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Initial Decision of an SEC Administrative Law JudgeIn the Matter of
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In the Matter of JEFFREY M. STEINBERG
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INITIAL DECISION
December 20, 2001 |
| APPEARANCES: | Kevin P. O'Rourke, Mark A. Adler, and Sean X. McKessy for the Division of Enforcement, Securities and Exchange Commission
Gandolfo V. DiBlasi for Respondent Jeffrey M. Steinberg Daniel F. Kolb for Respondent John Geron |
| BEFORE: | Robert G. Mahony, Administrative Law Judge |
I. INTRODUCTION
The Securities and Exchange Commission (Commission or SEC) instituted this proceeding on May 22, 1998, by an Order Instituting Proceedings (OIP) pursuant to Section 21C of the Securities Exchange Act of 1934 (Exchange Act). The OIP alleges that Respondents Jeffrey M. Steinberg (Steinberg) and John Geron (Geron) caused Spectrum Information Technologies, Inc.'s (Spectrum) violations of Section 13(a) of the Exchange Act and Rules 13a-13 and 12b-20 thereunder. The OIP requests that a cease and desist order be issued against Steinberg and Geron pursuant to Section 21C of the Exchange Act, as well as any other appropriate remedial relief under that section.
The OIP alleges that Spectrum improperly accounted for transactions with three entities, Megahertz Corporation (Megahertz), Apex Data Corporation (Apex), and U.S. Robotics, Inc. (U.S. Robotics). This improper accounting resulted in materially false and misleading quarterly reports for the quarters ended June 30, 1993 (First Quarter), and September 30, 1993 (Second Quarter). As a result of the improper accounting, Spectrum reported net income of approximately $400,000 in the First Quarter when it actually had suffered a net loss. Similarly, Spectrum reported net income of approximately $650,000 in the Second Quarter when it had suffered a net loss. The OIP also alleges that the quarterly reports contained inadequate footnote disclosures regarding the transactions. The quarterly reports purportedly violated Section 13(a) of the Exchange Act, and Rules 13a-13 and 12b-20 thereunder.
Respondents allegedly caused these violations by concurring with Spectrum's improper accounting treatment when they knew or should have known that the accounting was improper and that Spectrum would use their concurrence to justify the improper accounting. Steinberg is also alleged to have further caused the violations by drafting and revising footnotes to the financial statements included in the quarterly reports that concealed the true substance of the transactions in question. The OIP alleges that by these actions, Respondents failed to exercise the requisite due care. (OIP ¶¶ 1-3, 53.)
II. FINDINGS OF FACT
The findings and conclusions contained herein are based upon the record, my observation of the witnesses, all arguments and proposals of fact and law, as well as the relevant statutes and regulations.1 Preponderance of the evidence was applied as the standard of proof. See Steadman v. SEC, 450 U.S. 91 (1981). All arguments, proposed findings, and conclusions put forth by the parties were considered, and those consistent with this Initial Decision were accepted.
Jeffrey M. Steinberg
Steinberg graduated with high honors from the Wharton School of the University of Pennsylvania in May 1980, earning a bachelor of science degree in economics. He began his employment in the New York City office of Arthur Andersen in June 1980, and passed the certified public accountant examination in November 1980. He was promoted to manager in 1985, and was admitted to the partnership in September 1992. (Tr. 1536-37.)
Until recently, Steinberg concentrated in the audit and business advisory practice. He worked with a number of the office's largest clients, among which were approximately twelve advertising agencies, including two of the four largest advertising agencies in the world. Steinberg has been an instructor at Arthur Andersen for a number of years, regarding primarily advertising industry issues. (Tr. 1537-38.)
After becoming a partner, Steinberg transferred to the Long Island, New York office and became one of two audit partners in that office. (Tr. 1539-40.) In 1993, he served as the engagement partner for approximately thirty clients from various industries.
John Geron
Geron received a bachelor of science degree in accounting from the University of Scranton in 1966. (Tr. 2216-17.) He began his employment with Arthur Andersen in 1967. He became a partner in 1978, and spent two years in Hong Kong establishing an Arthur Andersen office. He returned to the New York City office in 1980, and became the head of an audit division in 1988. In March 1993, Geron became the regional practice director for the northeastern United States. (Tr. 2206-07.)
As regional practice director, Geron advises partners and managers in addressing accounting or auditing issues. He receives an average of fifteen to twenty inquiries a day regarding accounting and auditing guidelines, including generally accepted accounting principles (GAAP), statements from the Financial Accounting Standards Board (FASB), opinions of the Accounting Principles Board (APB), Statements of Position (SOP) from the American Institute of Certified Public Accountants (AICPA), consensus positions from the FASB Emerging Issues Task Force (EITF), and generally accepted auditing standards (GAAS). (Tr. 2208-12.) Neither Geron nor Steinberg has been named previously in any disciplinary proceeding.
Spectrum Information Technologies, Inc.
Spectrum is a Delaware corporation originally incorporated in Texas in 1984. It develops and licenses wireless data transmission technology through its wholly-owned subsidiary, Spectrum Cellular Corporation, also a Delaware corporation. (RX 314 at 1-2.)
In late 1992, Spectrum moved its headquarters from Dallas, Texas, to Manhasset, New York. (Tr. 542.) While in Dallas, Spectrum had been an audit client of Arthur Andersen's Dallas office. After the move, Spectrum became an audit client of Arthur Andersen's Long Island office. (Tr. 962-63.) Steinberg was the audit and engagement partner for the Spectrum audit.2 (Tr. 1543-44.)
The Megahertz Agreements
David E. Hardy (Hardy) served as outside legal counsel to Megahertz from 1986 to 1993. He then became senior vice president and general counsel of Megahertz. (Tr. 339.) When Hardy joined Megahertz in 1993, Megahertz and Spectrum were negotiating a new license agreement to replace a prior agreement that expired on March 27, 1993. (Tr. 344-45; RX 204.) At that time, Spectrum had commenced litigation to enforce certain patent rights. Megahertz felt that if Spectrum prevailed in its patent litigation, or entered into a license agreement with American Telephone & Telegraph Company (AT&T), everyone in the business would have to negotiate with Spectrum. (Tr. 350-62.) Megahertz's patent counsel felt that Spectrum's patent rights looked formidable and this, coupled with Megahertz's desire to market modems with cellular capabilities, led to the negotiation of a new license agreement and proposed advertising agreement. (Tr. 345-63.)
After extended negotiations, license and advertising agreements were executed on May 10, 1993. (Tr. 382-84, 410; DX 19, 20, RX 211, 212.) Under the license agreement, Megahertz paid a "sign-up" fee of $1.5 million, payable in six installments of $250,000. The first installment was due upon the signing of the license agreement. Five installments of $250,000 were due August 1, 1993; November 1, 1993; February 1, 1994; May 1, 1994; and August 1, 1994. (DX 19, RX 211.) The license agreement also called for Megahertz to pay continuing royalties based on unit sales. (Tr. 428; DX 19, RX 211, 469.) The advertising agreement obligated Spectrum to pay Megahertz $1.25 million in five payments of $250,000 on the same dates as the installment payments under the license agreement. (DX 20, RX 212.) During the term of the license agreement, all of Megahertz's advertising, packaging, externally visible product cases, and documentation for products incorporating Spectrum technology were to indicate that such product incorporated Spectrum technology. There was no discussion of the accounting treatment that either party would give the agreements. (Tr. 436.)
The advertising agreement relieved Spectrum from making payments if Megahertz cancelled the license agreement or failed to make an installment payment due thereunder. (Tr. 411; DX 20, RX 212.) Megahertz wanted a similar provision in the license agreement, or removal of this provision from the advertising agreement, but Spectrum refused both requests. (Tr. 411-12.) Hardy understood that each agreement called for separate obligations. Megahertz's obligation to pay under the license agreement was not contingent upon Spectrum's payments under the advertising agreement. (Tr. 410-13.)
Around the same time it was negotiating with Megahertz, Spectrum was negotiating with AT&T.3 In April 1993, Steinberg was in Spectrum's offices and heard from Peter Caserta (Caserta), Spectrum's president, and Sal Marino (Marino), the chief financial officer, that Spectrum was negotiating with AT&T. Marino described the terms of the AT&T transaction to Steinberg during a telephone conversation on May 17, 1993.4 That same day, Steinberg prepared a "key elements" memorandum for the AT&T transaction as described by Marino. (Tr. 1568; DX 68, 69.) Steinberg sent the memorandum to Marino via facsimile to confirm the facts as written. (DX 69, RX 270.) He then circulated the memorandum to other Arthur Andersen personnel to seek additional accounting advice.
Steinberg described the AT&T transaction as complicated. Under a patent license agreement described to Steinberg, Spectrum licensed its technology to AT&T for an initial fee of $150,000. Marino represented that this was a non-refundable fee and not an advance against future royalties.5 Spectrum would receive royalties as AT&T used Spectrum technology in its products. (Tr. 1569-70.)
Other key elements of the AT&T transaction were a promissory note, a call option, and a put option. The promissory note obligated AT&T to pay Spectrum $10 million on the earlier of two dates: the date AT&T exercised its call option, or within 180 days after Spectrum's stock reached a price of $5.50 per share. Marino told Steinberg that Spectrum's stock had reached the stated price, the timing was locked in, and Spectrum was entitled to receive $10 million in November 1993. (Tr. 1569-70.)
AT&T was granted a call option to purchase 3,636,364 shares of Spectrum stock at $2.75 per share for a total of $10 million. AT&T was also granted a put option, whereby it had the right to sell back the shares for $20 million. (Tr. 1571-72.) Stated simply, AT&T was obligated to pay $10 million to Spectrum under the promissory note. If AT&T exercised the call option and purchased Spectrum shares, it would have been obligated to pay another $10 million. If AT&T then exercised the put option, it would have received $20 million from Spectrum. (Tr. 1571-72.)
Marino and Steinberg discussed Spectrum's desired accounting treatment for the AT&T transaction. Marino believed that since the requirement for Spectrum to receive the $10 million had been met, this amount was a license fee in addition to the initial fee of $150,000 and should be recorded as income because it was a fixed amount. Marino believed that the $10 million payment met revenue recognition criteria because: (i) it was non-refundable, (ii) AT&T's creditworthiness was not an issue, (iii) Spectrum had performed by providing the technology, and (iv) it did not represent an advance of future royalties.
Steinberg had questions about the transaction. He needed to determine an appropriate income recognition date if the $10 million was to be considered income. He felt the call option involved an equity transaction and was not a revenue recognition issue. He assumed that AT&T would pay the $10 million under the promissory note and also exercise the call option. Steinberg assumed that AT&T would later exercise the put option, return the stock, and get its money back. (Tr. 1574-75.) If these events occurred, Spectrum would net only $150,000 from the initial fee.
