absence of any tender offers or merger proposals. Duffy believed that cost was no longer an appropriate basis for valuation of restricted Premier shares by year-end 1995. Rather, he concluded that restricted Premier shares should have been valued at some point below the $0.25 bid price on the last trading day of the year, consistent with his understanding of the Fund's policy to use the low bid for valuation. Duffy did not believe that there were any extraordinary circumstances that justified the Fund's valuation of restricted Premier securities at the bid price for unrestricted Premier securities for year-end 1994 or 1995 (Tr. 385-86; DX 144 at 5-6).
Duffy acknowledged that the Fund could have established a reasonable valuation policy for unrestricted securities anywhere between the bid and ask prices (Tr. 411-13). He also testified that a hypothetical board might properly consider all of the factors that Calandrella said that the Fund's board did consider in fair valuing Premier (Tr. 392-94).
Duffy's testimony was helpful, as far as it went. However, it stopped short on two important issues. First, Duffy did not opine as to how the Fund's board should have valued Premier under the methodology described in the Fund's 1983 prospectus. He confined his analysis to the 1994 and 1995 board policy statement, but he did not explain why that methodology, out of many methodologies, should assume primacy. Second, Duffy did not opine on whether the resulting differences between the board's valuations of restricted Premier shares and his own valuations of such shares were of sufficient magnitude to be "material."
Gordon Yale, CPA, testified for the Division as an expert on GAAP and GAAS. Yale was employed by an accounting firm that worked on about thirty audits of public companies, in addition to audits of brokers, dealers, and investment companies (Tr. 560-61). He was the manager, but not the engagement partner, on approximately twelve investment company audits and ten broker audits involving valuation issues (Tr. 561, 563). Yale has a wide range of other experiences in his professional career, including periods as a litigation consultant, investment banker, financial executive, and newspaper investigative reporter (DX 146).
Yale opined that the 1994 and 1995 Rockies Fund financial statements did not conform to GAAP and that the 1994 and 1995 audits did not conform to GAAS. In his view, these departures from auditing standards caused an overstatement of the value of the Fund's Premier holdings and caused the auditors to fail to catch the misclassification of Premier stock in 1994. Yale also opined that Wallace should have insisted that the Fund revise its 1994 financial statements, and that Wallace should have then issued a revised auditor's report.
Yale accused Respondent of "flagrant," "blatant," "egregious," "serious," "irresponsible," and "unconscionable" departures from GAAP and GAAS (DX 146). At other times, Yale opined that Wallace "knew or should have known" of deficiencies in the Fund's valuation procedures and KMPG's audit procedures. Despite the use of such language in his written report, Yale declined to express the opinion that either of the two audits was "reckless" (Tr. 563-65, 573). Unlike Duffy, Yale characterized the degree of error in the Fund's financial statements as "material" (DX 146 at 1,2,4,8). However, Yale did not explain the standard of materiality he used to form that opinion.26
Richard L. Smith, Ph.D., testified for Wallace as an expert on valuation issues (CWX 189). He holds a Ph.D. in Business Economics and a M.A. in Economics from the University of California at Los Angeles, and an M.B.A. in Finance from Washington University. Smith is a professor of financial management at Claremont Graduate University, where he is also Director of the Venture Finance Institute (CWX 189 at Ex. 1). He teaches graduate level courses in entrepreneurial finance and new venture finance. His research and academic writing focuses on topics related to the transition between private and public companies (Tr. 881-85).
Smith offered three opinions: (1) the Fund's description of its Premier holdings as unrestricted in the 1994 Form 10-K did not mislead investors about the value of the Fund; (2) the valuations by the Fund of its Premier holdings in the 1994 and 1995 Forms 10-K were reasonable and did not present a danger of misleading Fund investors about the value of the Fund; and (3) an alternative valuation by the Fund of its Premier holdings, as proposed by the Division and Duffy, would not affect the Fund's value to any significant degree because Rockies Fund is a closed-end management company and the market value of a closed-end fund can differ from its net asset value for reasons like tax considerations and managerial capability. Smith proceeded from the assumption, not supported by the record, that the Fund's board actually did use fair value methods for Premier. Smith's testimony is considered in more detail below.
A. Marvin Strait, CPA, testified for Respondent as an expert on GAAP and GAAS. Over his forty-year accounting career, Strait has signed several hundred audit reports, but none involving Commission registrants (Tr. 923, 925). Strait has been chairman of the board of directors of the AICPA, president of the Colorado Society of CPAs, and president of the Colorado State Board of Accountancy (CWX 191). He is also a certified valuation analyst. Strait serves on the board of directors and the audit committee of a public company (Tr. 922-24).
In Strait's view, the 1994 and 1995 audits of Rockies Fund were performed in accordance with GAAS, the auditors had a reasonable basis for their opinions that the Fund's 1994 and 1995 financial statements were in accordance with GAAP, and it was reasonable for the auditors to conclude that there was no need to revise the 1994 financial statements. Given Rockies Fund's substantial investment in Premier, the free flow of information from Premier to the Fund, and the fact that Premier's shares were thinly traded, the auditors also had a reasonable basis to conclude that the fair value of restricted Premier shares was equal to the bid price for unrestricted Premier shares. Finally, Strait gave heavy emphasis to the substantial number of audit procedures KPMG performed. He opined that the criticisms expressed by the Division's experts were no more than disagreements with informed judgments that Wallace made during the course of the audits. In Strait's opinion, none of the challenged judgments reflected recklessness on the part of Wallace.
Strait has testified for KPMG in another administrative proceeding and in a deposition,27 leading the Division to criticize him as a "biased partisan" and as KPMG's "house expert." Those harsh appraisals are not warranted. However, I was troubled that some of Strait's opinions rested on facts not established by the record (Tr. 940). Of particular concern were his assumptions that the Fund's board "considered everything" when valuing Premier (Tr. 932) and that "[t]he auditors understood that the [Fund's] board considered an extensive body of information in its review of the Fund's investments" (CWX 191 at 9). The issue is whether the auditors performed appropriate tests to verify that understanding.
DISCUSSION AND CONCLUSIONS
1. In attempting to show that Wallace was at least 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." 50 S.E.C. 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." 52 S.E.C. 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, Checkosky II, 139 F.3d 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. 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)
Wallace argues that the Commission is estopped from retroactively applying Rule 102(e)(1)(iv)(A) to professional conduct that occurred in 1994 and 1995 (Answer at 4). He believes that the Commission must measure his 1994 and 1995 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."
The OIP in this case charges that Wallace "intentionally, knowingly, or recklessly violated applicable professional standards." However, the OIP only cites to Rule 102(e)(1)(ii), not to Rule 102(e)(1)(iv)(A). If the wording of the OIP was designed to finesse a troublesome issue-by omitting any suggestion that the 1998 rule amendment was being applied retroactively-that subtlety has apparently been lost on the Division. See Div. Prehearing Br. at 14 and Div. Br. at 1, 36, which state that the proceeding was brought pursuant to Rule 102(e)(1)(iv)(A).29 Based on the Division's representations, I conclude that 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 Landgraf, 511 U.S. 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 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"); see also supra note 18.
In the two 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); Russell Ponce, 73 SEC Docket 442, 465 n.52, 467 n.57 (Aug. 31, 2000), appeal filed, 9th Cir., No. 00-71398; see also Potts v. SEC, 151 F.3d 810, 812-13 (8th Cir. 1998) (recklessness by a concurring review partner), cert. denied, 526 U.S. 1097 (1999). 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).
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 Wallace contends that he had no idea, prior to October 19, 1998, that reckless violations of professional auditing standards would be treated as "improper professional conduct," or if he believes that Checkosky II, Koch, Upton, or Carter compel a different result on the retroactivity or fair notice issues, he 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 David Disner, 52 S.E.C. 1217, 1222 & n.20 (1997); 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). 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.30 First, violations of GAAP, by themselves, do not constitute circumstantial evidence of scienter. See Chill v. General Electric 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 Management, 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 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 Management, 970 F. Supp. at 202; Price Waterhouse, 797 F. Supp. at 1242 & n.60. Fourth, 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 Sciences Corp., 9 F. Supp. 2d 925, 928-29 (N.D. Ill. 1998); Health Management, 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). 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. 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); Chalverus, 59 F. Supp. 2d at 234-35; 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 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 a Rule 10b-5 offense, 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. 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. In other situations, 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]."); see also 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. Paragraph IV.C of the instant OIP implicitly recognizes this, as it specifically alleges that the 1994 and 1995 financial statements of Rockies Fund "materially overstated net assets." The Division has assumed the burden of making that materiality showing, both at the hearing and in its pleadings (Tr. 646, 657-58; Div. Prop. Find. # 302-318, 432-455, Div. Br. at 21-22, 25-26, Div. Reply Br. at 17-19).
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. 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 arguments. 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,31 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 Wallace was reckless.32
Nor can the Division establish scienter by painting with too broad a brush. For example, the Division cannot win 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 v. Price Waterhouse Coopers LLP, 117 F. Supp. 2d 1003, 1012 (S.D. Cal. 2000) (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).
Likewise, each of the three alleged audit failures requires its own proof of scienter, and the Division cannot lighten its burden by urging that decision-makers consider Wallace's entire course of conduct over two years as an indivisible unit. This is not a case like Checkosky, where the Commission could find "repeated and accumulating indications" over several years that the audit client's product design was not ready for manufacture. See 50 S.E.C. at 1186 n.13, 1194. The OIP here alleges improper professional conduct during two different audit engagements. The junior auditors whom Wallace is charged with failing adequately to supervise were different in each engagement. In these circumstances, the Division's evidence that Wallace was reckless during the 1994 audit will not satisfy the Division's separate obligation to prove that Wallace was also at least reckless during the 1995 audit, or its separate obligation to prove that Wallace was also reckless when he determined not to require the Fund to revise its 1994 financial statements. Cf. Leflore Broad. Co. v. FCC, 636 F.2d 454, 463 (D.C. Cir. 1980) ("Where several violations are found, the [agency] should set forth the role each plays in the assessment of a penalty. Rarely should the agency be permitted to take a `gestalt' approach, one based upon a reaction to the `overall' situation rather than to each violation one at a time.").
2. Wallace violated GAAS by failing to plan and supervise those aspects of the audits dealing with the Fund's valuation of its Premier securities.
Paragraphs IV.D.1 and IV.D.5 of the OIP allege that Wallace violated GAAS by failing adequately to plan and supervise the audits and failing to exercise due professional care in performing the audits. The audits at issue encompassed much more than just the Fund's valuation of Premier securities within its investment portfolio. However, the Division alleges that Wallace violated the applicable professional standards only as to those aspects of the audits dealing with the Fund's valuation of its Premier securities, and not with respect to the audits in general.33
Applicable Professional Standards
The first general standard of GAAS states that the audit is to be performed by a person or persons having adequate technical training and proficiency as an auditor. The third general standard states that due professional care is to be exercised in the performance of the audit and the preparation of the report. The first standard of field work provides that the work is to be adequately planned and assistants, if any, are to be properly supervised. The second standard of field work provides that a sufficient understanding of the internal control structure is to be obtained to plan the audit and to determine the nature, timing, and extent of tests to be performed. AU § 150.02. The Codification of Statements on Auditing Standards offers authoritative interpretations of GAAS. See supra note 17.
The junior assistant, just entering upon an auditing career, must obtain his professional experience with the proper supervision and review of his work by a more experienced superior. The nature and extent of supervision and review must necessarily reflect wide variances in practice. The auditor charged with final responsibility for the engagement must exercise a seasoned judgment in the varying degrees of his supervision and review of the work done and judgment exercised by his subordinates, who in turn must meet the responsibility attaching to the varying gradations and functions of their work. AU § 210.03.
Supervision involves directing the efforts of assistants who are involved in accomplishing the objectives of the audit and determining whether those objectives were accomplished. AU § 311.11. The work performed by each assistant should be reviewed to determine whether it was adequately performed and to evaluate whether the results are consistent with the conclusions to be presented in the auditor's report. AU § 311.13.