On May 26, 1993, Steinberg spoke by telephone with Marino and Vito DeMaio (DeMaio), Spectrum's controller. (Tr. 992-93, 1243.) They discussed the AT&T and Megahertz transactions, and mentioned the Apex transaction in closing. (Tr. 973-74.) Marino and DeMaio claimed that upon advice of counsel, Spectrum had entered into two separate agreements with Megahertz. The first was a license agreement whereby Spectrum would license its technology to Megahertz. In return, Megahertz would pay Spectrum an upfront fee of $1.5 million in six quarterly installments of $250,000, one of which had already been made. The second agreement was an advertising agreement whereby Megahertz would refer to Spectrum technology in its literature, brochures, product boxes, or other types of advertising for products incorporating Spectrum technology. For the advertising, Spectrum would pay Megahertz $1.25 million in five quarterly installments of $250,000 on the same dates as the five remaining license installments. Marino and DeMaio explained to Steinberg that obtaining this type of cooperative advertising was critical during negotiations and a very important part of Spectrum's strategic business plan. (Tr. 1243-46, 1249-51.) Marino stated that the agreements were effective on March 29, 1993. (Tr. 974-78.) Steinberg knew that the license and advertising agreements were negotiated in the same general time frame. (Tr. 1077-78.)
Although Steinberg considered this a non-routine transaction, it was not unusual for Spectrum to contact him for advice. (Tr. 967-70, 983.) He knew that Spectrum's management lacked the expertise to account for non-routine transactions and they would rely on Arthur Andersen for necessary advice.6 Arthur Andersen preferred to be consulted on non-routine transactions by its smaller clients such as Spectrum. (Tr. 967-70, 1552; DX 72.) After the telephone call, Steinberg's initial reaction was that a conservative accounting approach under GAAP would be to consider the $250,000 received as revenue, and to net the quarterly installment payments under the license and advertising agreements. However, Marino and DeMaio sought a different treatment. (Tr. 1605-06.) Marino explained that Spectrum wanted to recognize revenue from the license agreement in the first quarter and amortize the $1.25 million payable under the advertising agreement over an extended period of time. Marino sought Steinberg's advice with respect to this approach. (Tr. 984.)
Steinberg prepared a key elements memorandum for the Megahertz transaction to aid in his analysis of Spectrum's desired accounting treatment, which included consultation with others. (Tr. 984-85, 1247; DX 74.) He provided a copy to Spectrum to verify the information. (Tr. 1002.) Steinberg sent Geron the key elements memoranda regarding the AT&T and Megahertz transactions on May 26, 1993. (Tr. 1584-85, 2220-21.) He called Geron later that day to discuss the issues in the memoranda.7 (Tr. 1585.)
Respondents researched and discussed the accounting issues raised by the AT&T transaction and concluded that the initial fee of $150,000 could be recognized as revenue, but that the $10 million due under the promissory note could not as it did not represent additional license fee income. (Tr. 1581-86, 2224; DX 75, 78.) Steinberg spoke with Marino the next day and informed him of the decision regarding revenue recognition for the AT&T transaction. He explained that it was Arthur Andersen's opinion that the promissory note, the call option, and the put option could not be viewed separately, but must be viewed as one transaction. Arthur Andersen believed that AT&T might exercise the call option and the put option, and Spectrum would net only $150,000. This contingency prohibited recognition of the $10 million as revenue. (Tr. 1588-91.) Steinberg again explained the reasoning when he met with Marino on June 4, 1993. (Tr. 1591-92, 1598-99; DX 78, 79.)
Steinberg's key elements memorandum regarding the Megahertz transaction listed the key elements as: (i) the "effective" date was March 29, 1993; (ii) the license agreement was for a period of seventeen years, with a non-refundable initial fee of $1.5 million plus continuing royalties; (iii) the initial fee was payable in six payments, one of which had been received; (iv) achieving name recognition in the marketplace was critical to Spectrum, and it sought to accomplish this through the advertising agreement, with quarterly payments totaling $1.25 million coinciding exactly with the license payments in both timing and amount; and (v) the transaction was accomplished through two legally separate agreements with payments made in accordance with the terms of each agreement. (DX 74.)
The key elements memorandum described the accounting issues as follows:
1) Is there any accounting recognition at all of this transaction in the financial statements as of March 31, 1993?
2) Is it appropriate to recognize the "upfront" initial license fee all at once as revenue upon consummation of the agreement (despite the extended payment terms)?
3) Could the "advertising" payments be deferred and amortized over the expected period of "promotion" by [Megahertz] of Spectrum's technology (i.e., 17 years)? If such costs were incurred directly by Spectrum, expense recognition would be immediate-should the fact that a third party will do the promotion over an extended period impact the accounting treatment (i.e., "prepaid advertising")? Does the presence of the 17 year license provide any "evidence of recoverability"?
4) Would the most logical answer be to "match" the "license revenue" and "advertising expense" since the transactions are so clearly interrelated, despite the fact that two legal agreements were executed? In this scenario, Spectrum would record $250,000 as a "pure" non-refundable license fee and then (in later quarters) have equally offsetting amounts of license revenue and advertising expense.
5) Following on Question #2, does the presence of the "advertising agreement" constitute a "contingency" in the context of revenue recognition that would preclude immediate recognition of the license fee as revenue?
(DX 74.)
Respondents discussed the accounting issues presented by the Megahertz transaction.8 (Tr. 2234-35.) Spectrum wanted to recognize income from the sale of the technology license, and record an asset from the purchase of the advertising rights. (Tr. 2225.) Megahertz was unconditionally committed to pay for the technology license, and those payments were non-refundable. The only issue to Geron was the time period over which payments were to be made. (Tr. 2253-54.) Spectrum initially wanted to amortize the $1.25 million cost of the advertising asset over the seventeen-year life of the license agreement by assuming that the advertising would run the same length of time. (Tr. 2225-26.)
At this time, however, there was no clear guidance as to the recognition and amortization of advertising assets. Companies were utilizing a number of methods. The AICPA published a proposed SOP in June 1992 in an effort to reduce the diversity. See AICPA Exposure Draft, Proposed Statement of Position, Reporting on Advertising Costs (June 22, 1992) (Exposure Draft). Respondents wanted Spectrum to understand that the issue of amortization of advertising was unclear. (Tr. 2249-51.) Respondents had discussed issues of prepaid advertising, including valuation, capitalization, and amortization. Respondents did not believe that Spectrum would receive advertising for the seventeen-year life of the underlying patent and license agreement with Megahertz. (Tr. 1064; DX 75.) They felt that expensing the advertising payments over five quarters was more reasonable.
Geron wanted a shorter period than seventeen years, and ultimately three years was agreed upon as the amortization period. (Tr. 1627-30, 2274-76; RX 461.) Geron believed that amortizing the advertising over three years was consistent with SEC guidance that goodwill should be amortized over a period less than ten years. It was also consistent with the Exposure Draft. (RX 412.) An accepted amortization method was to expense the cost of the advertising over its estimated life. This was analogous to the approach Respondents suggested, which was to expense the advertising cost over the expected life of the technology. (Tr. 2277-79.) This is also what GAAP requires. (Tr. 2283-85.) The final version of the Exposure Draft stated that advertising is an asset and requires amortization over an acceptable period of time. (Tr. 2286.) See AICPA Statement of Position 93-7, Reporting on Advertising Costs (AICPA SOP 93-7).
The matching issue Respondents discussed was that payments under the license agreement and the advertising agreement coincided in both amount and due date. The end result would be neutral as to the income statement, but the amounts were not offsetting because, as Respondents were told, the agreements were separate and did not provide for any legal right of offset. (Tr. 2255-57.) There was an interrelationship due to the payment dates and amounts, but the agreements were not interdependent. According to Geron, it was incorrect to net the payments under the license agreement and the advertising agreement because both agreements had substance. The financial statements would not accurately display assets purchased and revenues made. (Tr. 2266.)
Due to the matching payments, the value of the advertising was the most critical element of the Megahertz agreements. (Tr. 1068, 1074-75.) Because payments under both agreements were due on the same dates and in the same amounts, Respondents were concerned as to whether Spectrum's management could support the value of the advertising and if the amount paid for the advertising was reasonable. (Tr. 2240-41, 2265.) Geron understood that Spectrum's management had told Steinberg the amount due under the advertising agreement was reasonable. Geron found it reasonable that Spectrum wanted to increase its name recognition through cooperative advertising with Megahertz and it was not unusual for Spectrum to compensate Megahertz for doing so. (Tr. 2232-34.)
Respondents reviewed the four criteria for revenue recognition and concluded that as long as Spectrum's representations met the criteria they had no reason to object to revenue recognition.9 (Tr. 2263.) There were no contingencies on performance that would prevent the immediate recognition of revenue. (Tr. 2258-60.) Geron had seen reciprocal transactions such as these before. Where each party wanted something from the other party, the reciprocal nature of the transaction seemed to make good business sense to Geron. (Tr. 2268-69.)
By June 4, 1993, based upon the facts presented to them about the substance of the transactions, Respondents believed that Spectrum's proposed accounting treatment was aggressive but complied with GAAP. (Tr. 1001, 1250-51, 1258-59.) However, Spectrum had to be able to demonstrate that the value of the advertising was $1.25 million to support the accounting treatment it sought. If it failed to do so, it could not recognize the upfront license fee of $1.5 million as revenue. (Tr. 1259-60, 1641-42.) Steinberg considered the advertising a prepaid asset because it provided a benefit that had not yet taken place. (Tr. 1045, 1261-63.) Had Respondents determined that the advertising agreement was a contingency in relation to the license agreement, they would have recommended the same treatment as the AT&T transaction where the promissory note, call option, and put option were all viewed as contingencies in relation to each other. (Tr. 1617-18.)
Steinberg assumed that the parties had agreed that the value of the advertising was $1.25 million, but there was never any discussion about the quantity of advertisements. (Tr. 1007, 1010, 1015, 1018-22, 1035.) Neither he, nor anyone at Arthur Andersen, took steps to independently value the advertising. (Tr. 1028, 1037.) Marino advised Steinberg that Megahertz projected first-year sales of 400,000 to 500,000 units with boxes displaying the Spectrum logo, and increased sales during the second year. This was the best information Steinberg had at the time about the quantity of advertising. (Tr. 1304-05.) However, based upon Marino's description of Megahertz as a growing modem manufacturer, Steinberg's believed they were doing a significant amount of advertising. (Tr. 1626.) Marino reiterated the importance of the Megahertz advertising because Spectrum did not get the expected public relations benefit it desired from the AT&T transaction. It was important that Megahertz emphasize that Spectrum technology was a valuable resource and that it was in Megahertz's products. (Tr. 1624; DX 75.)
Steinberg prepared a "Memorandum to the Files" dated June 4, 1993, to which Geron and others at Arthur Andersen contributed.10 (Tr. 1080; DX 78, 79.) Steinberg also sent a copy to Geron. (Tr. 1101; DX 77-79.) The memorandum incorporated suggestions from Geron regarding the accounting treatment that they considered appropriate for the AT&T and Megahertz transactions, documented conversations regarding the transactions, and stated the conclusions that they had reached.11 (Tr. 1627-30, 2400.) Steinberg also provided Spectrum officials with a copy of the June 4,1993, memorandum at a meeting on that date. He gave it to Spectrum "so they could understand the basis upon which the advice was provided and . . . to help them understand what their obligations would be on an ongoing basis with respect to the accounting treatment that they were seeking." (Tr. 1113.)
With respect to the accounting treatment for the Megahertz transaction, Respondents' conclusions were based on the representations that Spectrum's management had made during the May 26, 1993, telephone call and in conversations prior to June 4, 1993. Spectrum had an accounting result in mind that it was hoping to achieve and had described the structure of the agreements, the value of the advertising, and the transfer of the license. Spectrum felt that it had two agreements that were legally separate and each was substantive in its own right. In Spectrum's view, the most appropriate accounting treatment was to give full recognition to the transfer of the technology license and full recognition to the purchase of the advertising asset.12 Based upon the facts as presented, Steinberg believed that the accounting treatment Spectrum sought was acceptable under GAAP. (Tr. 1082-84, 1250-52; DX 79.) However, Steinberg reiterated that such accounting treatment was aggressive and not the most conservative approach. (Tr. 1621.)
Respondents believed that Spectrum's recognition of $1.5 million as revenue from the Megahertz license agreement in the First Quarter would be acceptable under GAAP.13 It would not be considered an advance royalty payment, and continuing royalty payments by Megahertz were reasonable. After discussing the matter with Marino, Respondents concluded that there was no reasonable basis to question Megahertz's ability to make its payments to Spectrum when due. (Tr. 1090-92; DX 79.)
With respect to the advertising agreement, Respondents advised Spectrum that the suggested seventeen-year amortization period was not appropriate because of the volatile nature of the cellular technology industry. They noted that the advertising charges should be written off in about two years based upon Megahertz's projections of using Spectrum technology for a twenty-four month period. After discussion with Spectrum management about alternatives, Respondents advised that they could envision no circumstances where any portion of the deferred charge would be unamortized after three years from the initial payment dates. (DX 79.)
Steinberg clearly explained that a periodic evaluation (at least quarterly) of the recoverability of the advertising asset would need to be made. If market conditions or Megahertz's use of Spectrum's technology fell short of expectations, an accelerated write-off of the deferred charge would have to be considered. A careful evaluation would have to be made at each review date to determine if the asset was impaired. Steinberg noted the net effect of this accounting treatment would be $1.5 million of revenue in the First Quarter and no net profit or loss for several quarters thereafter. (Tr. 2318-19; DX 79, RX 749.)
The Apex Agreements
John Chess (Chess) was one of the founders of Apex in 1992, and served as its president and chief operating officer. When Apex was founded, its primary business was manufacturing modems. (Tr. 132-33.)
In March 1993, Chess attended a meeting in Manhasset with Spectrum officials to consider a license agreement. Spectrum proposed a license agreement in the amount of $1.5 million. (Tr. 143, 150-51.) Chess advised that Apex was financially unable to enter into an agreement for that amount. (Tr. 151, 159.) After a series of negotiations, license and advertising agreements were executed.14 (Tr. 199; DX 54, 55.) The license agreement called for a payment of $5,000 on execution, a payment of $45,000 after certain engineering work was completed, $1.5 million payable in quarterly installments of $250,000, and continuing royalty payments. (DX 54.) The advertising agreement obligated Spectrum to pay $1.5 million for advertising that would appear on Apex packaging, externally visible product cases, and documentation for products, although no specific quantity of advertising was described in the agreement. (Tr. 1359-60; DX 55.) The $1.5 million was payable in quarterly installments on the same dates as the payments due under the license agreement. The engineering work was not completed by Spectrum until over a year after the agreements were signed, and then Apex began shipping products incorporating Spectrum technology. (Tr. 237, 249, 310.)
At first, Chess testified that no payments were ever made under the license or advertising agreements because no payments were ever received from Spectrum and no advertising was ever performed. (Tr. 239-242.) However, on cross examination Chess acknowledged that in deposition testimony given in a class action proceeding in June 1995, he had testified that Apex had advertised products with Spectrum technology since June 1993. Chess further testified in response to a question about advertising involving Spectrum:
I remember certain advertisements that showed their logo and I believe their logo was displayed on some of our literature, on some of our boxes, certainly not all of the products. You know, I would represent that we made some effort to display the logo, but it's certainly not on all of our literature and every box we shipped product in.
(Tr. 283.)
Steinberg first heard about Apex during his conversation with Marino on May 26, 1993. (Tr. 968-69.) Marino stated that, except for two or three items, the Apex agreements were structurally and conceptually similar to the Megahertz agreements. Steinberg interpreted this to mean that the payments under both the Apex license agreement and advertising agreement would be made on the same day and in the same amount. (Tr. 974, 1133-35; DX 74.) This transaction was also noted in the Megahertz key elements memorandum drafted by Steinberg on May 26, 1993, and discussed with Geron later that day. Steinberg wrote, "Per [Marino], Apex transaction has very similar terms to those described below for Megahertz. Concepts are the same." (DX 74.)
In the June 4, 1993, memorandum, Steinberg stated that assuming assurance of Apex's creditworthiness, "upfront revenue recognition of the initial license fee should not be problematic." (DX 79.) Steinberg also stated, "Spectrum should follow the `Megahertz accounting treatment' for Apex as well . . . ." (DX 79.) He presented all conclusions set out in the June 4, 1993, memorandum regarding the AT&T, Megahertz, and Apex transactions at a meeting with Marino and DeMaio that same day. (DX 79.) At that time, Steinberg did not know when the Apex agreements had been signed. (Tr. 1120.)
Geron understood that the concepts involved in the Apex transaction were similar to the Megahertz transaction, and the accounting would be the same. (Tr. 2408-09.) He also noted that the three-year payment stream in the Apex transaction permitted a closer matching of the cash outflows by Spectrum and the expense recognition for the advertising payments than was achieved in the Megahertz transaction. This gave Spectrum some degree of control over the quality and quantity of advertising. (Tr. 2410-11.)
No one at Arthur Andersen took steps to value the advertising under the Apex advertising agreement, nor did Steinberg know the quantity of advertising to be provided. (Tr. 1038-43.) Steinberg believed that the dollar amount in the advertising agreement would represent the value of the advertising, but he did not know what that stated value was. (Tr. 1138.)
On July 12, 1993, Marino, John Rule (Rule), Spectrum's vice president of marketing for cellular, and their outside patent attorney, Charles Leedom (Leedom), called Steinberg to review one aspect of the Apex agreements.15 (Tr. 541, 1146; DX 89.) Specifically, Apex was concerned about its obligations in the event Spectrum declared bankruptcy. (Tr. 1151.) Apex was concerned that if Spectrum went bankrupt, it would be relieved of its obligations to pay Apex under the advertising agreement, but Apex would remain obligated to pay Spectrum under the license agreement. Steinberg was told there would be a six-quarter payment structure under the Apex agreements, which had been signed as of June 30, 1993.16 (Tr. 1180, 1183, 1663-66.) Because of bankruptcy concerns, Apex's counsel was hesitant about making payments over six quarters, or any extended period of time. (Tr. 1151-54.)
Steinberg assumed that due to Apex's concern, either Leedom or Marino had inquired if the $1.5 million payments called for under each agreement could be made on the same day rather than over six quarters. (Tr. 1156.) Steinberg advised that, as previously discussed relative to the AT&T and Megahertz transactions, the revenue recognition criteria had to be met. The credibility of each agreement had to be considered standing alone. Spectrum had represented to Steinberg that the advertising agreement was a separate obligation from the license agreement, with its own value. If true, the advertising agreement was not a contingency that would impact revenue recognition. (Tr. 1172-73.) Having previously seen Apex's financial statements, Steinberg was not convinced Apex could make one payment of $1.5 million without receiving $1.5 million from Spectrum at the same time. (Tr. 1169, 1173.) It appeared less substantive to exchange payments on one day rather than to pay over time when the advertising or other promotional activities were obtained.17 An exchange of payments on one day would make the advertising agreement appear less substantive than Spectrum had previously represented to Steinberg. This would have created both appearance and revenue recognition issues. (Tr. 1160-61, 1163.)
Steinberg made it clear that for Spectrum to achieve its objectives, there could be no connection or conditional relationship between Spectrum's obligations under the advertising agreement and Apex's obligations under the license agreement. (Tr. 652-53.) If the payments were made on one day, Spectrum still needed to establish valuable advertising worth $1.5 million, which would be recorded as a prepaid asset on that day.18 (Tr. 1275.) Further, the advertising had to be realizable as an asset from an asset recovery perspective. In his view, exchanging payments on one day changed nothing with respect to revenue recognition criteria.19 (Tr. 1195.)
Due to the timing of the inquiry about a one-day payment structure, Steinberg knew that Apex and Spectrum were still discussing the timing of the installment payments on July 12, 1993. Marino had previously told Steinberg that the Apex agreements had been signed as of June 30, 1993. However, Steinberg believed that the inquiry resulted from Spectrum and Apex negotiating a bankruptcy protection clause, which could have been a separate modification to an agreement executed on June 30, 1993.20 (Tr. 1176-79.) In Steinberg's opinion, the substance of the transaction was the exchange of the technology license and the value of the advertising. The substance did not rest completely on the timing of the payments and was not altered by the addition of bankruptcy protection language. (Tr. 1178, 1185.)
On July 13, 1993, Steinberg called Geron to advise him that Spectrum and Apex were considering making all payments due under the license and advertising agreements on one day. (Tr. 1270-71.) Geron opined that this would give Spectrum less control over the advertising than if the payments were made over time, but the advertising would still be considered an asset.21 (Tr. 2414-15; RX 279.) As was true with the Megahertz agreements, the value of the Apex advertising was crucial. To defeat any argument that the exchange of payments was the substance of the transaction, Spectrum had to show that the advertising had value. (Tr. 1274.) If the payments were to be made on one day, assurance that Apex could pay under the license agreement notwithstanding Spectrum's obligations under the advertising agreement would have been required. Inability to pay on that day would have affected revenue recognition. (Tr. 1675, 2421-22; RX 280.)
On July 14, 1993, Steinberg received "red-lined" unsigned drafts of the Apex agreements from Leedom via facsimile.22 Prior to receiving them he discussed Apex with Geron. (Tr. 1355; DX 45, 91, 91A.) The issue of exchanging payments on one day was still "on the table." (Tr. 1668-69.) Steinberg did not recall ever actually reviewing the agreements with Geron.23 (Tr. 1311-16.) Respondents ruled out treating the agreements as a non-monetary exchange because the value of the advertising was key. (Tr. 1325, 1672-74; DX 91, 91A.) Geron felt that the value of the advertising would determine how the transaction was recorded for revenue recognition purposes. The value of the advertising, not the timing of the payments, would determine if Spectrum could record $1.5 million of income from the license agreement. (Tr. 1326, 1328, 1676.) Spectrum could not merely inflate payment amounts due under the license and advertising agreements to increase revenue. (Tr. 1673-74.) Steinberg referred to this as "defeat[ing] the gross up issue." (Tr. 1326; DX 91, 91A.)
Although the timing of the payments had to be considered, the substance of the Apex and Megahertz transactions was the value of the advertising. Due to the reciprocal nature of the transactions, Spectrum had to show that the advertising it purchased had value. If the transaction did not have substance, it would have been just an exchange of payments. However, in Geron's view, the substance of the transaction was the exchange of rights: Apex's right to use Spectrum's technology and Spectrum's right to participate in Apex's advertising. (Tr. 2421-22, 2487; RX 280.)
Steinberg received another facsimile from Leedom on July 15, 1993, with proposed revisions to the Apex advertising agreement. The revisions called for Spectrum to report its cash position to Apex every two months beginning August 1, 1993. If Spectrum's cash position fell below $5 million, Spectrum had to create a cash collateral account, maintain a balance equal to the outstanding advertising balance owed, and give Apex a security interest in the account. If Spectrum was required to set up the cash account and did not do so within thirty days, the installment payments under both the license agreement and the advertising agreement were immediately due and payable. Leedom wanted to know if the revisions would change the accounting treatment Spectrum was seeking for the two agreements. (Tr. 1373, 1377-79; DX 50.) Steinberg considered the possibility of Spectrum's cash position falling below $5 million to be remote given its cash position of about $20 million. He viewed the proposal as a change in the bankruptcy protection language that Apex wanted, but it did not affect the accounting treatment. The proposed one-day payment exchange never took place.