Since the auditor's opinion on the financial statements is based on the concept of reasonable assurance, the auditor is not an insurer and his report does not constitute a guarantee. Therefore, the subsequent discovery that a material misstatement exists in the financial statements does not, in and of itself, evidence inadequate planning, performance, or judgment on the part of the auditor. AU § 316.08.
Conclusions
As the audit engagement partner, Wallace was ultimately responsibly for all aspects of both audits. Wallace's failure to develop appropriate audit programs is demonstrated by the absence of tests to verify the Fund's classification of its Premier securities in 1994 as unrestricted, and by the lack of inquiry as to what the market price of Premier stock represented in both years. Deficient supervision is illustrated by Wallace's failure to follow through on the review note he purportedly wrote to Young. See supra note 20. These failures, as well as others discussed throughout this decision, support the charge of failure to supervise.
There is no issue in the case about the technical training and proficiency of the junior auditors. The staffing decisions themselves were neither alleged nor shown to be a GAAS failure. The record is silent about the credentials and experience of the KPMG staff assigned to the 1995 audit. The Division does challenge the competence of Young and Hammer during the 1994 audit in its posthearing pleadings, but that issue was not identified in the OIP.34 Cf. Mishkin v. Peat, Marwick Mitchell & Co., 744 F. Supp. 531, 540-42 (S.D.N.Y. 1990) (rejecting a claim that the junior auditors had inadequate technical training and proficiency).
I decline to hold that Young was per se disqualified from serving as engagement manager on the 1994 Rockies Fund audit because he was a chartered accountant and not a CPA. No such evidence or opinion testimony was offered at the hearing. Moreover, the courts have recognized that a chartered accountant in Australia, Canada, and the United Kingdom is equivalent to a CPA in the United States. See Sstech Ry. Technol. Prop. Ltd. v. Herzog Servs., Inc., 1996 U.S. Dist. LEXIS 9146 at *30 n.10 (W.D. Mo. June 27, 1996); CNC Service Ctr., Inc. v. CNC Service Ctr., Inc., 753 F. Supp. 1427, 1431 (N.D. Ill. 1991); Faleck & Margolies, Ltd. v. Patrusky, Mintz & Semel, 1990 U.S. Dist. LEXIS 14624 at *2 (S.D.N.Y. Oct. 28, 1990). The Division is obviously frustrated that Young is beyond the reach of Rule 102(e), but that is not a basis for a ruling that could create havoc with international exchange programs.
Young completed his international rotation program with KPMG's Denver office in April 1995 and went home to New Zealand (DX 148 at 6, 8). He came back to Denver in August 1996 to testify in the Rockies Fund investigation and then returned to New Zealand. He was not employed by KPMG at the time of the hearing (Prehearing Conference of Aug. 26, 1999, at 8). I admitted the transcript of Young's investigative testimony into evidence under Rule 235(a)(2) of the Commission's Rules of Practice.
I have not placed much weight on Young's investigative testimony (DX 148). I did not find his many "I don't recall" answers very persuasive, particularly when those answers are compared with the testimony of Haddad, a witness with a more peripheral involvement in the case. However, Young did not testify in person and I am unable to make any demeanor-based credibility findings.
The Division urges me to take Young's evasive and incomplete responses during the investigation to make adverse inferences against Wallace. In effect, it asks me to treat Young's "I don't recall" testimony as if it were truthful, i.e., as if Young really never understood what restricted securities or market makers were. The Division then asks me to use that as evidence that Wallace placed an incompetent accountant in the role of 1994 engagement manager. I decline to do so. The transcript demonstrates that Young was an uncooperative witness and may well have been trying to obstruct the Rockies Fund investigation. However, there has been no showing that Wallace controlled Young at the time of Young's testimony, or that Wallace should now be held to account for Young's answers.
However, I do place weight on Wallace's terse evaluation of Young's 1994 audit performance as not more than "adequate" (Tr. 479). Wallace knew of Young's capabilities from several prior audits, as well as from his role in bringing Young to KPMG's Denver office and appraising Young's performance. In those circumstances, GAAS, as interpreted by AU § 210.03, required Wallace to exercise a greater degree of supervision over both Young and the far-less-experienced Hammer than was evident from the work papers and testimony.
3. Wallace violated GAAS by failing to maintain the required attitude of professional skepticism and by failing to obtain sufficient competent evidential matter.
Paragraphs IV.D.2 and IV.D.3 of the OIP allege that Wallace violated GAAS by failing to obtain sufficient competent evidential matter concerning the Fund's classification and valuation of its Premier securities. Paragraph IV.D.4 of the OIP alleges that he also violated GAAS by failing to maintain an attitude of professional skepticism when he ignored "indications" that the Fund's valuations of its Premier securities were inflated and when he failed to question representations about Premier's value that were made to the auditors by the Fund's management.
The Applicable Professional Standards
Professional skepticism. The third general standard of GAAS requires that due professional care must be exercised in the performance of the audit and the preparation of the report. An audit of financial statements in accordance with GAAS should be planned and performed with an attitude of professional skepticism. The auditor neither assumes that management is dishonest nor assumes unquestioned honesty. Rather, the auditor recognizes that conditions observed and evidential matter obtained, including information from prior audits, need to be objectively evaluated to determine whether the financial statements are free of material misstatement. AU § 316.16; see also Larry P. Bailey and Martin A. Miller, GAAS Guide § 7.47 (1993).
Confirmation is undertaken to obtain evidence from third parties about financial statement assertions made by management. AU § 330.06. When confirming management's assertions through third parties, the auditor should exercise an appropriate level of professional skepticism. Professional skepticism is important in designing the confirmation request, performing the confirmation procedures, and evaluating the results of the confirmation procedures. AU § 330.15.
As stated in the Audit Risk Alert-1993, General Update on Economic, Regulatory, Accounting and Auditing Matters, issued by the Auditing Standards Division of the AICPA:
Auditors should be skeptical about the answers they receive from management. Explanations received from an entity's management are merely the first step in an audit process, not the last. Listen to the explanation, then examine or test it by looking at sufficient competent evidential matter. The familiar phrase "healthy skepticism" should be viewed as a "show-me" attitude and not a predisposition to accepting unsubstantiated explanations. Auditors should document working paper notes and conclusions as if they will be challenged on them because a likelihood exists that this will occur.
While Audit Risk Alerts are prepared by the AICPA staff and not acted upon by a senior technical committee of the AICPA, they are intended to help auditors plan their audits, and auditors should carefully review and consider the issues discussed in the Audit Risk Alerts throughout the audit process. See MicroStrategy, 115 F. Supp. at 654 (finding that failure to heed an Audit Risk Alert contributed to a strong inference of scienter).
Sufficient competent evidential matter. The third standard of field work states "[s]ufficient competent evidential matter is to be obtained through inspection, observation, inquiries, and confirmations to afford a reasonable basis for an opinion regarding the financial statements under audit." AU § 150.02. Most of the independent auditor's work in forming his opinion on the financial statements consists of obtaining and evaluating evidential matter concerning the assertions in such financial statements. AU § 326.02.
During an audit, management makes many representations to the auditor, both oral and written, in response to specific inquiries or through the financial statements. Such representations from management are part of the evidential matter the independent auditor obtains, but they are not a substitute for the application of those auditing procedures necessary to afford a reasonable basis for his opinion on the financial statements. AU § 333.02. When considering related party transactions, in particular, audit procedures should extend beyond inquiry of management. AU § 334.09.
In the great majority of cases, the auditor finds it necessary to rely on evidence that is persuasive rather than convincing. AU § 326.20. An auditor typically works within economic limits; his opinion, to be economically useful, must be formed within a reasonable length of time and at reasonable cost. The auditor must decide, again exercising professional judgment, whether the evidential matter available to him within the limits of time and cost is sufficient to justify expression of an opinion. AU § 326.21. As a guiding rule, there should be a rational relationship between the cost of obtaining evidence and the usefulness of the information obtained. The matter of difficulty and expense involved in testing a particular item is not in itself a valid basis for omitting the test. AU § 326.22; see also Knapp v. Gomez, [1993 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 97,645 at 96,968 n.7 (S.D. Cal. May 5, 1993) (concluding that when the auditor cannot economically justify the required effort, the answer is to decline the project rather than to perform substandard work), aff'd, 90 F.3d 1431 (9th Cir. 1996); Public Oversight Board, A Special Report by the Public Oversight Board: Issues Confronting the Accounting Profession (SEC Practice Section of the AICPA) (1993) at 52 ("Audit firms have [an] obligation to refuse to perform audit services for fees that may compromise the integrity of the audit.").
If the auditor remains in substantial doubt about any assertion of material significance, he must refrain from forming an opinion until he has obtained sufficient competent evidential matter to remove such substantial doubt, or he must qualify or disclaim his opinion. AU § 326.23.
As to investment company portfolios, the independent auditor does not act as an appraiser for security values estimated in good faith by the client's board of directors, and is not expected to substitute his judgment for that of a fund's directors. Instead, the auditor should review the investment company's procedures for its continuing appraisal of such securities, determine whether the methods established for valuation are followed, and make certain that these methods have been reviewed and approved currently by the board of directors. The auditor should review the procedures applied by the directors in valuing such securities, and inspect the underlying documentation to determine whether the procedures are reasonable and the documentation appropriate for that purpose. AICPA Audits of Investment Companies § 2.157. Wallace recognizes that publication as authoritative (Tr. 435-36).
The concept of materiality is inherent in the work of the independent auditor. There should be stronger grounds to sustain the independent auditor's opinion with respect to those items which are relatively more important and with respect to those in which the possibilities of material misstatement are greater than with respect to those of lesser importance or those in which the possibility of material misstatement is remote. AU § 150.04.
Valuing restricted securities. The Fund's prospectus stated that the Fund's board, including a majority of the board's independent directors, would make portfolio valuation determinations at least quarterly. Section 2(a)(41) of the Investment Company Act provides that in determining net asset value, "securities for which market quotations are readily available" must be valued at current market value while other securities and assets must be valued at "fair value as determined in good faith by the board of directors." The Commission has recognized that there can be no automatic formula by which an investment company can value the restricted securities in its portfolio to comply with Section 2(a)(41) of the Investment Company Act. Restricted Securities, Accounting Series Release No. 113, [1937-1982 Accounting Series Releases Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 72,135 at 62,283 (Oct. 21, 1969) (ASR No. 113). It has emphasized that "readily available market quotations" refers to reports of current quotations for securities similar in all respects to the securities in question, and that "no such current public quotations can exist in the case of restricted securities. For valuation purposes, therefore, restricted securities constitute securities for which market quotations are not readily available. Accordingly, their fair market values must be determined in good faith by the board of directors." Id.
ASR No. 113 also provides guidance as to the accounting treatment to be afforded to restricted securities. The Commission has noted that restricted securities are often purchased at a discount, frequently substantial, from the market price of outstanding unrestricted securities of the same class. This reflects the fact that securities which cannot be readily sold in the public market place are less valuable than securities which can be readily sold, and also the fact that, by the direct sale of restricted securities, sellers can avoid the expense, time, and public disclosure which registration entails. Id. The Commission has recognized that, as a general principle, the current fair value of restricted securities would appear to be the amount which the owner might reasonably expect to receive for them upon their current sale, and it has cautioned that "the valuation of restricted securities at the market quotations for unrestricted securities of the same class would, except for most unusual situations, be improper." Id. The Commission has made clear that "it is the responsibility of the [investment company's] board of directors to determine the fair value of each issue of restricted securities in good faith; and the data and information considered and the analysis thereof should be retained for inspection by the [investment] company's independent auditors." Id.
Consistent with ASR No. 113, the Commission has held that restricted shares should be valued at a meaningful discount from the current price of the comparable unrestricted shares having an active trading market. See Robert F. Lynch, 46 S.E.C. 5, 8 n.9 (1975).