The Rockwell Transaction
On July 21, 1993, Steinberg called Geron about a transaction Spectrum was contemplating with Rockwell International Corporation (Rockwell).24 It involved a sale of license rights and the creation of a joint venture relationship to market Spectrum's technology in Rockwell's products. Geron expressed concern due to the number of similar transactions that Spectrum was entering. Four had been discussed in the previous ninety days. Each involved the sale of license rights upfront and the creation of an ongoing advertising relationship. His concern was that although the sale of the license rights created current income, the ongoing relationships could cause Spectrum to incur future costs if the relationship did not work out as anticipated. He did not believe that the accounting was wrong, but unexpected problems could have resulted in impairment of the advertising asset. He believed that Spectrum could be criticized for this pattern of transactions if something went wrong, and he wanted Steinberg to discuss this with Spectrum. (Tr. 1390-91, 2430-36; DX 92.)
Geron's next contact concerning Spectrum was in late August 1993 when he spoke with Brian Peoples (Peoples), advisory partner for the Spectrum engagement, about an upcoming audit committee meeting.25 The last contact occurred in late September or early October 1993, when Steinberg called Geron about a stock option matter that Spectrum was considering. Respondents reviewed the proposal and advised Spectrum as to their conclusions. Caserta was unhappy with Respondents' conclusion, but they refused to change it. Altogether, Geron billed nine hours on the Spectrum matters with which he was involved. (Tr. 2380-91.)
Fiscal Year 1993 Audit
Steinberg signed the auditor's report on July 2, 1993. It was included in Spectrum's Form 10-K filed on July 7, 1993.26 A fifteen-day extension had been required because of difficulties with the audit. There were discrepancies in the financial statements of a Spectrum subsidiary acquired in 1992. Spectrum was required to restate its financial statements for fiscal year 1992, and all quarters in fiscal year 1993, in order to report information, including losses, in the correct quarters. After discussions with the practice director, Phillip Peller, Steinberg informed Spectrum of his decision to require the restatement. (Tr. 1562-66.) As a result, Spectrum reported a loss of $9.9 million.
The U.S. Robotics Agreements
In 1991, Ross Manire (Manire) joined U.S. Robotics as the vice president of finance. In 1993, he was the chief financial officer and senior vice president of operations. He gave the final approval on any major contract entered into by U.S. Robotics. (Tr. 477-78.) Manire approved the license and advertising agreements with Spectrum, both of which were signed on October 25, 1993.27 The license agreement called for five quarterly payments of $250,000 beginning December 31, 1993. Spectrum was to make identical and contemporaneous payments to U.S. Robotics under the advertising agreement. (Tr. 484, 492; DX 64, 65.) The license agreement did not contain any provision relieving U.S. Robotics of payment obligations if Spectrum did not make payments under the advertising agreement first. However, there was a provision in the advertising agreement whereby Spectrum was not obligated to make payments if U.S. Robotics did not make its payments under the license agreement. (Tr. 513-15.)
Spectrum Audit Committee Meeting
Steinberg, Peoples, and Anthony Teri (Teri), the managing partner for Spectrum's fiscal year 1994 audit, attended the inaugural Spectrum audit committee meeting on September 29, 1993.28 (Tr. 1544-46.) Steinberg had been encouraging Marino for several months to form an audit committee. The audit committee was composed of Spectrum directors. Two members of the audit committee were present along with Marino, who represented Spectrum's management. (Tr. 2613-14; DX 101.)
Peoples learned of the Apex and Megahertz transactions and the proposed accounting treatment from conversations with Steinberg and Geron.29 (Tr. 2298-99, 2604-09; RX 478.) Around August 1993, Peoples read a draft of the First Quarter Form 10-Q including the footnotes relating to the Apex and Megahertz agreements. (Tr. 2600.) Among other issues, Peoples discussed the portions of the First Quarter Form 10-Q regarding the license and advertising agreements with Steinberg. (Tr. 2601.) Peoples believed that the accounting complied with GAAP, but was not as conservative as might be desired. He was concerned that if unit sales did not reach projected levels, revenue would be recorded in one quarter, but the deferred advertising charge would be written off earlier than expected. (Tr. 2612-13.)
The attendees discussed the responsibilities of management versus the audit committee. The Arthur Andersen representatives discussed generally the function of the audit committee, including composition, focus, and frequency of meetings. Arthur Andersen personnel would be available to assist the audit committee as needed. (Tr. 1400-01, 1410, 1693-1705, 2613; DX 101.)
Marino reviewed a number of agreements for the audit committee, including the Megahertz and Apex agreements. (Tr. 2613; DX 101.) Marino mentioned the U.S. Robotics transaction, but gave no details. He described the U.S. Robotics transaction as similar to the Megahertz and Apex transactions with license and advertising agreements, and stated that Spectrum would account for the transactions similarly.30 Marino did not disclose the amounts or dates of payments due under the agreements.
Steinberg described the accounting treatment for the AT&T, Megahertz, Apex, and Rockwell transactions. (Tr. 1401-02.) Peoples criticized the accounting treatment being utilized. Although it complied with GAAP, it was not conservative.31 Due to the number of agreements involved, Peoples was concerned about increased chances of failure in the future.32 (Tr. 2613-18.) He also commented that it was important for Spectrum to take a more responsible position in license negotiations so as to refrain from agreements resulting in aggressive revenue recognition. With each questionable transaction Spectrum risked public scrutiny from both the media and the SEC.33 (Tr. 1413, 2615-14; DX 101) If unit sales did not meet projected levels, the revenue recognition and advertising expense deferral could be questioned. (Tr. 2615-16.) The audit committee seemed to agree with Spectrum management's proposed accounting treatment notwithstanding Peoples's and Steinberg's concerns. (Tr. 2613-18; DX 101.) However, Peoples emphasized that he would have spoken out if he believed that the accounting was not in conformity with GAAP. (Tr. 2617.)
On October 5, 1993, Steinberg and Peoples discussed the concepts involved with the license and advertising agreements. Peoples again expressed his concern that if unit sales of products incorporating Spectrum technology did not reach projected levels, the deferred advertising asset would have to be written off in a later quarter. The SEC might question such an occurrence and contend the advertising costs should never been deferred because they had no value in the first place. (Tr. 2623-24.) If sales reached projected levels, the advertising would clearly have value. If sales did not reach projected levels, the value of the advertising, if any, would not be so clear. (Tr. 2622-24; DX 103.) Peoples reminded Steinberg the transactions must have economic substance in order for Spectrum to recognize revenue.34 The advertising had to be real and substantive. If the transactions did not have substance and the advertising was not real and substantive, Steinberg would have recommended Spectrum net the two agreements. Peoples believed that the SEC would take the same view. (Tr. 1446-52; DX 103.) However, Peoples did not say that Spectrum's accounting treatment for the Megahertz and Apex transactions was incorrect, should be restated, or that he thought the SEC would disagree with the accounting. (Tr. 1727-28.)
Shareholder Questions
Steinberg and Peoples attended the annual Spectrum shareholders meeting on October, 20, 1993, in Pasadena, California. (Tr. 1463, 1466, 1729.) Prior to the meeting, Spectrum hired John Sculley (Sculley) as chief executive officer. Sculley was well known in the business community and had achieved a very good reputation from his prior experience at large corporations. Sculley addressed the shareholders meeting via hook-up from a remote location. (Tr. 1729-30.)
At Marino's request, Steinberg and Teri prepared possible questions that might arise at the shareholders meeting. Teri prepared answers to the questions.35 (Tr. 1463-64; DX 104.) They were intended to aid Spectrum officials in responding to questions posed at the meeting. The questions and suggested answers were designed to be short but appropriate for an anticipated audience of approximately 3,000 people. (Tr. 1472-73.) They covered numerous issues, including the Apex, Megahertz, and AT&T transactions. (DX 104.) Steinberg believed that the questions and answers accurately summarized the transactions at issue, tracking the language in Spectrum's quarterly reports. (Tr. 1475-78, 1731-32.) Spectrum officials never used the prepared questions and answers at the shareholders meeting. (Tr. 1731.)
Footnotes to the Quarterly Reports
Steinberg read and commented upon Spectrum's First Quarter and Second Quarter Forms 10-Q, before Arthur Andersen was terminated as Spectrum's outside auditor. (Tr. 1214, 1222-23.) Prior to viewing a draft of the First Quarter Form 10-Q, Steinberg learned that Spectrum had recorded the assets and liabilities related to the Apex and Megahertz agreements on its balance sheet. Steinberg recommended further disclosure regarding the agreements so that the recorded assets and liabilities could be explained. (Tr. 1501-09.)
When Steinberg drafted the June 4, 1993, memorandum, he expected Spectrum to record prepaid advertising payment by payment so there would never be any liability showing on the financial statements. However, Spectrum recorded the full amount of the advertising asset. Since payments would be made over five quarters, Spectrum needed to record a liability to cause each side of the balance sheet to increase by equal amounts. This reflected the full amount of prepaid advertising and the full amount that had to be paid for the advertising. Under this approach, Spectrum had a current liability for amounts that had to be paid out in twelve months, with the remainder being recorded as a long-term liability. Once Steinberg learned that the asset and current and long-term liabilities were reported, his suggestion, which became footnote eleven, was to disclose in more detail the amounts that had been recorded for the advertising asset and corresponding liabilities. He recommended that Spectrum disclose why they were recorded as presented and how they would be treated.36 (Tr. 1752-54.)
Spectrum added a footnote to another draft of the First Quarter Form 10-Q, which Steinberg reviewed. (Tr. 1507-09; DX 95.) Steinberg made written comments and suggestions on the draft, which Spectrum's management was free to accept or reject. (DX 95.) Steinberg did not draft the original language in relevant portions of the First Quarter Form 10-Q. (Tr. 1734-39.) The final version of the First Quarter Form 10-Q that was filed with the SEC on August 16, 1993, did not include Steinberg's suggested changes to the consolidated balance sheet or statement of cash flows. (Tr. 1747-49; DX 96, 97.)
Spectrum added footnote eleven to the First Quarter Form 10-Q in response to Steinberg's suggestions. (Tr. 1506-07, 1509; DX 95-97.) Footnote eleven to the First Quarter Form 10-Q read:
The Megahertz and Apex Data agreements were accompanied by mutual advertising agreements, in which both the Company and the licensees would participate, and under which the Company would make payments to each of the licensees to publicize the use of Spectrum's technology in the products they produce. The term of these advertising agreements would be for the life of the patents. The accompanying balance sheet as of June 30, 1993 includes $883,333 in other current assets and $1,866,667 in other assets, which reflect the anticipated benefits to be derived from the joint advertising agreements between the licensees and Spectrum for the Company's technologies which will be amortized in future periods. At June 30, 1993, $2,000,000 and $750,000, respectively, are included in current liabilities and other liabilities, to reflect the payments which the Company will make to Megahertz and Apex Data in connection with these mutual advertising agreements.
(DX 97.) Footnote eleven explained that Spectrum recorded prepaid advertising on the balance sheet in two parts: $883,333 as a current asset and $1,866,667 as a long-term asset. These amounts reflect the anticipated benefits to be derived from the advertising agreements, which would be amortized in future periods. Steinberg felt this disclosure gave the reader an idea as to when the expense would be occurring. (Tr. 1754-56; RX 303.) A reader could also determine that current assets had increased substantially. Likewise, other assets increased from $150,000 to over $2 million. Current liabilities had tripled and the balance sheet reflected that Spectrum would be paying $2 million within twelve months to Megahertz and Apex. Other liabilities of $750,000 referred to payments that would be made beyond the twelve-month period in connection with the advertising agreements. (Tr. 1756.) A reader could view those four numbers and determine what the increases represented and relate them directly to the advertising agreements. (Tr. 1756.)
With respect to the timing and amount of the payments, Spectrum disclosed the aggregate amount of the fees under the license agreements in footnote ten ($3.2 million) and the aggregate amount of the advertising payments ($2.75 million) in footnote eleven of the First Quarter Form 10-Q. Spectrum did not disclose that the payments were due on the same dates and in the same amounts. Steinberg stated that Spectrum had the option to disclose or not disclose this information. (Tr. 1514.) Footnote ten to the Second Quarter Form 10-Q read as follows:
During the quarter ended June 30, 1993 the company signed non-exclusive license agreements with AT&T, Megahertz and Apex Data. Each of the agreements involved a non-refundable initial license fee to be paid to the Company, totaling $3,200,000 in the current quarter and which are included in other revenues. The agreements also provide for royalty payments to be paid to the Company which would be based on volumes of production for the use of the Company's patented technologies. The AT&T agreement also includes a potential equity arrangement in excess of $10,000,000.
(DX 97.) The First Quarter Form 10-Q also stated that "[t]he increase for the quarter is primarily attributable to an increase in revenue at Spectrum Cellular to record the accrual of the non-refundable license fees of $3,200,000 to be paid by AT&T, Megahertz and Apex Data for the use of the Company's patented technologies." (RX 303 at 9.) Steinberg explained that the significance of the word "accrual" was to show that from Spectrum's perspective the revenue recognition process had been completed and Spectrum was entitled to recognize revenue under the three license agreements, but had not yet received the money. This caused a receivable to be reflected on the balance sheet due to the installment payment feature called for in the agreements. (Tr. 1758-59; DX 96.)
While in Paris on November 12, 1993, Steinberg received a facsimile draft of the Second Quarter Form 10-Q. (Tr. 1521-22, 1524; DX 106.) He read the draft, prepared some questions, and made comments. He included comments regarding the cash flow statement needing to show advertising amortization by quarter, a comment to add dates when proceeds were received, and comments regarding the cancellation of a line of credit of a subsidiary impacting liquidity. Spectrum did not incorporate these suggested changes into the Second Quarter Form 10-Q filed with the Commission. (Tr. 1762-69; DX 106, 106A, 108.)
Footnote six in the Second Quarter Form 10-Q explained certain portions of the balance sheet, and was very similar to footnotes ten and eleven of the First Quarter Form 10-Q. (Tr. 1769.) As in the other footnotes, Spectrum disclosed the assets, liabilities, and the amounts to be paid, but did not disclose the payment amounts and due dates. (Tr. 1529.) Footnote six of the Second Quarter Form 10-Q read as follows:
During the quarter ended September 30, 1993, the company signed non-exclusive agreements with U.S. Robotics, Inc., and Rockwell International Corporation. Each of the agreements involved a non-refundable initial license fee to be paid to the Company, totaling approximately $3,782,000 which are included in other revenues. During the quarter ended June 30, 1993, the Company signed non-exclusive license agreements with Megahertz, Apex Data and AT&T, which included non-refundable license fees totaling $3,200,000. These agreements also provide for royalty payments to be paid to the Company which would be based on volumes of production for the use of the Company's patented technologies.
These agreements (with the exception of two) are generally accompanied by mutual advertising agreements, in which both the Company and the licensee would participate, and under which the Company would make payments to each of the licensees to publicize the use of Spectrum's technology in the products they produce. The term of these advertising agreements would be for the life of the patents. The accompanying balance sheet as of September 30, 1993 includes $1,333,000 in other current assets and $2,587,000 in other assets, which reflect the anticipated benefits to be derived from the joint advertising agreements between the licensees and Spectrum for the Company's technologies which will be amortized in future periods. At September 30, 1993, $3,834,000 and $1,000,000, are included in current liabilities and other liabilities respectively, to reflect accruals of future payments which the Company will make to the above mentioned licensees in connection with these mutual advertising agreements.
(DX 109.) Steinberg did not prepare any portion of the Second Quarter Form 10-Q.
Subsequent Events
Just prior to the annual shareholders meeting, Spectrum sought Arthur Andersen's advice on accounting for a proposed stock option plan. In essence, Spectrum wanted to issue preferred stock options at $1.00 per share and then have the shareholders at the annual meeting eliminate the preferred stock and make the preferred stock options into common stock options. The common was selling for $6.00, but Spectrum did not want to change the price of the preferred shares, or record the $5.00 difference as compensation expense. Sculley was to get ten million of the preferred stock options.
After consulting with Geron and others at Arthur Andersen, Steinberg advised Spectrum that it would have to record an expense. Spectrum was "quite upset" to receive this advice. Spectrum's outside legal counsel attempted to persuade Arthur Andersen that it was incorrect, but Arthur Andersen would not change its opinion. Arthur Andersen was terminated as Spectrum's outside accountant on November 23, 1993, and replaced by KPMG Peat Marwick (KPMG). (Tr. 1771-80.)
Restatement of Results from First and Second Quarters
Eugene DeMark (DeMark) was the engagement partner for KPMG's audit of Spectrum for fiscal year 1994. In preparing KPMG's proposal to become the outside auditor, DeMark conducted a "prospective client evaluation." In conducting this evaluation, DeMark spoke with Steinberg about issues that remained after Arthur Andersen ceased being the auditor. He prepared a memorandum of this conversation dated December 3, 1993. (Tr. 774-76; DX 118.)
According to DeMark's memorandum:
In connection with [Spectrum's] recent transactions, including the AT&T, Megahertz and Rockwell license agreements, [Steinberg] indicated that Arthur Andersen was consulted with respect to [Spectrum's] accounting, and as part of this consultation Spectrum was desirous of reporting license income. [Steinberg] indicated that [Arthur] Andersen was involved in a number of discussions about accounting treatment and had concluded that [Spectrum's] accounting treatment, while gray, was, in [Arthur] Andersen's opinion, appropriate. [Steinberg] also indicated that [Arthur] Andersen's professional practice group, headed by Phil Peller, was involved in discussing the accounting for the AT&T and Megahertz license agreements. It should be noted that both of these agreements were negotiated and concluded in the first and second quarters of [Spectrum's] 1994 year end. On some of [Spectrum's] recent license agreements, [Steinberg] also informed me that David Evans, a reporter for Bloomberg Business News, has written some articles which describe [Spectrum's] accounting treatment in a slightly unfavorable light. Nevertheless, Steinberg informed me that the reporter has "had it out for the company" for a number of years and frequently called Arthur Andersen, in particular Jeff Steinberg, to discuss [Spectrum's] operating results.
. . . .
[Steinberg] confirmed that the AT&T and Megahertz license agreements were interesting and presented a number of gray areas with respect to income recognition. However, he indicated that [Arthur] Andersen was comfortable with [Spectrum's] accounting treatment and had been involved in reviewing the transactions prior to their closure.
. . . .
The results of these conversations confirmed information previously disclosed in the company's annual report and quarterly 10-Q and, as a result of this conversation and our association with John Sculley, I continue to believe that the acceptance of this engagement is appropriate.
(DX 118.)
In mid-December 1993, Roger Siboni (Siboni), KPMG's managing partner of its information, communication, and entertainment practice, asked DeMark to read Spectrum's agreements with Megahertz, Apex, and U.S. Robotics. Siboni indicated that Sculley was concerned about the accounting for these agreements. (Tr. 780, 789.)
In late January 1994, DeMark contacted Edward Trott (Trott) to discuss accounting issues involving Spectrum, specifically the Megahertz, Apex, and U.S. Robotics agreements.37 (Tr. 707-08, 711; DX 123, 123A.) KPMG was concerned with Spectrum's "trend" of agreements that, in KPMG's view, had offsetting obligations between licensees and Spectrum. (Tr. 807.)
After reviewing the agreements over a weekend, but prior to talking to DeMark or receiving any other information about the transactions, Trott felt the agreements needed to be "linked." (Tr. 739-40.) By "linked," Trott meant that the revenue stream under each license and advertising agreement should be netted to determine revenue. (Tr. 748-49.) Trott felt the advertising benefits, if there were any, should be accounted for as a non-monetary exchange under APB Opinion No. 29, Accounting for Nonmonetary Transactions (APB Opinion No. 29). (Tr. 747, 749.) However, Trott knew of no method for valuing the cooperative advertising, and made no inquiry as to if there was an appropriate valuation method. Because he felt the license and advertising agreements should be linked, he did not consider the issue. (Tr. 751-53.)
When DeMark met with Trott at the end of January 1994, they discussed the items on a "pro and con" list, which included the existence of an SEC investigation. (Tr. 882; DX 131.) The document listed:
PRO:
Separate legally binding agreements
License agreements are establishing value
Royalty provisions provide future income stream
Advertising agreement is separable and is amortized based on royalty payments
Agreements were negotiated with prior accountants advice
Independent investment banking analysis of cellular market indicates 1994 royalty of $14 million
Sign up fee is non-refundable
Accounting meets industry practice no credit risk
Alternatives are unacceptable
Acceptable practices
World renowned licensees
Tax Treatment
Current $40,000 per month royalty (Megahertz)
Modeled after Intel
CON:
Advertising agreements are concurrent
Substance over form
Advertising payments are lock step with license payment
Technology can change
Default events could stop payment
Accounting is aggressive
High visibility
Relationship of advertising to licensee
Risk of Criticism (listed twice)
Matching principal - royalty vs. licensee
SEC activities
Further adverse publicity
Concurrent agreements could inflate real value
Date agreements are signed
(DX 131.)
DeMark agreed that under the license and advertising agreements, one payment stream bought a license and the other bought advertising, but they did not "unbundle" the two sides of the transaction.38 KPMG gave some consideration to whether the advertising could be valued, but focused on the link between the payment streams. (Tr. 889-90.) The only consideration given to the advertising was whether or not in the aggregate, it was going to be recovered from future royalties. (Tr. 890-91.)
Trott and DeMark discussed the valuation of the advertising, but Trott "was not aware of how you could come up with such a value." (Tr. 737.) Again, Trott was not concerned with the value of the advertising as he did not believe Spectrum should account for the agreements separately. (Tr. 737.) He was unaware of advertising performed by any of the licensees, and did not state that the existence of advertising would have changed his view. (Tr. 738, 745-46.) DeMark testified that KPMG considered whether the royalty stream would be sufficient to insure the recoverability of the advertising asset. However, other than "to think about it," DeMark recalled nothing specific regarding the valuation of the advertising. (Tr. 904.)