The Commission has also cautioned that the information an investment company's directors consider in determining the fair value of a particular security, together with, to the extent practicable, judgment factors considered by the board in reaching its decisions "should be documented in the minutes of the directors' meetings and the supporting data retained for the inspection of the company's independent accountant." Accounting for Investment Securities by Registered Investment Companies, Accounting Series Release No. 118, [1937-1982 Accounting Series Releases Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶72,140 at 62,293 (Dec. 23, 1970) (ASR No. 118).
Although ASR Nos. 113 and 118 are over thirty years old, they continue to represent the views of the Commission. See Parnassus Invs., Initial Decision, 67 SEC Docket 2760 (Sept. 3, 1998), final, 68 SEC Docket 586 (Oct. 8, 1998).35 Wallace acknowledged that ASR Nos. 113 and 118 are authoritative accounting literature (Tr. 436).
If the audit discloses that the valuation procedures used by the client's board of directors are inadequate or unreasonable, or that the underlying documentation does not support the valuations, the auditor's opinion should be modified for lack of conformity with GAAP. The modification would include the phrase "except for." Depending on the significance of the misstatement to the financial statements, the auditor may determine that an adverse opinion is appropriate. See AICPA Audits of Investment Companies § 2.160; see also GAAS Guide § 64.14 (same).
The Division's Evidence
It is undisputed that the Fund wrongly classified its restricted Premier securities as unrestricted in its year-end 1994 financial statements, and that the auditors simply failed to catch this major discrepancy. Once the auditors had received a response from TrustCorp and learned that it held only 750 shares, they were obliged to design a new confirmation request tailored to the specific audit objective, namely, to ascertaining the classification of the Fund's shares not in the custody of TrustCorp. AU § 330.16. They failed to employ the required professional skepticism in this matter.
The Division also established that the Fund's board never documented the use of anything except market prices to value its Premier securities at year-end 1994 and 1995, that Wallace knew of this lack of documentation, and that Wallace confined his subsequent inquiries on the subject to Calandrella. The auditors did not test the market to determine if Premier was actively traded, did not inquire about the number of market makers for Premier, and did not know what the Hanifen and TrustCorp price confirmations represented.
The 1994 work papers listed the securities to which the Fund's board said it had applied fair value methods, and Premier was not one of them. The 1994 work papers contained no entries discussing the documents the junior auditors read during the field work, other than Hammer's note that she had "examined the support used by the board in determining valuations as considered necessary and as available" (Tr. 157-58; JX 1 at 1496). Young did not recall if he took any audit steps to test the board's valuation decisions, or even if he spoke to Hammer on the subject (DX 148 at 68-70, 101). Neither Wallace nor Haddad knew what specific documents the junior auditors reviewed during the field work (Tr. 450, 824-25). The Division argues that Wallace fell far short of his obligations under GAAS, pointing to Wallace's testimony that he should have qualified his audit opinion only if he believed the Fund's documentation to be "totally inadequate" (compare Tr. 444-45 with AICPA Audits of Investment Companies § 2.160).
Based on the board's own documents, and the lack of credible testimony from Calandrella, Wallace, Young, and Hammer, the Division argues that the Fund simply substituted market price of unrestricted shares for fair value of restricted securities, without any explanation, and that Wallace should have known that this was grossly improper.
Respondent's Defense
As to the misclassification of the Fund's Premier shares, Wallace argues that there is not all that much difference between the values of restricted shares and unrestricted shares in a thin and illiquid market. As to the Fund's valuation of its restricted Premier securities, Wallace relies principally on the credibility of Calandrella and on the unique regulatory status of BDCs. He stresses that Calandrella knew all about Premier, because of his role as its president until June 1994 and as a director until February 1995. Wallace notes that, after Calandrella resigned from Premier's board, he spoke at least weekly with Powell and received copies of Premier's quarterly reports from Neuman (Tr. 290-91; CWXs 182-83). Wallace also points to language in the board's valuation policy statement, emphasizing that Rockies Fund board members had "additional insight" into the circumstances of portfolio companies, because of their positions on the boards of such companies. Wallace contends that, when Calandrella spoke about the valuation of Premier, he was fully justified in giving Calandrella deference.
Conclusions
Wallace's claim that there is little difference between restricted and unrestricted shares in a thin and illiquid market lacks support in the case law and the applicable academic literature. See Schwartz v. Slawter, 751 F.2d 317, 321 (10th Cir. 1984) (holding that, where shares are restricted and not traded on a national stock exchange, but on the over-the-counter market, quotes in the pink sheets do not accurately reflect the effect on the market price of the offering for sale of a large block of 270,000 shares of a lightly traded stock); see also William L. Silber, Discounts on Restricted Stock: The Impact of Illiquidity on Stock Prices, Fin. Analysts J., July-Aug. 1991 at 60 (finding that restricted stock sold at an average price discount of 33.75% when compared with the price of an otherwise identical class of common stock traded in the open market). Professor Silber further determined that, for firms with larger revenues and positive earnings, discounts on restricted stocks were significantly smaller than average. Id. In contrast, he found that discounts were larger when the block of restricted stock was larger relative to the total shares outstanding. He concluded that marketing a large block of illiquid securities required significant price concessions. Id. at 62.
Other than Calandrella's incredible testimony, there is nothing that supports Wallace's claim that the Fund's board took full consideration of all available evidence when valuing Premier. Neither Calandrella nor Neuman could recall specifically what the board actually did at its February 15, 1995, meeting. No independent board member testified for Wallace to corroborate the speculation of Calandrella. The fact that other restricted securities in the Fund's portfolio also were valued at the market price of the corresponding unrestricted shares at year-end 1995 persuades me that the board did not consider anything beyond market price when it valued Premier for year-end 1995.36
Wallace correctly observes that there are several important differences between BDCs and investment companies. However, he ignores both the text and the legislative history of the Small Business Investment Incentive Act of 1980 when he contends that it was appropriate for the auditors to give deference to Calandrella's views on valuation. While that legislation generally relaxed the regulatory treatment accorded to BDCs, it strengthened regulation in one significant area. Unlike investment companies, which must have a board composed 40% of disinterested directors, see Section 10(a) of the Investment Company Act, BDCs must have a board composed of a majority of disinterested directors, see Section 56(a) of the Investment Company Act.
As explained by the Committee on Interstate and Foreign Commerce of the U.S. House of Representatives:
The Bill provides for numerous other liberalizations in the existing structure of the Investment Company Act for [BDCs]. . . .
There is one instance, however, where the provisions of the Act are tightened to some extent with respect to [BDCs]. Section 10(a) of the Investment Company Act presently requires that at least 40% of the directors of a registered investment company be so-called "disinterested" directors. By contrast, the Bill requires that [BDCs] have a majority of disinterested directors. The special status of such companies under the Act places particular responsibility on their boards of directors to assure compliance with the Act's provisions, particularly where board approval is made expressly a substitute for Commission review or for a per se restriction. The Committee believes that the protection afforded by the board of directors in these instances-and in the governance of the company generally-is best assured to the extent that directors are not otherwise affiliated with the company, and hence are able to exercise their business judgment without the conflicts of interest inherent in service in multiple capacities.
The Committee also believes that in reviewing judgments made by investment company directors (including [BDC] directors), courts should be cognizant of the special fiduciary responsibilities inherent in the Investment Company Act with which those directors are charged.
H.R. Rep. No. 1341 at 24-25, 96th Cong., 2d Sess., reprinted in 1980 U.S.C.C.A.N. 4800, 4806-07.
As here relevant, the "special fiduciary responsibilities" of the directors on a BDC board are those identified in Section 1(b) of the Investment Company Act. That provision finds that "the national public interest and the interest of investors are adversely affected . . . (5) when investment companies, in . . . computing . . . the asset value of their outstanding securities, employ unsound or misleading methods or are not subjected to adequate independent scrutiny."
The issue is not what Calandrella thought about the valuation of the Fund's Premier securities at the time of the hearing, or even what he may have thought on the valuation dates. Calandrella was Fund management, he owned Premier securities for his own account, and his self-interest in "talking up" the value of Premier was obvious. The appropriate inquiry for the auditors was what the Fund's board, and specifically, the two disinterested members of that board, considered when the board valued Premier. I agree with the Division that the Fund's board did not attempt in good faith to find the fair value of its restricted Premier securities, and that Calandrella's testimony to the contrary is untrue.
In this critical audit area, Wallace failed to perform his duties with an attitude of professional skepticism and failed to obtain sufficient competent evidential matter. Wallace knew that his client had not documented the reasons for its valuation determinations in the board's minutes or consent resolutions, as set out in ASR No. 118. The independent auditors thus had an obligation under the applicable professional standards to dig deeper to obtain the required evidential support for the board's valuations.
Wallace's defense would have been easier if he had insisted that the junior auditors describe the supporting data with particularity in the work papers.37 Because he did not do so, he assumed the burden of producing credible testimony from the junior auditors about the underlying documentation they reviewed. Young and Hammer were not credible, and Haddad was not specific.
Wallace also argues that the "most unusual situations" language of ASR No. 113 is triggered any time a BDC fair values one of the portfolio companies to which it provides significant managerial assistance or financing, in which it holds illiquid shares, or from which it receives continuous and extensive information. Wallace is correct that ASR No. 113 provides guidance, not rigid rules, and that it does not absolutely prohibit the use of the bid price for unrestricted securities to value restricted securities. However, under Wallace's expansive reading of ASR No. 113, the exception would become the norm. I reject Wallace's interpretation for two reasons. First, the Commission has been quite restrained in finding circumstances that satisfy the "most unusual situations" language of ASR No. 113. See Christiana Sec. Co., 45 S.E.C. 649, 662 n.43 (1974), aff'd, 432 U.S. 46 (1977); Report of Investigation in the Matter of Greater Washington Investors, Inc., 17 SEC Docket 40, 43-45 (Mar. 22, 1979) (report under Section 21(a) of the Exchange Act). Duffy's experience has been similar; he never encountered the "most unusual situations" described in ASR No. 113 in twenty-five years of valuing securities for Kemper (Tr. 414-15). Second, the Commission has been quite consistent in applying the requirements of ASR Nos. 113 and 118 to sanction valuation fraud by BDCs and their directors, and improper professional conduct by their outside auditors.38
I conclude that Wallace unjustifiably relied on the representations of the Fund's management about the classification of the Fund's Premier securities in 1994, and about the board's reasons for the valuation of Premier's securities in 1994 and 1995. I further conclude that he failed to apply the auditing procedures necessary to afford a reasonable basis for his audit opinions.
4. The audited financial statements overstated Rockies Fund's net assets by material amounts.
Paragraph IV.C of the OIP charges that Wallace engaged in improper professional conduct by failing to assure that the Fund's 1994 and 1995 financial statements were prepared in conformity with GAAP. The 1994 financial statements are alleged to have materially overstated net assets because the Fund improperly classified its restricted Premier securities as unrestricted and failed to value those securities in accordance with GAAP. The 1995 financial statements are alleged to have materially overstated net assets because the Fund failed to value its restricted Premier securities in accordance with GAAP.
The first standard of reporting specifies that the auditor's report "shall state whether the financial statements are presented in accordance with [GAAP]." AU § 150.02. Professional standards further preclude an auditor from issuing an unqualified audit opinion stating affirmatively that the client's financial statements were presented in conformity with GAAP if those financial statements contained any departure from a promulgated accounting principle that had a material effect on the financial statements taken as a whole. AU §§ 508.14-.15.
The valuation of stock is a question of fact. See Becker v. United States, 968 F.2d 691, 695 (8th Cir. 1992); Heyen v. United States, 945 F.2d 359, 364 (10th Cir. 1991); Trust Servs. of Am., Inc. v. United States, 885 F.2d 561, 568 (9th Cir. 1989). Where there is evidence of low volume and light trading, pink sheet bids and asks are too speculative to form a basis for valuation. See Schwartz, 751 F.2d at 321; cf. Commissioner v. National Alfalfa Dehydrating & Milling Co., 417 U.S. 134, 150 (1974) (holding that over-the-counter quotes for a thin market were hardly representative of the fair market value of 47,059 preferred shares outstanding).
The Year-End 1994 Valuations Were Overstated
The auditors tested management's representation as to the value of the Fund's unrestricted Premier shares by confirming the bid with two different sources, Hanifen and TrustCorp. Had they checked with a third source, the National Quotation Bureau's pink sheets, they would have received an identical valuation confirmation (DX 17). These procedures were reasonable, as far as they went, but they did not go nearly as far as suggested by the applicable professional literature.
The Division argues that the 1994 audit was deficient because the auditors did not obtain additional detail from a fourth source, NASD's quote report overview (DX 16). Had the auditors reviewed that document, they would have learned that Premier's only market maker opened the last trading day of 1994 with a bid of $2.00 per share and then increased its bid to $2.25 per share. They would also have learned that the market maker's bid was firm for no more than 500 shares, the minimum size permitted by NASD at the time. The Division maintains that the board-approved valuation policy statement required the Fund to use the low bid price in valuing its unrestricted securities. With the NASD quote report overview in hand, the Division contends, the auditors should have required the Fund to value its unrestricted Premier shares at $2.00 per share (Div. Prop. Find. # 304, Div. Br. 21 & n.102).
AICPA Audits of Investment Companies § 2.32 provides that quotations for an over-the-counter security, such as Premier, should ordinarily be obtained from more than one broker-dealer, unless they are available from an established market maker for that security. It further provides that quotations should always be obtained from unaffiliated entities, and quotations for several days should be reviewed. It notes that NASDAQ may be the most convenient source of such quotations, and states that, if a security has been sold infrequently or if the market in the security is thin, the reliability of market quotations should be considered.39
The auditors knew that trading in unrestricted Premier shares was thin and the market was illiquid. They nonetheless treated Premier as if it were actively traded and the electronic bulletin board as if it were a "stock exchange." They never explained either assumption. They made no inquiry as to the volume of shares traded; the opening bid and ask; the high bid and ask; the low bid and ask; the closing bid and ask; the inside bid and ask; or the date and price of the last trade. I agree with the Division that the audit was deficient in this critical area.
The first paragraph of the board-approved valuation policy statement is not even relevant here, inasmuch as the bulletin board has not been shown to be a "stock exchange." See supra note 11. Assuming relevance, however, I reject the Division's interpretation of the final sentence in the first paragraph of the board's policy statement. The term "low bid price" does not appear in the text of that sentence. Neuman, the author of the policy statement, did not agree with the Division's reading (Tr. 830). Neither of the Division's expert witnesses lent support to the Division's $2.00 per share valuation.40 I agree with Calandrella that a policy of the type the Division describes would not make good business sense. I accept Calandrella's explanation as to the meaning of the contested sentence in the policy statement: if a security had two possible values that could be arrived at by using two different valuation approaches, such as bid price and last sale price, the board would generally select the more conservative figure (Tr. 322-23).
The Division is correct in contending that the auditors also failed to inquire as to the number of shares the market maker's bid represented (Tr. 494-95). Miraculously, the actual difference between the unrestricted Premier shares held by the Fund and the bid quantity posted by the market maker (750 shares versus 500 shares) did not turn out to be significant. I find no basis for questioning the Fund's valuation of these 750 unrestricted shares at $2.25 each, inasmuch as the Division's experts did not even address the topic.
The OIP in the Rockies Fund administrative proceeding alleges that Calandrella and Power manipulated the market for Premier common stock from June 1994 through December 1994. That allegation is not relevant to the valuation analysis here. Wallace is not accused of conducting a deficient audit because he failed to crack the case of the alleged price manipulation. I have made my finding on the assumption that $2.25 per share was a legitimate bid. Cf. Andrews v. Commissioner, 135 F.2d 314, 318 (2d Cir. 1943) ("[T]he `fair market value' of securities often consists of what honest and willing dupes (or, to use Americanese, `suckers') were actually paying for similar securities on a `rigged' market."); W.T. Grant Co. v. Duggan, 94 F.2d 859, 861 (2d Cir. 1938) (rejecting a claim that exchange prices were greatly inflated during the boom market of 1929 in excess of their actual value and finding it immaterial that the market crashed shortly after a security was valued). I acknowledge Greenberg's testimony that she knew of no corporate developments during 1994 that would have warranted an increase in the price of Premier's common stock, and that Premier issued no press releases between June 1994 and December 1994 because there was no corporate good news (JX 5 at 124, 146). That testimony does not establish that the $2.25 bid was artificially high, or that the "true" market value of unrestricted Premier shares was some unidentified lower figure.
After considering all the evidence, I find that the fair value of Premier's restricted shares at year-end 1994 was the cost to the Fund: i.e., $1.00 per share for 112,500 shares bought in the Impostors private placement; $1.10 per share for 25,000 shares bought from Kober; and $1.00 per share or less for 85,000 shares bought from Stanz. Consistent with this determination, I further find that the fair value of the Fund's Class C and Class D warrants was zero. That was their acquisition cost. In addition, when restricted Premier shares are appropriately valued at $1.00 or $1.10 each, the warrants were below the exercise price.
Fair valuation of the restricted shares at the cost of acquisition is consistent with Greenberg's testimony about the absence of significant positive events for Premier during 1994. It accords with Calandrella's testimony that he knew he could not sell the Fund's entire portfolio into the market at the $2.25 bid. It is also consistent with the Fund's prospectus, which stated that restricted securities would be valued at a discount from the value of similar publicly-traded securities and that the cost method of valuation was most likely to be used early in the life of a portfolio company (DX 66 at 19-20). I have given considerable weight to ASR No. 113 and to Duffy's testimony that restricted shares should generally be valued at less than the unrestricted shares of the same issuer. I also credit Duffy's testimony that the Fund's restricted Premier shares should have been fair valued at cost because of Premier's large operating losses during 1994, the thin and illiquid market for its unrestricted shares, and the absence of tender offers or merger proposals.
Fair valuing restricted Premier shares at cost is also consistent with the decision of Premier's outside auditors to add a "going concern" qualification to Premier's 1994 financial statements. There is an argument that Wallace could not have known of this qualification when he was completing the Fund's audit and that doing so now involves the impermissible use of hindsight (Tr. 609-10). However, it is not a persuasive argument, given Wallace's and Calandrella's emphasis on the free flow of information from Premier to the Fund, based on the Fund's seat on Premier's board. I infer that Calandrella knew of that "going concern" qualification well before it was actually published in Premier's 1994 Form 10-K. If he did not, then perhaps the flow of information from Premier to the Fund was not as free as has been suggested.
I reject as incredible Calandrella's testimony about the reasons the Fund's board fair valued its restricted Premier shares at $2.25 each. His explanations find no support in the board's minutes or consent resolutions, or in the auditors' work papers. His comparisons of Premier with competitor firms, created in 1998 for litigation purposes, are not probative.
Respondent argues that the Fund's purchase of Stanz's shares for $1.00 each was not an appropriate benchmark for valuing restricted Premier stock because it was tied to the settlement of potential litigation claims, including Stanz's employment relationship with Premier and the acquisition of Mirage by Premier. The burden of sustaining this argument falls on Wallace, and I find that he has not met it. For $1.00 per share, the Fund obtained not only Stanz's restricted securities, but also (presumably valuable) additional consideration in the form of a release of Stanz's claims against the Fund. If Stanz's claims had any merit, the fair value of the restricted stock was something less than $1.00 per share. If Stanz's claims lacked merit, as Calandrella insisted, then the fair value of each restricted share was $1.00.
Based on the above, I find that the Fund should have valued its Premier securities at $226,688, instead of $688,668. As a result, the audited financial statements for year-end 1994 overstated the Fund's total assets by $461,980. Total assets should have been $1,961,097 ($2,423,077 minus $461,980). Net worth should have been $1,245,059 (total assets of $1,961,097 minus total liabilities of $716,038). The audited financial statements thus overstated the Fund's actual net assets by 37% ($1,707,039 divided by $1,245,059).
The Year-End 1995 Valuations Were Also Overstated
I recognize that 31,000 shares of unrestricted Premier stock changed hands on the last trading day of 1995, at prices no lower than $0.625 per share. I have previously found that the prices of these trades could have been one of many legitimate measurements of the value of an unrestricted share of Premier on the date in question. However, the board's policy statement and its consent resolution of February 1, 1996, KPMG's work papers, and the testimony of Calandrella and Wallace all confirm that the Fund and the auditors ignored those sales and relied on the closing bid. That worked to the Fund's detriment in this instance, because the closing bid was a significantly lower figure. However, it is not unusual for low price issues like Premier to gyrate back and forth over a wide range.
I have previously found that $0.25 per share was the closing bid price for unrestricted shares of Premier stock at year-end 1995-not the low bid, but the only bid. The bid was firm only for 5,000 shares, the minimum size permitted by NASD at the time. As discussed above, I am persuaded by ASR No. 113 and by Duffy's testimony that restricted shares should generally be fair valued at less than the corresponding unrestricted shares. That suggests that the fair value of restricted Premier shares should have been something less than the year-end bid of $0.25 per share for the unrestricted stock. However, Duffy did not identify a specific lower valuation figure or a methodology for computing it. I decline to do so on my own motion.
I find that $0.25 per share was the maximum fair value of the Fund's restricted shares of Premier stock at year-end 1995. Fair valuing restricted Premier shares at $0.25 each would have been consistent with the valuation policy Calandrella insisted the Fund was applying. This valuation was also appropriate because the Fund had just bought 200,000 shares of restricted Premier stock from the issuer at that price only twelve days before the end of the year. I reject Calandrella's claim that this purchase should be ignored for valuation purposes because it was a "fire sale" or "distress" price. Calandrella is correct that a distress sale cannot be used to measure the value of a stock. See Pandolfo v. United States, 128 F.2d 917, 921 (10th Cir. 1942). As a factual matter, however, the claim is utterly bogus. It is inconsistent with Calandrella's testimony that Premier's financial condition was much improved in 1995, because it was operating on a break-even basis and with the "going concern" qualification removed from its financial statements. The fact that Calandrella and Greenberg were no longer on speaking terms after the end of 1994 persuades me that this was an arms' length transaction between a willing buyer and a willing seller.
I also reject Calandrella's companion claim that $0.25 per share was too low as a year-end valuation benchmark because the 200,000 Premier shares in question carried valuable registration rights. ASR No. 113 proscribes reliance on such speculative registration undertakings by an issuer. Moreover, Wallace never tested to confirm the existence of such rights and he gave them little weight in his determination of the shares' value. As a factual matter, there is no merit to Calandrella' assertion that the Fund's stock commanded a premium for control. Cf. Schwartz, 751 F.2d at 321. Finally, the prices of the Fund's sale back to Premier in December 1996 and of the public offering in April 1997 were too remote in time to shed light on the fair value of Premier stock as of December 31, 1995.
Based on the above, I find that the Fund should have fair valued its restricted Premier stock at no more than $107,938, instead of $269,845. As a result, the audited financial statements for year-end 1995 overstated the Fund's total assets by at least $161,907. At most, total assets should have been $2,024,880 ($2,186,787 minus $161,907). At most, net worth should have been $1,145,657 (total assets of $2,024,880 minus total liabilities of $879,223). The audited financial statements thus overstated the Fund's actual net assets by at least 14% ($1,307,564 divided by $1,145,657).
The Overstatements Were Material
A fact is material if there is a substantial likelihood that a reasonable investor would consider it important in making an investment decision and if disclosure of the omitted or misstated fact would have significantly altered the total mix of information made available. See Basic, Inc. v. Levinson, 485 U.S. 224, 231-32 (1988); TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976).
The question of whether a fact is material is an objective one. Resolution of the issue of materiality is a mixed question of fact and law, and the trier of fact is uniquely competent to make the materiality determination, requiring as it does "delicate assessments of inferences a `reasonable [investor]' would draw from a given set of facts and the significance of those inferences to him." TSC Indus., 426 U.S. at 450.