After speaking to DeMark, Trott adhered to his view that the license and advertising agreements should be linked and accounted for as a unit. (Tr. 715-716, 720.) Trott later saw a memorandum prepared by DeMark or one of his associates that discussed the accounting treatment for the license agreements. (Tr. 733; DX 130.) The memorandum noted that "[a]t the current time, only one of the five agreements we reviewed has begun to generate a royalty stream," and that certain of the agreements provided for "further development and refinement of Spectrum's technology before saleable units can be produced by the licensee. . . . The existence of these future development provisions leaves some doubt as to whether the earnings process is complete." (Tr. 735-36, 745; DX 130.)
KPMG concluded that some of the agreements were recorded in the wrong accounting period because they reflected an effective date preceding the actual signing date. (Tr. 781-83, 833.) DeMark raised this issue with Spectrum's officials. According to DeMark, the dates used reflected the dates that Spectrum felt it had reached agreement on all substantive terms of the agreements. (Tr. 871.)
KPMG also concluded that the license and advertising agreements had to be looked at as one economic transaction and offset for accounting purposes.39 (Tr. 781.) KPMG viewed the issue as one of substance over form and concluded that the liability for the advertising payment should be offset against the license fees.40 Because Spectrum did not account for the agreements as a unit, it was KPMG's recommendation that the financial statements for the First Quarter and Second Quarter be restated. (Tr. 721.)
In early February 1994, KMPG advised Spectrum that the accounting used for the transactions at issue was incorrect and that it should restate its financial statements for the First Quarter and Second Quarter.41 As a professional courtesy, Trott informed Arthur Andersen that KPMG did not believe that the original accounting was in accordance with GAAP.42 Trott informed Arthur Andersen that KPMG felt the agreements had to be linked and Spectrum could not recognize total license fees as revenue and the prepaid advertising expense. (Tr. 726.)
In its restated financial statements, Spectrum reversed the non-cash portion of the revenue, representing approximately 88% of the revenue from the three license agreements. Instead of reporting net income for each of these quarters, Spectrum now reported net losses. When applying the test of substance over form with regard to the income statement, KPMG reflected the obligations as offsets. Spectrum reflected the net amount of the license fees less its obligation to make future payments as income. (Tr. 907-08.) The restated balance sheet still reflected receivables and payables for the Megahertz and Apex agreements. (Tr. 899-903.) DeMark stated that KPMG considered netting the receivables and payables, but decided against it because the principal issue was income recognition and KPMG felt it "would be appropriate to reflect both the licensee and the advertising obligation as assets and liabilities, respectively." (Tr. 901.)
Footnote eleven to the Amended First Quarter Form 10-Q disclosed that $400,000 reported in other revenue was the total non-refundable license fees under two license agreements less Spectrum's obligation to make payments under the companion advertising agreements. It also disclosed that $1.25 million was included in accounts receivable to reflect the balance of the non-refundable license fees due under the license agreements. Current liabilities included $1 million, and $250,000 was included in other liabilities, to reflect the payments Spectrum was to make in connection with the advertising agreements. (Tr. 903; DX 137.)
When Spectrum restated its earnings for the First Quarter and Second Quarter, it issued a press release listing A. Werner Pleus (Pleus) as the point of contact.43 Pleus received hundreds of calls from shareholders on February 7, 1994, the date of the press release announcing the restatement. (Tr. 940; DX 135.) It was also the day that Sculley resigned from Spectrum. The calls Pleus received concerned both the restatement and Sculley's resignation. (Tr. 946, 948.)
III. EXPERT WITNESSES
Sally L. Hoffman
Sally L. Hoffman, (Hoffman) testified as an accounting expert for the Division of Enforcement (Division). Hoffman became a certified public accountant in December 1981. She is a member of the AICPA and has served on various committees, including the Accounting Standards Executive Committee and the Professional Ethics Executive Committee. Hoffman became a member of the Auditing Standards Board on January 1, 1999. (Tr. 1861-63.)
Hoffman received her undergraduate degree from the University of Toronto and an MBA from Pace University in 1980. Her professional career began in 1980 as a member of the audit staff with the Main Hurdman firm. In 1987, Main Hurdman merged with KPMG and Hoffman became an audit partner with KPMG in 1988. (Tr. 1864-65.) In 1990, Hoffman left KPMG and joined Richard Eisner & Co. as a partner in the technical standards and litigation services groups. In March 1997, she joined Perelson Weiner as partner in charge of technical standards and litigation services. (Tr. 1864-66; DX 158 at ex. 5.)
Perelson Weiner was retained by the Division to opine on whether the accounting used by Spectrum for the license and advertising agreements with Megahertz, Apex, and U.S Robotics complied with GAAP. Perelson Weiner was also asked to consider whether the services Respondents provided complied with professional standards. Hoffman considered the relevant authoritative literature, the filings and reports in this case, and her own experience and professional training in forming her opinions. (Tr. 1869-70; DX 158 at ex. 5.)
Hoffman opined that Spectrum's accounting for the relevant transactions violated GAAP and that the net income reported for the First and Second Quarters was materially overstated. In her opinion, this rendered the financial statements materially false and misleading. Because Spectrum accounted for the license and advertising agreements as separate independent agreements, it accounted only for the form and not the substance of the transactions. Hoffman felt that the agreements were interrelated and must be accounted for together to properly reflect their economic substance.44 (Tr. 1871, 1922-23.)
Hoffman opined that because the installment payments under the license and advertising agreements were identical, the amount of the payments did not matter. The amount could have been $1.00 or $10 million, but the economic impact would remain zero.45 (Tr. 2122.) She linked each license agreement with each corresponding advertising agreement and netted the receivables and payables. (Tr. 2103-05.) Hoffman conceded that the agreements did not expressly provide for any right of offset. However, because she believed that the transactions were not substantive with regard to the advertising asset, receivables and payables were not created and, therefore, not recorded on the balance sheet. Hence, Hoffman felt the criteria set out in FASB Technical Bulletin 88-2, Definition of a Right of Setoff (FASB Technical Bulletin 88-2) were not applicable.46 According to Hoffman, even if receivables and payables were created and recorded, they did not support revenue recognition. She did agree, however, that booking receivables and payables is consistent with the terms of the agreements. (Tr. 2113-15.)
In Hoffman's opinion, the fact that there was no legal right of offset in the agreements did not "drive the accounting" for the transactions. (Tr. 2102-03.) Hoffman opined that no reasonable business entity would continue to make payments under the license agreement if Spectrum stopped making payments under the advertising agreement. Therefore, she disregarded the fact that the agreements had no offset rights. (Tr. 2116-17.)
Hoffman stated that the relevant license agreements were substantive agreements, but Spectrum should not have recorded a prepaid advertising asset. In her opinion, the advertising asset had no separate substance and its value could not be determined at the time the agreements were executed. (Tr. 1872-73, 2015-17, 2033-34, 2037-41, 2082.) According to Hoffman, the advertising was not an asset under GAAP at the time the agreements were executed because Spectrum had no way to require advertising, or control the quantity or quality of advertising. Spectrum would receive value only if products incorporating Spectrum technology were sold and the advertising was actually performed. (Tr. 1937, 1944, 1960, 1975-76, 1978, 2021, 2024.) Because Spectrum had no control of the advertising, an auditor would not be able to consult a specialist to assist in the valuation. Hoffman did not have the expertise to value the advertising and made no effort to consult a specialist to do so because she concluded that the advertising assets could not be valued as of the dates of the agreements. (Tr. 1957-58, 2006, 2052-56.) She assumed, however, that someone knowledgeable in advertising could evaluate the advertising that was planned by Megahertz. (Tr. 2024.) She agreed that if Megahertz advertised or sold products with Spectrum's technology, the advertising would be a valuable right for Spectrum. (Tr. 1961.)
Hoffman stated that Spectrum might have expected future benefits from the advertising agreements, but that expectation of future benefits was not an insufficient basis to record the prepaid advertising asset. Future benefits must be controlled and measured to meet the definition of an asset.47 (Tr. 1894-98, 1940-41.) Hoffman agreed that reasonable people could disagree as to whether the advertising agreements provided for a probable future economic benefit.48 (Tr. 1991.) After reviewing the testimony of Hardy, Chess, and Manire, Hoffman acknowledged that it was probable that they would provide advertising for the useful life of Spectrum's technology. However, she maintained her opinion that the probability of providing the advertising was not sufficient to record the advertising asset when the agreements were executed. (Tr. 2026-31.)
In her opinion, Spectrum should have recorded only $250,000 as revenue at the time the Megahertz agreements were executed. Instead, Spectrum recorded $1.25 million as revenue and deferred the advertising expense. Spectrum accounted for the Apex and U.S. Robotics transactions in the same way. (Tr. 1873-76.) Hoffman felt this recognition of revenue violated GAAP. (Tr. 1891.) The principle of revenue recognition requires that revenue be earned, realized, or realizable, and that to be realized it must be convertible to cash or a claim for cash. See FASB Statement of Accounting Concepts No. 5, Recognition and Measurement in Financial Statements of Business Enterprises (FASB Concepts Statement No. 5). Hoffman stated that the revenue from the license agreement payments was not realizable as it was not paid upfront, and it was not convertible into cash because it was going to be offset by the advertising agreement payments.
Hoffman opined that the installment payments due under the license agreement were contingent upon receipt of the advertising installments, and recognizing them as upfront revenue resulted in Spectrum recognizing a contingent gain. In addition, Hoffman opined that the "realizability" of the prepaid advertising asset was contingent because the license fee accounts receivable and the advertising fee accounts payable exactly offset each other. Furthermore, no advertising had been performed when the asset was recorded, and none was required unless Spectrum's technology was incorporated in the licensee's products. Thus, if there were no advertising, there would be no benefit. Likewise, if no products were manufactured or sold with Spectrum technology, there would be no royalties. By recording a contingent gain, Spectrum's accounting allegedly violated paragraph 17(a) of FASB Statement of Financial Accounting Standards No. 5, Accounting for Contingencies (FASB Accounting Standard No. 5). (Tr. 1891-93; DX 158 at 17-19.)
Hoffman further opined that Spectrum's accounting violated FASB Concepts Statement No. 5 and FASB Statement of Financial Accounting Concepts No. 2 Qualitative Characteristics of Accounting Information (FASB Concepts Statement No. 2). Spectrum allegedly violated FASB Concepts Statement No. 5 because the criteria of reliability/representational faithfulness, uncertainty or lack of measurability, the definition of an asset, and revenue recognition were not met. Also, FASB Concepts Statement No. 2 was allegedly violated because the principle of substance over form is subsumed in the qualities of reliability and representational faithfulness. (DX 158 at 20-25.) Hoffman found it very significant that as a result of the misstated results, Spectrum went from a net loss to a net profit, particularly since Spectrum incurred annual losses almost from its inception. Hoffman also found it significant that Spectrum issued a press release stating that it had two consecutive quarters of income for the first time in its history. (Tr. 1911.) Hoffman considered APB Opinion No. 29, but did not apply it because she determined that the fair value of the advertising was not determinable.49 (Tr. 2095.)
Hoffman believed that Respondents had sufficient information to conclude that the transactions were not accounted for in accordance with GAAP. (Tr. 1912.) Her report stated "[t]he accounting Steinberg and Geron approved, in addition to violating other accounting principles, is so clearly contrary to the economic substance of the transactions, that any objective accountant would have rejected the treatment." She concluded that Spectrum's accounting was not aggressive; rather, it was wrong. She felt that Respondents violated Article V of the AICPA Code of Professional Conduct, which requires that due care be followed in all professional engagements. (Tr. 1910-12; DX 158 at 25-27.)