The function of the materiality requirement is to weed out claims based on trivial or tangential omissions. An analysis of materiality should include an evaluation of both the meaning of the information that allegedly should have been disclosed and the "total mix of information made available" to the reasonable investor.
Financial information that must be disclosed within the various periodic filing requirements imposed by the Commission has been held to be highly material to investors. See In re Burlington Coat Factory Sec. Litig., 114 F.3d 1410, 1420 n.9 (3d Cir. 1997); In re Kidder Peabody Sec. Litig., 10 F. Supp. 2d 398, 410 (S.D.N.Y. 1998).
The formulation of materiality in the accounting literature is substantially identical to that used by the courts in interpreting the federal securities laws. In its Statement of Financial Accounting Concepts No. 2, Qualitative Characteristics of Accounting Information (1980) (Concepts Statement No. 2), the Financial Accounting Standards Board stated that "[t]he omission or misstatement of an item in a financial report is material if, in the light of surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item."41
Exclusive reliance on a single numerical or percentage benchmark to determine materiality is inappropriate under Basic, 485 U.S. at 236 n.14, as well as under Concepts Statement No. 2 at ¶ 125 ("magnitude by itself, without regard to the nature of the item and the circumstances in which the judgment has to be made, will not generally be a sufficient basis for a materiality judgment."); see also Ganino v. Citizens Utils. Co., 228 F.3d 154, 162-64 (2d Cir. 2000); cf. Ponce, 73 SEC Docket at 460-61 (finding that an overstatement of assets by 88% to 95%, coupled with violations of GAAP, was material).
The cornerstone of Smith's testimony was his opinion that the Fund's stock price would not have reacted to any significant degree if the Fund's Premier shares had been valued as Duffy and the Division said they should have been valued. In Smith's judgment, this was because Rockies Fund was a closed-end fund and (1) the market value of a closed-end fund often differs from its net asset value for several reasons and (2) the liquidity of investments made by a closed-end fund is not directly relevant to the liquidity of investments in such a fund.
It is true that the shares of closed-end funds in general and BDCs in particular frequently trade in the secondary market at substantial discounts to their underlying net asset values. Here, however, Rockies Fund's prospectus provided investors with very little disclosure of that fact.42 It does not follow that the bid price for the Fund's shares was the only relevant measurement of the materiality of the net asset information in the Fund's financial statements, or that the Fund's management was free to publish inaccurate net asset information in its financial statements if the Fund's stock price was unlikely to react.
In this case, the audited financial statements for year-end 1994 overstated the Fund's net assets by $461,980 or 37%, while the audited financial statements for year-end 1995 overstated the Fund's net assets by at least $161,907 or 14%. The overstatements involved the Fund's investment portfolio, the single most significant aspect of its business. The outside auditors properly recognized the importance of the Fund's investment portfolio by identifying securities valuation as a critical audit area. The auditors' materiality threshold, or audit gauge, was $33,000 in 1994 and $30,000 in 1995. Errors above that level cannot be ignored as "immaterial" to the reported financial results. Moreover, the fact that the Fund's management padded the value of its Premier assets in the preliminary financial statements meant that the audit gauge itself was likely too large. A rising rate of return and a rising bid price for the Fund's stock were matters of importance to Calandrella (Tr. 285), if not to Smith. After considering the "total mix" of information, I find that the overstatements of the Fund's net assets in both years were "material."
5. Wallace's failure to insist that the 1994 financial statements be revised or to withdraw his favorable opinion was not identified as improper professional conduct in the OIP and, in any event, the Division has not proven a violation of the applicable professional standards.
The Applicable Professional Standards
In pertinent part, the fourth standard of reporting provides that in all cases where an auditor's name is associated with financial statements, the report should contain a clear-cut indication of the character of the auditor's work, if any, and the degree of responsibility the auditor is taking. In interpreting that standard, AU § 561 describes the procedures to be followed by an auditor who, subsequent to the date of his report on audited financial statements, becomes aware of information that he would have investigated if it had come to his attention during the course of his audit, and that might have affected his report.
AU § 561.04 permits the auditor to discuss the newly discovered information with his client "at whatever management levels he deems appropriate, including the board of directors." AU § 561.05 requires the auditor to take action if the nature and effect of the matter are such that (a) his report would have been affected had he known the information at the time of his report, and (b) he believes there are persons currently relying or likely to rely on the financial statements who would attach importance to the information. With respect to the latter point, consideration should be given to the time elapsed since the financial statements were issued. Finally, AU § 561.06 provides an auditor with a broad range of disclosure methods to prevent future reliance on the report. As here relevant, "[w]hen issuance of financial statements accompanied by the auditor's report for a subsequent period is imminent, so that disclosure is not delayed, appropriate disclosure of the revision can be made in the [next financial] statements instead of reissuing the earlier statements."
Conclusions
Certainly, withdrawing the favorable 1994 audit opinion once the flaws of the 1994 financial statements became known would have been the sensible thing to do, whether or not Wallace was reckless at the time the opinion issued. But this charge was not identified in the OIP. Nor did the Division meet its burden of showing that revision or withdrawal was required under the applicable accounting standards. Even assuming proper notice and failure to follow the applicable literature, the allegation still fails because the Division did not show that Wallace acted recklessly.
First, there is a question as to whether Wallace had fair notice that his duty to revise or withdraw would be an issue in the case. The OIP does not allege that Wallace engaged in improper professional conduct when he failed to insist that Rockies Fund issue revised 1994 financial statements. In contrast to the present case, the OIP in another administrative proceeding, alleging improper professional conduct by accountants, did identify the issue with precision, and in considerable detail. See OIP in Bernard Weiner, CPA, and Paul Young, CPA, Admin. Proc. 3-8576 (Dec. 19, 1994) at ¶¶ 43-45 and III.D. When the Commission wants to allege that an accountant has a duty to revise a client's financial statements or to withdraw his prior audit opinion, it knows how to do so.
More than three months after the Commission issued the OIP, this charge entered the case for the first time through the report of the Division's expert witness, Gordon Yale (DX 146 at 2, 8). Yale opined that Wallace was "required to insist" that the Fund revise its 1994 financial statements, and that Wallace's failure to do so was an "egregious departure" from GAAS. The Division never sought to amend the OIP under Rule 200(d) of the Commission's Rules of Practice to encompass this new allegation and the time for doing so has expired. Cf. Ponce, 73 SEC Docket at 464 n.49 (refusing to consider the Division's allegation about improper professional conduct by an accountant when the conduct at issue had not been identified in the OIP).
Second, even assuming that the issue is properly a part of the case, the Division has not shown that Wallace's handling of the matter violated the applicable professional standards. Yale's report and testimony and the Division's pleadings do not discuss the significance of the time elapsed since the 1994 financial statements under AU § 561.05, whether the Fund's 1995 Form 10-K was "imminent" within the meaning of AU § 561.06b, or whether the disclosure made in the Fund's 1995 Form 10-K was sufficient to cure the prior error. In these circumstances, the allegation of "improper professional conduct" in violation of the "applicable professional standards" has not been established.
Third, even assuming that Wallace's handling of the matter had been proven to fall short of the guidance in AU § 561, the Division must also establish that Wallace acted recklessly. See Robin v. Arthur Young & Co., 915 F.2d 1120, 1126-27 (7th Cir. 1990). The Division has not separately addressed this issue.
6. Setting aside the evidence of auditing negligence, the weight of the evidence establishes that Wallace was at least reckless during the 1994 and 1995 audits.
Negligence Or Less Than Negligence
There is evidence that Wallace behaved negligently during the 1994 audit. However, as discussed above, even multiple instances of negligence will not support an inference that an auditor behaved intentionally, knowingly, or recklessly under Rule 102(e)(1)(iv)(A). Lack of curiosity alone will not suffice. Thus, Wallace's determination not to read the Fund's Forms 10-Q and amended Forms 10-Q does not support an inference of recklessness. Carelessness alone will not suffice. Wallace knew that Rockies Fund had acquired Premier stock in private transactions or directly from the issuer. He failed to appreciate that meant the shares were likely to be restricted. That is evidence of professional negligence, but not recklessness. Succumbing to distractions alone will not suffice. Wallace was devoting a significant amount of time in 1994 and 1995 to his collateral duties as partner-in-charge of the audit department of KPMG's Denver office. I seriously doubt that Rockies Fund audits ever had his full attention, even for the ten to twelve hours he claimed he devoted to each engagement. This may be negligence, but not recklessness.
Finally, an inference that Wallace may have cut corners in KPMG's economic self-interest will not suffice to prove recklessness. This is not a case like Price Waterhouse, 797 F. Supp. at 1222, where there was credible evidence that the audit engagement partner, knowing that the audit would be unprofitable for his firm, instructed his staff to expend whatever hours were necessary to carry out a thorough examination without regard to fees. To the contrary, Wallace knew that the Fund was thinly capitalized and had serious cash flow problems. Wallace thus planned an audit for 1994 that drastically cut the number of hours that KPMG intended to spend on the engagement (from 134 hours in 1993 down to ninety hours in 1994). By March 1995, however, KPMG had already devoted 126 hours to an audit that would enrich the firm by only $12,500. The Fund's 1995 audit also came in way over budget (KPMG planned to spend only 126 hours, but it actually devoted 160 hours to the engagement). Its fee was again modest ($14,500). In the end, Wallace still needed to hold his completed audit report as a hostage until the Fund paid what it owed. However, cost-cutting was not raised as an issue in the OIP. See supra note 34. In addition, a long line of cases, including DiLeo, Melder, Health Management, and Price Waterhouse, establishes that assumptions about an auditor's financial self-interest alone will not support a finding of scienter.
This evidence, individually and collectively, is not enough to establish recklessness. Cf. Wells, ¶ 90,110 at 90,152. If this were the all the Division could show, dismissal of the charges would be appropriate.
Recklessness Or Actual Knowledge
Wholly apart from the evidence of auditing negligence, there is sufficient evidence that Wallace behaved recklessly during the 1994 audit. First, Wallace ignored the fact that the Fund had many different and inconsistent valuation policies. This was an egregious refusal to see the obvious in a critical audit area. I recognize that Calandrella testified that the Fund's valuation documents were consistent, and Wallace testified that they were "generally consistent." The testimony of both witnesses is rejected as incredible. I acknowledge that Wallace can point to statements in KPMG's work papers reciting that the Fund's valuation policies were consistent from year to year. The conclusory statements in the work papers are rejected because they ignore the plain language of the source documents. Simply writing that the Fund's valuation policies were consistent hardly made it so. Second, the 1994 audit amounted to "no audit at all" on the important issue of whether the Fund's Premier shares were restricted or unrestricted. Beyond making an initial inquiry to TrustCorp, Hammer and Mah simply failed to perform this key audit procedure. Wallace assumed the junior auditors had designed the necessary confirmation requests and conducted the appropriate tests, but he never checked. Third, the auditors paid insufficient attention to two legitimate "red flags" that should have heightened their professional skepticism: they relied on Calandrella's self-serving representations about the Fund's alleged "good faith" response to the Commission staff's deficiency letter, and they ignored a suspicious year-end transaction, namely, the instant appreciation in value of the Class D warrants. Fourth, the auditors took Calandrella's word on other matters when they should have tested. The auditors knew that Calandrella was the subject of a Commission investigation, that the board minutes and consent resolutions were silent on the reasons for the Fund's portfolio valuations, that ASR Nos. 113 and 118 required the Fund's board to maintain documentation for their inspection, and that the guidance in AU § 339.05 and the Audit Risk Alert cautioned them to document their conclusions in the work papers. They should have known that the Fund's status as a BDC made the thinking of the independent directors on valuation issues especially important.43 Fifth, an inference of recklessness is warranted from the magnitude of the reporting errors. The Fund's restricted Premier shares should have been valued at $1.00 and $1.10, at most, instead of $2.25. Because they were not, the Fund's net assets were overstated by $461,980 or 37%. KPMG had a materiality standard, or audit gauge, of $33,000. While that in-house benchmark is not binding on the Commission, the fact that it was exceeded many times over certainly supports the determination that Wallace was reckless.
The weight of the evidence also supports a conclusion that Wallace was at least reckless during the 1995 audit. Wallace's blindness to the Fund's multiple valuation policies, discussed above, was aggravated in 1995. Wallace personally drafted a note to the Fund's financial statements describing a new valuation policy that the Fund's board had never approved. There were different "red flags" in 1995. For example, by the time of the 1995 audit, KPMG knew of the Fund's misclassification of its Premier's shares, and of the formal Commission investigation. This knowledge should have heightened the auditors' professional skepticism, yet they took Calandrella's word on many matters where testing was required. During the 1995 audit, the auditors again ignored a suspicious year-end transaction, namely, the instant appreciation of 200,000 shares of restricted Premier stock. Management declared those shares, purchased on December 19, 1995, for $0.25 per share, to be worth $0.625 per share only twelve days later. Wallace failed to scrutinize the transaction. Wallace also approved language in the financial statements reciting that those shares were free trading due to demand registration rights. Yet Wallace did not consider the alleged demand registration rights important and he never even tested to confirm their existence. Finally, an inference of scienter is warranted from the magnitude of the 1995 reporting errors. Had Premier's restricted shares been valued at $0.25 or less instead of $0.625 each, the Fund's assets would have been reduced by at least $161,907. Thus, net assets were overstated by at least 14%. KPMG's materiality threshold, or audit gauge, for the 1995 audit was $30,000. As in 1994, the fact that the benchmark was exceeded many times over supports the determination that Wallace was reckless.
SANCTIONS
Under Rule 102(e)(1), the Commission may censure a person or deny, temporarily or permanently, the privilege of appearing or practicing before it to any person who is found to have engaged in improper professional conduct. If the Commission has "permanently suspended or disqualified" a person under Rule 102(e)(1), then under Rule 102(e)(5), that person may apply for reinstatement "at any time." In the Commission's discretion, that person may be afforded a hearing on such application; however, the permanent suspension or disqualification shall continue unless and until the Commission reinstates the applicant for good cause shown. As I read Rule 102(e)(1), a temporary denial is something different from a permanent denial, and only those persons who are permanently denied need to go through the reinstatement process in Rule 102(e)(5).
The Division urges that Wallace should be denied the privilege of appearing or practicing before the Commission as an accountant (Div. Prop. Find. at 55). Although the Division does not say so, a fair reading of its pleading suggests that it seeks a permanent denial, and not a temporary denial, under Rule 102(e)(1). The Division also requests an order stating that, after three years from the effective date of any order, Wallace may request that the Commission consider his reinstatement by submitting an application. That application to resume practicing or appearing would be required to address several public interest factors (Div. Prop. Find. at 55).
The Division's proposal--suggesting that Wallace be forbidden to petition for reinstatement relief any earlier than three years--runs afoul of the language in Rule 102(e)(5) providing that a person who is "permanently suspended or disqualified" under Rule 102(e)(1) may apply for reinstatement "at any time." The Division can seek a permanent disqualification, in which case the respondent retains the right to seek reinstatement "at any time," or it can seek a temporary disqualification for a fixed period, in which case no petition for reinstatement is required. The rule envisions one or the other, but not a blend of both.
The Commission's orders in Checkosky and Potts suspended the respondents for fixed periods of time, but did not require the respondents to go through the reinstatement process after the fixed periods of suspension had been served. The recent Commission order in Ponce did just the opposite, but it did not address the text of Rule 102(e)(1) and (e)(5), nor did it distinguish Checkosky or Potts. I follow the approach of Checkosky and Potts here, and I therefore deny the Division's request that Wallace should be ordered to go through the reinstatement procedure of Rule 102(e)(5) after serving a fixed period suspension.
Both parties suggest that the Commission should apply the public interest analysis in Steadman v. SEC, 603 F.2d 1126, 1140 (5th Cir. 1979), aff'd on other grounds, 450 U.S. 91 (1981), when determining the appropriate professional discipline against accountants (Div. Br. at 43; Resp. Prop. Find. #1123). That analysis requires that several issues be considered, including: (1) the egregiousness of the respondent's actions; (2) the isolated or recurrent nature of the infraction; (3) the degree of scienter involved; (4) the sincerity of the respondent's assurances against future violations; (5) the respondent's recognition of the wrongful nature of his conduct; and (6) the likelihood that his occupation will present opportunities for future violations. No one factor is controlling.
The Commission has not specifically invoked the Steadman factors in its prior decisions under Rule 102(e) or Rule 2(e). However, at least one Administrative Law Judge has done so. See Combellick, Reynolds & Russell, Inc., Initial Decision, 49 SEC Docket 244, 260 (June 19, 1991), final, 49 SEC Docket 1682 (Oct. 2, 1991); Ernst & Whinney and Michael L. Ferrante, CPA, Admin. Proc. 3-6579, Initial Decision at 101-07 (June 28, 1990), final, 46 SEC Docket 1507 (July 27, 1990).
The year-end 1994 and 1995 audits did not comply with GAAS and, contrary to Wallace's representations, the Fund's financial statements materially deviated from GAAP. Wallace's conduct demonstrated a reckless disregard of his duties as an independent auditor. His improper professional conduct was not isolated, it was repeated. Wallace continues to insist that he did not deviate from the applicable professional standards. He attempts to minimize the evidence against him as little more than quibbling about matters of professional judgment. He makes no promises of altering his professional behavior in the future, and he shows no remorse. Wallace still devotes one-third of his professional time to audits of public companies and thus remains in a position to repeat his professional misconduct. Unless meaningful professional discipline is imposed, there is a realistic danger of future harm to the integrity of the Commission's processes.
The level of scienter established on this record is low to moderate; it is certainly not high. It is roughly comparable to that in Potts, where the Commission found that a concurring review partner had acted recklessly. In Potts, the Commission noted that the respondent: (1) had extensive professional experience and was familiar with the client company's operations; (2) knew the contents of the work papers and knew that the questioned audit area had a material effect on the client's financial statements; and (3) accepted management's oral assurances, even though the client did not have appropriate written records. Potts, 65 SEC Docket at 1387-94.
Wallace has lived in Colorado for forty-five years, and he has made significant contributions to his community (Tr. 964-66). He has served as a board member for six years and as president of the board for two years of the Colorado Special Olympics, which organizes athletic events for developmentally disabled and mentally retarded individuals. He was also a board member for five years and president of the board for two years of the Denver Children's Home, a residential facility where juveniles under the care of a local court receive psychological treatment. In addition, Wallace was a board member at Craig Hospital, a spinal injury and head injury rehabilitation hospital located in Englewood, Colorado.
I have given this evidence of good character minimal weight. It was a poor predictor of the likelihood that Wallace would engage in improper professional conduct in the first instance, and it cannot be assumed to be an accurate predictor that he represents no future threat to the integrity of the Commission's processes. Cf. In re Walter, [1987-1990 Transfer Binder] Comm. Fut. L. Rep. (CCH) ¶ 24,215 at 35,014 n.19 (1988) ("[A] history of civic achievement or charitable associations does not mitigate a disqualification that arose despite the existence of this evidence of `good character.'"); In re Horn, [1986-1987 Transfer Binder] Comm. Fut. L. Rep. (CCH) ¶ 23,731 at 33,889-90 (1987) ("Absent evidence that the wrongful conduct arose from peculiar circumstances that have no substantial likelihood of recurrence, . . . the weight that might normally be accorded evidence of a history of good conduct is simply eviscerated by the subsequent wrongful conduct.") (footnote omitted). Wallace has many obvious talents, but they were spread too thin here. Between his civic activities and his collateral duties as partner-in-charge of KPMG's audit department, there was little time left to attend to the two Rockies Fund audits with the necessary level of careful attention.
In 1988, KPMG audited the financial statements of American Federal Savings & Loan, Inc., and its parent, American Federal Financial Corporation (collectively, Am Fed). Wallace was the engagement partner on the AmFed audit (Tr. 547-48). In March 1995, the Colorado State Board of Accountancy (Board of Accountancy) began an investigation of KPMG, after learning that KPMG had entered a global settlement with the Office of Thrift Supervision (OTS), relating to alleged accounting and auditing failures at twenty-two failed financial institutions, including AmFed.
KPMG learned of the AmFed investigation in late 1998 and it settled with the Board of Accountancy in February 1999 (Tr. 956-62; DX 63). KPMG agreed to pay the Board of Accountancy $150,000, to include its Denver office in a peer review program, and to certify that all its Denver office audit partners and managers would comply with the training and continuing education requirements of the OTS. There was no trial. There were no findings of fact and no admissions of liability. No individual auditors were named as respondents. In these circumstances, I decline to consider KPMG's settlement with the Board of Accountancy to be evidence of a prior disciplinary history by Wallace.
In my judgment, professional discipline of three years' duration is not required in the public interest. The Division has not proven all of its allegations of recklessness. Some breaches of professional standards, such as the alleged failure to insist that the Fund revise its 1994 financial statements or to withdraw the favorable 1994 audit opinion, were not proven at all. Other breaches of professional standards were shown to have involved negligent conduct, but not the recklessness alleged in the OIP. I have not considered that negligence in determining liability for improper professional conduct, but I have evaluated it in connection with the appropriate sanction. See supra note 32. In addition, the Division has given Wallace far too little credit during the 1995 audit for persuading the Fund to reduce its proposed valuation of Premier securities from $0.75 to $0.625 per share. No investor losses were charged or proven. Finally, Wallace has enjoyed a lengthy and successful accounting career, otherwise free from professional discipline.
"Practicing before the Commission" is very broadly defined in Rule 102(f) and nothing in this record suggests what its outer limits may be. For example, the rule recites that the phrase "shall include, but shall not be limited to" actions enumerated in subsections (f)(1) and (f)(2). It would seem that a respondent prohibited from "practicing" should know in advance if conduct not identified in subsections (f)(1) or (f)(2) is or is not forbidden during a term of professional discipline. The breadth of the phrase "transacting any business with the Commission" in subsection (f)(1) is likewise unclear. At its most sweeping, the phrase arguably encompasses the actions of a person who comments on proposed Commission rules, attends open Commission meetings, files Freedom of Information Act requests, or contacts the staff to complain that he has been the victim of a fraudulent boiler-room solicitation. Cf. Teicher v. SEC, 177 F.3d 1016, 1019 (D.C. Cir. 1999) (finding that the Commission's interpretation of statutory authority to "place limitations" on the petitioner's activities suffered fatal structural difficulties as the statutory language "requires some concept of the relevant domain"), cert. denied, 120 S. Ct. 1267 (2000).
It is an interesting legal question whether Wallace is obliged to establish the metes and bounds of the term "practicing before the Commission" in Rule 102(f) by bringing a void-for-vagueness challenge,44 or whether the Division, as the proponent of an order of suspension or disqualification from practice, bears the burden of proof on that issue under the Administrative Procedure Act. See 5 U.S.C. § 556(d). Here, however, it is unnecessary to address the question. The Division has crafted a request for relief that is more circumscribed than the full reach of Rule 102(f), and Wallace has not objected to the scope of that request.
After considering all the facts and circumstances in the light of Steadman, I conclude that Wallace should be temporarily denied the privilege of appearing and practicing before the Commission as an accountant for one year. Since this is not a permanent denial, the reinstatement application provisions of Rule 102(e)(5) are inapplicable.
RECORD CERTIFICATION
Pursuant to Rule 351(b) of the Commission's Rules of Practice, I certify that the record includes the items set forth in the record index issued by the Secretary of the Commission on July 7, 2000, as amended on August 15, 2000.