D. Gerald Searfoss
D. Gerald Searfoss (Searfoss) testified for Respondents as an expert in accounting. Searfoss was retained to opine on the accounting issues in this proceeding and whether Respondents' actions were appropriate. (Tr. 2666; RX 478, 579, 753.)
Searfoss is a professor of accounting at the University of Utah, where he teaches both undergraduate and graduate courses. He has been a professor at the University of Utah for four and one-half years and also served on the faculty from 1976 to 1982. (Tr. 2654-55.) Prior to his current position, Searfoss was a national office partner for twelve years with Deloitte & Touche and its predecessor, Touche Ross. He was invited to join the partnership as the Director of Accounting Standards, a position he held for three years. His responsibilities included maintaining a relationship with the FASB and the AICPA, responding to AICPA exposure drafts, and participating on committees and task forces. (Tr. 2655-58.) He has served on the AICPA Accounting Standards Executive Committee (ACSEC), the senior technical accounting committee of the AICPA. ACSEC works with the FASB to develop and modify accounting guidance. (Tr. 2657-58.) He has co-edited a reference book on technical accounting issues, and has been a consultant on a broad range of complex and novel accounting matters. (Tr. 2659-61.) Searfoss is not an expert in auditing. (Tr. 2662.)
Searfoss opined that the accounting advice given by Steinberg, after consultation with Geron, fell within the scope of acceptable accounting practice at the time. (Tr. 2668.) Searfoss considered whether Respondents, given their respective roles and knowledge at the time, addressed the correct issues. He also considered that the advice was given at interim, rather than during an audit. (Tr. 2668-70.) Searfoss disagreed with Hoffman's opinions that: (i) the advertising should not be treated as an asset and amortized, (ii) the $1.5 million from Megahertz should not be treated as income, (iii) the payables and receivables should be netted, and (iv) the transaction should be viewed as a circle of cash without taking into consideration the substantive assets purported to be exchanged. (Tr. 2791-92.) Under the accounting guidance at the time of these transactions, Spectrum was permitted to recognize upfront income from the license agreements and defer the advertising expenses. (Tr. 2680-81, 2703-07.)
Searfoss stated that when an accountant advises a client at interim, the accountant gathers information about the transactions from the client and assesses it in the context of existing guidance and practice. It is not unusual to rely on the representations of the client when giving advice at interim. Respondents had no responsibility to validate the information Spectrum gave them. (Tr. 2669-70.) An accountant cannot object to a client's accounting treatment if consistent with GAAP, although not conservative, if the accountant believes that there is substance to the transaction and recognition tests are met. It is appropriate, however, for the accountant to counsel the client and point out risks, which is what Respondents did for Spectrum. (Tr. 2789.)
Searfoss disagreed with Hoffman's opinion that Spectrum violated the principle of substance over form by accounting for the license and advertising agreements separately. In a reciprocal transaction, if the items of value to be exchanged have substance, the transactions are viewed separately when accounting for them. (Tr. 2678.) Here, both the technology license and the right to engage in cooperative advertising had value.50
Searfoss opined that the advertising due under the advertising agreements met the definition of asset in FASB Concepts Statement No. 6. Spectrum controlled the contractual right to participate in the advertising. It was probable that the licensees would advertise and the future economic benefit, for which Spectrum would pay, was the advertising. (Tr. 2715, 2721, 2729.) If Spectrum became dissatisfied, it could withhold payment without losing the payment for the license because there was no contractual right of offset. (Tr. 2717.) Searfoss believed that Hoffman confused "control" with both "uncertainty" and "past transaction." (Tr. 2727.) Spectrum had legally binding agreements with the right to withhold payments if it was not allowed to participate in the advertising. The agreements constituted past transactions. Whether the market accepted the product incorporating Spectrum technology, or whether it became outdated, went to the issue of uncertainty, rather than control.51 (Tr. 2727, 2744-45.) Further, Searfoss stated that the uncertainty over appearance of the advertisements did not mean that the right to participate in the advertising was not an asset. (Tr. 2731.)
Searfoss would determine the value of the item being exchanged based upon Spectrum's representation of the value of the advertising to the company. (Tr. 2679.) Spectrum had represented to Steinberg that the parties to each agreement had negotiated at arm's length in arriving at the amounts involved in the transactions. It was reasonable for Respondents to accept Spectrum's representation that the advertising asset had value without doing an independent verification or audit. (Tr. 2689-91, 2698-2702, 2707, 2768.) Based on what he knew about the representations made to Respondents, and the fact that the representations were made at interim, Searfoss felt it was reasonable for Steinberg to believe that there was support to treat the advertising as an asset and to value it at $1.25 million. (Tr. 2746-47.)
Searfoss stated that at the time these agreements were executed, there was no specific authoritative guidance on how to amortize advertising.52 The Exposure Draft dealt with reporting on advertising costs and amortizing them against revenues over given benefit periods. (RX 528.) The draft stated that "[s]ome entities expense such costs over the estimated life of the advertising." Contrary to Hoffman's testimony, Searfoss concluded that certainty as to all aspects of such expenses was not necessary before they could be treated as capitalized and amortized assets. (Tr. 2763-65; RX 528.) Searfoss stated that the Exposure Draft and AICPA SOP 93-7 point out that it is the right to participate in the advertising, regardless of any revenues it may generate, that is the benefit. (Tr. 2765-66.) The process involves matching the advertising costs to revenues over the period in which advertising is expected, not the periods where revenues from the advertising are expected. (Tr. 2767, 2770-71.)
Arthur Andersen required that the Megahertz advertising agreement be amortized over three years. It believed this to be the useful life of the technology. Seventeen years, which was the life of the license agreement, was too long and unacceptable. (Tr. 2773.) Accounting guidance for amortizing purchased goodwill in the high-tech industry is to look to a period of less than ten years. (Tr. 2774; RX 538.) See SEC Accounting and Disclosure Rules and Practices, An Overview, Appendix A.II.L "Intangible Assets" ¶4 b. By rejecting seventeen years as the amortization period, Respondents acted in accordance with this analogous guidance. (Tr. 2775.) Searfoss opined that the proposal by Arthur Andersen to cap the useful life of the asset at three years asset and to allow the client to match against royalties during that time. (Tr. 2778.) Searfoss concluded that recognition of the advertising as an asset, with a three-year amortization period, was reasonable. (Tr. 2779-82.)
Searfoss also concluded that Respondents' approach to revenue recognition for the license fees was reasonable. (Tr. 2779-82.) Accounting guidance for revenue recognition provides that revenues and gains of an enterprise are generally measured by the exchange of values of assets, goods or services or liabilities involved. Revenue recognition involves consideration of two factors: (i) being realized or realizable, and (ii) being earned. (Tr. 2751-52; RX 505.) See FASB Concepts Statement No. 5 ¶ 83.
Searfoss disagreed with Hoffman's opinion that the cash flows constituted the substance of the transactions. If there is substance to the items being exchanged, in this case a license right for cash and a prominent association by way of advertising for cash, there is value being exchanged for value. It would be inappropriate to not treat them separately for accounting purposes. It would not be representationally faithful to account for the transactions based on cash flow alone.53 (Tr. 2685.) To be representationally faithful, the accounting for the advertising agreement should reflect a liability based upon Spectrum's obligation to pay for the advertising. The right to participate in the advertising would be a future benefit and reflected as an asset. (Tr. 2683-84; RX 566.) Because there is no legal right of offset, Searfoss stated that there was no basis for the accountant to offset the license agreements and the accounting agreements.54
Searfoss opined that the overall accounting and disclosure for the Apex transaction was reasonable. (Tr. 2801; DX 96, 108.) With regard to the proposed one-day payment structure, Searfoss stated that if there was substance to the things being exchanged, the coincidence of the timing would not dictate whether there was a recordable transaction involving an exchange of valuable rights. Under GAAP, the timing of the payments would not matter in determining whether there was a recordable transaction as long as there was substance to the reciprocal transaction. (Tr. 2748.) A one-day payment could have created an appearance problem, but he understood Respondents addressed this possibility by noting that the value of the advertising was "key."
As of June 4, 1993, Respondents knew the Apex agreements were structured similarly to the Megahertz agreements. (Tr. 2783.) Based upon Spectrum's representations, Searfoss felt that Respondents' assessment of the Apex agreements was reasonable. The transactions had not taken place and the need for adequate assurance of Apex's creditworthiness had been addressed. (Tr. 2784-85.) The addendum to the Apex agreement calling for Spectrum to create a cash collateral account under certain circumstances did not change Searfoss's opinion about the reasonableness of the accounting treatment. Searfoss understood the request for the cash collateral account language to be an amendment to a previously consummated agreement. Based upon the financial condition of Spectrum, he believed the chance that the conditions for creating the account would occur were remote. (Tr. 2795-96; DX 50A.) Furthermore, absent any integrity issue with Spectrum and considering that the advice was given at interim, it was reasonable for Steinberg to rely on Spectrum's representation of Apex's financial condition. (Tr. 2797; RX 271.)
Searfoss considered the substance of the Megahertz agreements to be the rights exchanged between the parties. Megahertz was getting a technology license and Spectrum was getting the right to participate in cooperative advertising. This arrangement made business sense for Spectrum because it associated Spectrum with a major modem manufacturer and gave it market exposure. The technology was valuable to Megahertz for modem production and to maintain its market position. (Tr. 2674-75.)
Spectrum fulfilled its obligation by transferring the license. Megahertz had to pay an unconditional upfront fee that did not represent future royalties, and it represented that it had the ability to pay. This meant that the earnings process was complete and Spectrum would recognize, in the period that the license agreement was consummated, the upfront license fee as revenue and a receivable from Megahertz. The cost of the advertising asset would be amortized over the periods in which the benefit was received. (Tr. 2756-60; RX 508, 509.)
Searfoss opined that the disclosures in footnotes ten and eleven to the First Quarter Form 10-Q, as well as the footnotes to the Second Quarter Form 10-Q, were sufficient. He felt footnote disclosure to be a matter of judgment based on how the transaction is viewed, and that reading footnotes ten and eleven to the First Quarter Form 10-Q disclosed the net effects of the transaction. He did not considerate it relevant that the exact payments dates were not set out. (Tr. 2800.)
William Wallace Holder
William Wallace Holder (Holder) testified as an expert witness on behalf of Respondents. Holder is the Ernst & Young professor of accounting at the Leventhal School of Accounting at the University of Southern California. His work has been in the area of financial reporting and auditing. His duties include teaching, research and publication, and professional and institutional service. He has been a full time faculty member since 1979. (Tr. 2976-77.) His prior experience includes a faculty position for five years at Texas Tech University where he taught financial reporting and auditing. He received a doctor of business administration degree from the University of Oklahoma where his principal field of study was accounting. He has written a number of books and authored or co-authored over fifty articles. (Tr. 2978-79.)
Holder has served as a member of ACSEC, holding the single position reserved for the academic community. Generally all AICPA accounting guidance that will achieve authoritative status must be approved by ACSEC. (Tr. 2979-81.) Holder has also served as a member of the Compliance Auditing Task Force of the Auditing Standards Board of the AICPA. He served as chair of the Financial Reporting Research Committee of the American Accounting Association and as a member of the Financial Accounting Standards Committee of the American Accounting Association. He has also served as a member and Chair of the Professional Conduct Committee of the California Society of Certified Public Accountants. (Tr. 2983.) Through his professional experience, he has become familiar with accounting standards and considers himself an expert in this area. (Tr. 2984.) He was asked to opine as to whether or not Respondents, in their respective roles, performed in accordance with professional standards. (Tr. 2984-85.)