ORDER
Based on the findings and conclusions set forth above, and pursuant to Rule 102(e)(1) of the Commission's Rules of Practice, Carroll A. Wallace is temporarily denied the privilege of appearing and practicing before the Commission as an accountant for one year.
This order shall become effective in accordance with and subject to the provisions of Rule 360 of the Commission's Rules of Practice. Pursuant to that Rule, a petition for review of this initial decision may be filed within twenty-one days after service of the initial decision. It shall become the final decision of the Commission as to each party who has not filed a petition for review pursuant to Rule 360(d)(1) within twenty-one days after service of the initial decision on that party, unless the Commission, pursuant to Rule 360(b)(1), determines on its own initiative to review this initial decision as to that party. If a party timely files a petition for review, or the Commission acts to review on its own motion, the initial decision shall not become final as to that party.
______________________________
James T. Kelly
Administrative Law Judge
| 1 | "Generally accepted accounting principles" are the basic postulates and broad principles of accounting pertaining to business enterprises. These principles establish guidelines for measuring, recording, and classifying the transactions of a business entity. "Generally accepted auditing standards" are the standards prescribed for the conduct of auditors in the performance of an examination of management's financial statements. See SEC v. Arthur Young & Co., 590 F.2d 785, 788 nn. 2 & 4 (9th Cir. 1979). |
| 2 | The exhibits offered by the Division and by Wallace will be cited as "DX ___" and "CWX ___," respectively. Citations to the parties' Joint Exhibits will be noted as "JX ___." Pursuant to my Orders of November 15, 1999, and January 14, 2000, and for the reasons stated therein, the official transcript of the hearing is the second revised transcript filed with the Commission on December 29, 1999, as modified by the parties' errata sheet. See Order of January 14, 2000. That transcript is cited herein as "Tr. ___." Citations to the posthearing pleadings will be noted as follows: Amended Division Proposed Findings of Fact and Conclusions of Law and Amended Division Brief, both dated February 9, 2000, will be cited as "Div. Prop. Find. ___" and "Div. Br. ___," respectively. Respondent's Amended Proposed Findings of Fact and Conclusions of Law and Respondent's Amended Brief, both dated May 1, 2000, will be cited as "Resp. Prop. Find. ___" and "Resp. Br. ___," respectively. The Division's Reply Brief, dated May 10, 2000, will be cited as "Div. Reply Br. ___." |
| 3 | BDCs, as defined in Section 2(a)(48) of the Investment Company Act, are domestic, closed-end companies that are operated for the purpose of making certain types of investments and that make available significant managerial assistance to the companies in which they invest. BDCs must invest at least 70% of their funds in companies in which they either own greater than 5% of the outstanding shares or maintain representation on either the company's board or its management. Section 5(a)(2) of the Investment Company Act defines closed-end companies as management companies that do not issue any redeemable securities.
Congress singled out BDCs for distinct regulatory treatment in Title I of the Small Business Investment Incentive Act of 1980, Pub. L. No. 96-477, 1980 U.S.C.C.A.N. 4800 et seq. That legislation was designed to stimulate the flow of venture capital to small, developing businesses and to financially troubled businesses by removing unnecessary regulatory burdens, while at the same time adequately preserving important investor protections. Once a company elects BDC status, it is exempt from many of the provisions of Sections 1 through 53 of the Investment Company Act, and is instead subject to the revised regulatory scheme set out in Sections 54 through 65 of the Investment Company Act. Among other things, BDCs file financial statements with the Commission under Section 13 of the Exchange Act, rather than Section 30 of the Investment Company Act. |
| 4 | The electronic bulletin board is not a part of the NASDAQ stock market. No trading whatsoever occurs on the bulletin board. Market makers simply post quotations and if the viewer likes what he sees, he must contact the market maker. See Rebecca Buckman, Market Tries to Distance Itself from Securities Traded on the Quotation Service, Wall St. J., Aug. 8, 1997, available in 1997 WL 2430793. See infra note 11. |
| 5 | Rule 405 under the Securities Act of 1933 (Securities Act) defines "affiliate" and "control" with regard to securities owned by a person who is an affiliate of an issuer. "Affiliate" means "a person that directly, or indirectly through one or more intermediaries, controls or is controlled by, or is under common control with, the person specified." "Control" means "the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a person, whether through the ownership of voting securities, by contract, or otherwise." 17 C.F.R. § 230.405; see also Sections 2(a)(2), 2(a)(3), and 2(a)(9) of the Investment Company Act. |
| 6 | Most of the Premier securities in the present case were restricted as defined by Rule 144 under the Securities Act. 17 C.F.R. § 230.144. Restricted securities bear a legend that they are restricted and cannot be freely resold (DX 51). |
| 7 | A "going concern" qualification raises the possibility that the subject of the audit will not keep "going" and warns that in the event of a shutdown the balance sheet asset valuations may not be fully realized. |
| 8 | Greenberg was far more realistic than Calandrella. The latter's credibility suffered from his ability to find signs of success on the flimsiest of evidence, and then to rely on those signs to justify an inflated valuation of Premier's stock. For example, Calandrella claimed that Premier had received an informal offer to purchase its flagship store in San Francisco for over $1 million in 1994. There was never a contract and the sale did not occur (Tr. 299, 348). He likewise asserted that an unidentified New York group had discussed putting its money into Premier in 1995. That transaction also never came to pass (Tr. 372-73). In contrast, Greenberg knew of no corporate "good news" that warranted any press releases in 1994, and she acknowledged that Premier had acute cash needs during 1995 (JX 5 at 101-03, 124, 146).
Calandrella found hidden value in Premier based on comparisons he made to the market capitalization of its competitors (Tr. 299-300, 315-19; CWXs 154, 160-67). Calandrella's comparisons, created in 1998, were never considered by the Fund's board in valuing Premier or by Wallace in auditing the Fund's financial statements (Tr. 317). They have little relevance here. In any event, Premier's 1994 Form 10-KSB and its 1994 annual report to shareholders threw cold water on Calandrella's comparisons. See DX 59 at 7; CWX 159 at 5 ("As the popularity of jewelry reproductions increases, entities with greater revenues and marketing experience are expected to continue entering the market to the detriment of [Premier]."). |
| 9 | Calandrella attributed Premier's slow start to missteps during "the Stanz era" and he portrayed "the Greenberg era" as a time of steady progress. He testified that he brought in Greenberg as president only after he had become disillusioned with Stanz (Tr. 249, 262-64, 288). In fact, Calandrella had asked Greenberg to join Premier as early as March 1994 (JX 5 at 136).
The Fund's payment of $85,000 for the Premier stock was accompanied by a mutual general release (DX 39 at ¶ 10, CWX 138). The release was intended to settle all claims arising out of Premier's acquisition of Mirage and the termination of Stanz's employment with Premier. However, a separate agreement became necessary because of a subsequent dispute (Tr. 216-18; DXs 40, 42, 43, JX 5 at 115-18, 134-35). The separate agreement did not alter the fact that Rockies Fund paid Stanz $85,000 and received 85,000 restricted Premier shares and a mutual general release (Tr. 837-38; CWXs 172, 173). |
| 10 | A closed-end fund only needs to update its prospectus if it issues shares to the public and Rockies Fund had not done so since 1983. |
| 11 | None of the Fund's eligible portfolio companies had securities that met this definition, because the electronic bulletin board was not a "stock exchange." At the relevant times, the bulletin board did not come within the definition of an exchange in Section 3(a)(1) of the Exchange Act and it was not registered as an exchange under Section 6 of the Exchange Act. The bulletin board simply provided an electronic quotation medium for subscribing members to reflect market-making interest in various securities. See NASD Manual, OTC Bulletin Board Service Rules, ¶¶ 2571 et seq. (July 1994); see also Section 15A(b)(11) of the Exchange Act (requiring NASD's rules to address the form and content of quotations relating to "securities sold otherwise than on a national securities exchange"). |
| 12 | Calandrella explained that the board reviewed each security portfolio position in detail to establish fair market value (Tr. 243, 296-97, 354). During the meeting, the board members went down the schedule of investments and discussed each investee company's prognosis and any material changes in the company's operations. The board considered every factor of which it had knowledge, including the positive attributes of each investee company, the Fund's exit strategy, and the type of price the Fund was looking for. Then, the board determined the proper valuation to be attributed to each security. The length of the discussion varied, depending on the size of the Fund's position-the larger the position, the longer the discussion. Premier was a large position and the Fund had played a particularly active and time-consuming role in its management. |
| 13 | Calandrella said that Neuman wrote the minutes (Tr. 295, 297), but Thygesen was the person who eventually signed them (JX 3 at 2344-45). Of the three copies of the February 15, 1995, minutes in the record, two are unsigned (CWX 108 at 1143CC, CWX 118 at 1943). The facsimile trailer shows that Neuman faxed these to KPMG on March 3, 1995. The third copy bears Thygesen's signature (JX 3 at 2345). The facsimile trailer shows that Neuman faxed the signature page to KPMG on March 6, 1995. |
| 14 | I understand the work papers' reference to the "3/4 last trade price" to mean the September 27, 1995, transaction in which Rockies Fund bought 8,500 shares of unrestricted Premier stock through Hanifen. The reference otherwise makes no sense, because the last reported trades in Premier stock before year-end 1995 took place on December 29, 1995, at prices ranging from $0.625 to $0.6875 per share (DX 14, DX 20 at 19). |
| 15 | In contrast to Calandrella's testimony that Premier and the underwriter had discussed the $0.75 price range of the prospective offering in the first quarter of 1996, Greenberg stated that Premier and the underwriter did not discuss pricing until October 1996 (JX 5 at 184-85). Premier's 1995 Form 10-KSB stated that the anticipated offering would be priced between $0.60 and $0.75 (DX 55 at F-15, adjusted for a reverse split the public offering would involve). The 1995 work papers do not contain any documents from the underwriter about the pricing of the proposed offering. |
| 16 | The Division's other alleged red flags range from the substantial (for example, the Fund's multiple inconsistent valuation policies, discussed above) to the trivial (for example, the Fund's practice of recording securities transactions on the settlement date rather than the trade date, see Div. Prop. Find. # 207). |
| 17 | Rule 202 of the AICPA's Code of Professional Conduct requires adherence to GAAS, and recognizes Statements on Auditing Standards as interpretations of GAAS. The Codification of Statements on Auditing Standards will be cited as "AU § ___." |
| 18 | A subsequent Commission interpretation dealing with auditing responsibilities in an unrelated area stated as follows:
Statement of the Commission Regarding Disclosure of Year 2000 Issues and Consequences by Public Companies, Investment Advisers, Investment Companies, and Municipal Securities Issuers, 67 SEC Docket 1973, 1980 (Aug. 4, 1998) (footnote omitted). By using the term "at this time," I understand the Commission to intend that its interpretation of the AICPA's guidance would have only prospective application. No Commission releases available to Wallace in 1994 or 1995 informed him that he would have to "justify" his failure to follow an optional procedure. I decline to shift the burden of proof retroactively. |
| 19 | NASD's quote report overview provided additional detail (DX 16). It showed that Hanifen opened that day with a bid price for Premier of $2.00 and an ask price of $2.75. At approximately 10:17 a.m. Eastern time, Hanifen increased its bid price to $2.25 and its ask price to $3.00 (Tr. 24-25; DX 16 at 4635-36). The bid and ask quotes, which had been posted by a single market maker and were firm only for 500 shares, remained at that level for the rest of the day. The $2.25 figure thus represented both the high bid and the closing bid for the last business day of 1994. There is no evidence that the Fund knew this information when it valued its securities or that KPMG knew it during the audit. |
| 20 | According to Wallace, he noticed that the junior auditors had not placed "tick marks" next to the Class D warrants in the work papers. He therefore wrote a review note to Young, requesting Young to verify the existence of the Class D warrants (Tr. 75-78, 460-63). Wallace was not questioned as to whether he asked Young to confirm the classification of the warrants as unrestricted, or to take a hard look at their instant appreciation in value. Young had no recollection of seeing any review note from Wallace (DX 148 at 110). Hammer could not recall what she or Young did in response to Wallace's review note (Tr. 77). The work papers do not contain a written response from Hammer or Young to clear such a review note (Tr. 77, 85-87). Wallace testified that he accepted Young's verbal representation that the junior auditors had done as he had instructed (Tr. 460, 482). |
| 21 | This issue was not identified in the OIP. The Division's expert witness first raised it in his written report. |
| 22 | Wallace identified Robison on his witness list, but elected not to call him to testify at the hearing. |
| 23 | Fiske's testimony about her employer's purported error must be considered carefully. The pink sheets from the National Quotation Bureau also showed that the high bid price for Premier on December 29, 1995, was 5/8 and the low bid was 1/4 (DX 17). It is unlikely that both the NASD and the National Quotation Bureau, acting independently, would have made the same error about the 5/8 high bid. Other exhibits support an inference that there were bids at and above $0.625 per share-successful bids, resulting in trades (DXs 14, 20). Additional inaccuracies in the inside bid information in DX 16 are summarized infra in note 24. |
| 24 | By comparing DX 16, on the one hand, with DX 14 and DX 20, on the other, one finds four days in 1995 where Premier traded at prices that differed from the reported inside bid: July 18, 1995 (sales at $1.00, inside bid at $0.50), July 26, 1995 (same), July 27, 1995 (same), and August 29, 1995 (sale at $0.50, inside bid at $0.25). |
| 25 | Notwithstanding the date on the letter, Wallace told Neuman that he would not release the 1995 audit report until he got paid (Tr. 868-69). Wallace and Robison did not sign KPMG's completion memorandum until April 12, 1996 (JX 3 at 2205). The Fund did not file its 1995 Form 10-K with the Commission until April 15, 1996 (DX 10). |
| 26 | The inconsistency is troubling. If Yale was not comfortable using legal terminology, I would have expected him to refrain from addressing not only "recklessness," but also "materiality." On the other hand, if he was comfortable discussing "materiality," I would have expected him to explain what he meant by that term and not to be so reticent on the issue of "recklessness." I note that the Division took one of Respondent's expert witnesses to task for his imperfect understanding of "materiality" (Tr. 900; Div. Prop. Find. # 485-89, Div. Br. at 41 n.152). |
| 27 | Tr. 927; see KPMG Peat Marwick, L.L.P., Initial Decision, 71 SEC Docket 1464, 1497-98, 1507 n.59 (Jan. 21, 2000), petition for review filed. |
| 28 | Administrative disciplinary proceedings against accountants originate with a recommendation to the Commission by the Office of the Chief Accountant. See 17 C.F.R. § 200.22. Until December 1993, the Office of General Counsel handled the prosecution. The Commission then transferred prosecution responsibility to the Division. See SEC News Release No. 93-62 (Dec. 9, 1993). The rule was renumbered as Rule 102(e) in 1995 as part of a comprehensive revision of the Rules of Practice, but was not changed in substance. See Rules of Practice, 59 SEC Docket 1546, 1554-55 (June 9, 1995). |
| 29 | Little guidance comes from the OIPs in comparable cases, alleging pre-1998 reckless professional conduct by accountants, but issued after the 1998 rule amendment. The OIPs in Kevin E. Orton, CPA, Admin. Proc. 3-9872 (Apr. 14, 1999), and Barry C. Scutillo, CPA, and Mark F. Jensen, CPA, Admin. Proc. 3-9863 (Apr. 1, 1999), do not invoke Rule 102(e)(1)(iv)(A). In contrast, the OIPs in Michael J. Marrie, CPA, and Brian L. Berry, CPA, Admin. Proc. 3-9966 (Aug. 10, 1999) at ¶ 48, and Scott E. Edwards, CPA, Admin. Proc. 3-10220 (June 8, 2000) at ¶ 28, do invoke Rule 102(e)(1)(iv)(A). |
| 30 | Private plaintiffs alleging securities fraud filed most of the cited cases. Many of the decisions involve rulings on motions to dismiss complaints under Federal Rule of Civil Procedure 9(b) (failure to plead fraud with particularity). Others involve rulings on motions to dismiss complaints under the heightened pleading requirements of the Private Securities Litigation Reform Act of 1995 (PSLRA). None involve adjudications under Rule 102(e).
While the PSLRA creates new pleading standards applicable to private plaintiffs distinct from the pleading standards governing the Division, there has been no change in the substantive law regarding what constitutes scienter under the federal securities laws. The Division might not be precluded from initiating or maintaining an antifraud case as easily as an ordinary civil plaintiff, but it is not sufficient for the Division to rest its case on evidence of scienter that would be inadequate to plead or prove a case in a civil Rule 10b-5 suit. A ruling to the contrary would render meaningless the Commission's representation, with regard to Rule 102(e)(1)(iv)(A), that "for purposes of consistency under the federal securities laws, `recklessness' in subparagraph (A) of the rule amendment should mean the same thing as courts have defined `recklessness' to mean under the antifraud provisions" of the federal securities laws. See Rule Amendment, 68 SEC Docket at 710. |
| 31 | See Rule Amendment, 68 SEC Docket at 721 (Johnson, Comm'r, dissenting) ("I support the intentional or reckless part of the amendment without reservation. As to that part addressing a pattern of negligence, I would generally reach the same result as the majority, but through a different analysis [i.e.,] . . . only if the pattern of negligence supports an inference that the accountant acted recklessly.") (footnote omitted); see also Wallace's Answer at 4 (raising the affirmative defense that Rule 102(e)(1)(iv)(B) is fundamentally ambiguous, ignores Checkosky I and Checkosky II, and violates due process). |
| 32 | If other competent evidence proved recklessness, then it would be appropriate to consider the evidence of negligence when sanctioning. |
| 33 | See Division's Reply to Wallace's Motion for a More Definite Statement at 2, dated April 27, 1999. |
| 34 | The present OIP contrasts with the OIP in Michael J. Marrie, CPA, and Brian L. Berry, CPA, Admin. Proc. 3-9966 (Aug. 10, 1999) at ¶¶ II.D.9 and II.D.10. In that proceeding, it is specifically alleged that the respondents decreased staffing and cut audit hours to keep down expenses, assigned a junior associate with less than two years' auditing experience as the "in charge" accountant, and appointed another junior associate with less than six months experience to assist the "in charge" accountant. No comparable allegations were made here about the technical training and proficiency of the junior auditors, and the focus of this OIP is on Wallace's supervision. |
| 35 | The Commission's staff has recognized the limited scope of these two ASRs and has expressed the view that "they were not intended to provide comprehensive guidance to funds on how to address all pricing issues" but only "to provide general illustrative guidance on certain valuation issues." Investment Company Institute, SEC No-Action Letter, [1990-2000 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 77,658 at 76,383, 76,385 (Dec. 8, 1999). |
| 36 | Obviously, there are practical limitations on the level of "hands on" involvement by a fund's board in its oversight of "fair value" pricing, and nothing in this decision should be read as suggesting otherwise. This decision does not address situations where a fund's board fair values instruments other than the common stock of domestic corporations posted on the electronic bulletin board. Nor does it address the obligations of directors or outside auditors of open-end funds that value their securities daily, or of closed-end funds other than BDCs. It does not address situations where fund boards have appointed valuation committees to minimize the burden of pricing on directors. Finally, it does not consider the obligations of a fund's board when the board has adopted a single, clear valuation methodology, has articulated that methodology in a recent prospectus, and has consistently followed that methodology. |
| 37 | AU § 339.01 provides that the information contained in the work papers constitutes the principal record of the work that the auditor has done and the conclusions that he has reached concerning significant matters. AU § 339.05(c) provides that work papers ordinarily should include documentation showing that the audit evidence obtained, the auditing procedures applied, and the testing performed have provided sufficient competent evidential matter to afford a reasonable basis for an opinion. The Audit Risk Alert-1993 provides that auditors should document work paper conclusions as if they will be challenged on them because it is likely that they will be challenged.
Wholly apart from the guidance of AU § 339 and the Audit Risk Alert-1993, Wallace was obliged to show that he "obtained" sufficient competent evidential matter under the third standard of field work. If he could not do so through documentation, he had to do so through credible testimony. Here, he did neither. |
| 38 | The Commission has stated its views on the improper valuation of restricted securities in several settled cases that predated the audits in question. See Robert A. Domingues, CPA, 50 S.E.C. 1091, 1094-96 (1992) (settled case) (applying ASR Nos. 113 and 118 to sanction outside auditors of a BDC for improper professional conduct).
Several settled cases arose out of the collapse of Vintage Group, Inc., a BDC. See Brewster B. Gallup, 56 SEC Docket 1872 (May 3, 1994); John J. Mohalley, 56 SEC Docket 253 (Feb. 18, 1994) (applying ASR No. 113 to a BDC); Beatrice A. Brown, 55 SEC Docket 2652 (Jan. 6, 1994); William V. Burns, CPA, and Hemming Morse, Inc., 55 SEC Docket 249 (Sept. 28, 1993) (outside auditors). Several other settled cases arose out of the collapse of Corporate Capital Resources, Inc., a BDC. See Daniel L. Gotthilf, CPA, 56 SEC Docket 1543 (Apr. 21, 1994) (outside auditor); William P. Hartl and Eric P. Lipman, 55 SEC Docket 1115 (Nov. 8, 1993); Lloyd Blonder, 55 SEC Docket 393 (Sept. 30, 1993); Daniel D. Weston, 55 SEC Docket 388 (Sept. 30, 1993); Arnold M. Gotthilf, Public Accountant and Glenn R. Haft, CPA, 55 SEC Docket 224 (Sept. 28, 1993) (applying ASR No. 113 to sanction outside auditors of a BDC for improper professional conduct). See generally Carl L. Shipley, 45 S.E.C. 589, 591-92 n.6 (1974) ("A long series of such non-adjudicative orders issued in many cases may be significant for certain purposes as pointing to a settled administrative construction or practice."). While I am reluctant to cite settled cases as authority, I do so here because the Commission has never specifically updated or revised ASR Nos. 113 and 118 to embrace BDCs. |
| 39 | "With respect to valuation of non-exchange-traded investments by a certifying accountant, independent verification should be interpreted as reliance on quotations received from a source independent of the source used by the client. . . . In the case of only one market maker or broker-dealer providing a market quotation, the independent public accountant should employ alternative valuation procedures that provide an accurate and reasonable valuation." Accounting-Related Matters for Investment Company Registrants, SEC No-Action Letter [1994-1995 Decisions] Fed. Sec. L. Rep. (CCH) ¶ 76,956 at 78,762, 78,763 (Nov. 1, 1994). |
| 40 | Duffy and Yale did embrace the Division's "low bid price" analysis for year-end 1995 valuations (DX 144 at 5, DX 146 at 8), but they did not support the Division's argument for valuing unrestricted shares of Premier at $2.00 for year-end 1994. |
| 41 | Concepts Statement No. 2 is "other accounting literature" that an auditor "may consider." AU § 411.11. |
| 42 | The prospectus made clear that holders of the Fund's shares had no right to require the Fund to redeem or purchase their shares (DX 66 at 42). However, the prospectus only stated that it was "possible" that the market value of the Fund's common stock would bear little or no relationship to the market value of the Fund's underlying net assets or the resulting net asset value per share (DX 66 at 9) |
| 43 | As I use it here, the phrase "should have known" connotes recklessness. Greebel, 194 F.3d 198-99; Gelfer, 96 F. Supp. 2d at 15 n.6. |
| 44 | A civil statute or agency regulation may be void for vagueness if it does not define the conduct it prohibits so that an ordinary person would not know what is required of him. See Grayned v. City of Rockford, 408 U.S. 104, 108-09 (1972); Association of Intl. Automobile Mfrs., Inc. v. Abrams, 84 F.3d 602, 614 (2d Cir. 1996); Freedom to Travel Campaign v. Newcomb, 82 F.3d 1431, 1439 (9th Cir. 1996). |
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