Holder opined that Respondents' conduct complied with relevant professional standards. (Tr. 2985, 2989-90.) Considering his experience and knowledge of professional standards, and what Respondents knew at the time, Holder stated that Respondents considered the correct issues and exhibited the appropriate level of professional skepticism.55 (Tr. 2985-86, 2990-91; RX 586, 755.) He agreed with Respondents' concerns regarding multiple transactions with aggressive accounting. (Tr. 3096.)
Holder disagreed with Hoffman's opinion that the relevant transactions did not involve a matter of professional judgment. Holder felt the transactions required substantial professional judgment, and the judgments exercised complied with applicable professional standards. (Tr. 2994-95.) Holder stated that there are often uncertainties and ambiguities involved in determining financial statement amounts. In some instances there are no professional standards directly on point and a considerable amount of professional judgment must be used. Holder stated that the transactions in this case are the kind of "challenging accounting events" that require judgments and estimates in order to resolve the ambiguities. (Tr. 2992-93; RX 754.) See FASB Statement of Financial Accounting Concepts No. 1, Objectives of Financial Reporting by Business Enterprises.
Holder stated that financial information must be reliable and relevant to those using it. When there are no clear professional standards, the accountant must use professional judgment to determine the degree of reliability and relevance that will be achieved and whether that will be appropriate for a particular financial reporting purpose. The goal of the financial report is to be representationally faithful.56 At the time the financial statements are prepared, the responsibility to insure representational faithfulness through verification lies with management. If a client wishes to use an accounting method within GAAP, the accountant cannot insist that a more conservative approach be taken.57 Conservatism may be appropriate where uncertainties exist in accounting measurements, but a company is not required to select a method that reflects unfavorably on it. (Tr. 3000-03, 3005-06; RX 566.)
Holder reviewed the relevant financial statement footnotes in both the First Quarter and Second Quarter Forms 10-Q. (Tr. 3007.) He felt they complied with professional standards, and were in fact "excellent" because they were clearly worded, concise, complete, and conveyed the substance of the transactions very efficiently. He also noted the relevant balance sheet disclosures reflecting assets and liabilities. (Tr. 3007-09.) Holder felt the essence of the transactions was disclosed and it was unnecessary to disclose that payments were to be made on the same day. The payment dates were not part of the essence of the transactions, although the coincidence of the timing and amounts of payments were matters to be given serious consideration. (Tr. 3011.) The substance of the transactions was the exchange of rights and, as expressed to Steinberg, the transactions had a valid business purpose. (Tr. 3012.)
Holder stated it was proper to recognize revenue because it was earned and realizable. Spectrum had transferred to Megahertz and Apex the right to use its technology for the time set out in the agreement. Megahertz's obligation to pay the license fee was unconditional, non-refundable, and did not represent an advance of future royalties. Megahertz also had the ability to make the payments. (Tr. 3016-17.) On June 30, 1993, Steinberg received Apex's financial statements, which considered unaudited. These financial statements showed that Apex had obtained two or three substantial customers, evidence that Respondents were considering Apex's creditworthiness. (Tr. 3017-18; DX 40, RX 271.) The balance sheet showed significant liquidity and substantial accounts receivable. The financial statements showed substantial equity given the size of the company and "healthy" earnings for the two months presented. (Tr. 3020.) Holder stated that professional standards allowed the accountants to rely at interim on the oral opinion of the client that Apex was creditworthy. (Tr. 3021.)
Holder agreed with Hoffman that Spectrum's right to participate in Megahertz's advertising was a valuable right. He also agreed with Hoffman that it was probable that Megahertz would continue to advertise as long as the technology was viable. (Tr. 3022-24; RX 731.) However, contrary to Hoffman's view, Holder opined that Spectrum controlled that right. (Tr. 3031-42, 3053-55; RX 738.) Holder found Hoffman's use of the concept of control throughout her testimony too extreme. (Tr. 3057.) He also disagreed with Hoffman's assertion that uncertainty prohibited the recognition of the right obtained through the advertising agreement as an asset. (Tr. 3055-56; RX 546.) Holder felt the rights Spectrum obtained from Megahertz and Apex met the criteria for treating the advertising as an asset. (Tr. 3027-31.) He disagreed with Hoffman's view that there were no past transactions sufficient to qualify the advertising rights as assets. Holder viewed the signed agreements as being the past transactions. These agreements gave Spectrum the right to a future benefit: an absolute right to participate in cooperative advertising. (Tr. 3056-57; RX 608.)
In Holder's opinion, the advertising asset could have been valued and an accountant could have, if necessary, relied on the opinion of an expert in the field of advertising to do so. He disagreed with Hoffman's view that the advertising asset could not be valued especially when she did not seek expert advice. Based upon Spectrum's representations to Steinberg, Holder believed that Steinberg had a reasonable basis for believing that Spectrum would have support for the stated value of the advertising asset. If needed, additional evidence could have been obtained from advertising experts. (Tr. 3058-59.)
At this time, the methods of accounting for advertising costs varied, and this included the methods of amortization of advertising assets. The Exposure Draft referred to the diverse methods then in practice. Holder opined that Respondents' choice of amortization period fell within accepted practice. Holder agreed with Steinberg's advice that the advertising could be recorded in May 1993 and capitalized as an asset, and amortized for a period not to exceed three years, the expected life of the advertising. (Tr. 3062.) This advice met the requirements for amortization, which are that amortization be rational and systematic. He also agreed with Steinberg's advice that Spectrum review, at least quarterly, the recoverability of advertising costs. (Tr. 3063-64; 3067-68; RX 461, 538, 547A.) This was particularly appropriate because the cash flows were identical in amount and timing. If royalties from unit sales were to decrease, it may suggest that the useful life of the technology was diminishing. This could mean that the advertising asset was impaired. Additional information would be needed to assess that possibility. In any event, Spectrum was told that there would be further review and testing during the annual audit, particularly to verify the substance and value of the advertising. (Tr. 3068-69.)
Ultimately, the advertising asset had to be evaluated in terms of whether the cost attributable to it was reasonable or not. The additional advice of the Arthur Andersen accountants was to test for impairment for each quarter prior to the issuance of any financial statements. (Tr. 3086-87.) If treated as a non-monetary exchange under APB Opinion No. 29, and the $1.25 million was a fair value for the advertising, the net effect on income would be the same as if cash payments were made. The same values would be attributed to the transferred license rights and the advertising rights that were received. The advertising asset could be amortized the same way. (Tr. 3087-90.)
Holder did not agree with Hoffman's opinion that Spectrum violated the principle of substance over form. The parties exchanged valuable rights, and the structure of the transaction did not change its substance. It was reasonable to use the cash flows under the separate agreements as a basis for valuing the transaction, subject to verifications at audit. (Tr. 3092-93.) He also disagreed with her view that the payables and receivables should have been offset because to do so would have departed from the accounting standard for offsetting payables and receivables. (Tr. 3094-95; RX 466.) See FASB Technical Bulletin 88-2; see also FASB Interpretation No. 39, Offsetting of Amounts Related to Certain Contracts.
Holder found nothing sinister in the one-day payment structure considered by Spectrum and Apex. Holder agreed with Respondents' analysis that if the payments had been made on one day it would have diminished the significance of the cash flows, and it might have heightened concerns about the value of the license rights, the revenue, and the advertising asset. However, if there was substance to the transaction, the accounting would stay the same. (Tr. 3081-85.) He also believed that it was reasonable for them to consider how it would be treated as a non-monetary transaction under APB Opinion No. 29. Such an approach would diminish the significance of the cash flows and the accounting would be based on the fair value of either the asset given up or the asset received, whichever was more clearly determinable. He believed that the advertising could have been subject to reasonable estimation. (Tr. 3085-87.)
Holder relied on Steinberg's investigative transcripts regarding the execution date of the Apex agreements. (Tr. 3156-57.) Holder felt it reasonable for Steinberg to rely on Spectrum's representations regarding the signature date of the Apex agreements based on his prior dealings with Spectrum. Parties often decide to amend agreements after they are executed, and Steinberg had no reason to doubt Spectrum management's credibility and integrity. (Tr. 3158-63; DX 45.)
Allen Adamson
Allen Adamson (Adamson) received a bachelor of science degree in communications and marketing from Syracuse University in 1977 and his MBA in finance and management from New York University in 1979. Since 1992, he has been the managing director of the New York City office of Landor Associates, a branding and design consultancy and subsidiary of Young & Rubicam Inc. He guides the overall vision of the New York City office, overseeing all aspects of client relations, business development and operations for over ninety professionals. He led major global branding programs for Proctor & Gamble, Compaq, Pepsi, Kodak, and Iridium. (RX 599 at App. 2.) His prior work experience includes development of strategic branding and marketing programs for advertising agencies, as well as companies. (RX 599 at App. 1.) He is an adjunct professor of marketing/advertising at the Stern Graduate School of Business of New York University, and a member of the American Management Association. He speaks regularly on branding for a range of professional organizations and is frequently consulted on branding issues by journalists and industry publications. (RX 599 at 5.) He was retained by Respondents to give an expert opinion on the value of ingredient branding in advertising. (RX 599 at 1, 4.) In preparing his report, Adamson considered the license and advertising agreements with Megahertz, Apex, and U.S. Robotics, along with the OIP. (RX 599 at App. 2.)
After detailing branding, ingredient branding, and case studies involving Intel, NutraSweet, and Dupont's Lycra, Adamson claimed that "[i]ngredient branding is a valuable strategy for many brands to increase awareness of their products and services and to drive purchase decisions." (RX 599 at 17.) With regards to the entities at issue, Adamson determined:
By integrating [Spectrum] technology . . . into their modems as an ingredient, modem manufacturers had the possibility to gain competitive advantages in their markets. Spectrum had the opportunity to apply itself as a branded ingredient inside modem manufacturers such as Megahertz, U. S. Robotics, Apex and others. Their immediate goal was to gain brand recognition through alliances with these and other established brands. . . . I have reviewed some samples of advertisements placed by Spectrum's licensees incorporating references to Spectrum and its logo, and in my opinion, these advertisements are consistent with industry practice in ingredient brand strategies.
Financially, both Spectrum and the host brands would benefit from an ingredient branding strategy. Often both the host brand and the ingredient brand will share the costs of production, promotion and advertising. Advertising can serve to boost recognition of an ingredient brand and eventually may boost the image of the host brand. By helping to increase sales, it becomes a significant source of revenue for both brands. . . . In my opinion, Spectrum's proposal to model an ingredient branding strategy on the Intel approach was a reasonable one.
(RX 599 at 17-18.)
Suzanne Kaufman
Suzanne Kaufman (Kaufman) was retained by Respondents to provide an expert opinion as to whether the advertising rights Spectrum purchased from Megahertz, Apex, and U.S. Robotics were "customary, in accordance with general advertising industry standards, and capable of being valued with a reasonable degree of certainty." (RX 600 at 1.) Kaufman received her bachelor of arts degree in sociology and political science from Vassar College in 1975. She has been employed by The Media Edge from 1978 until the present, where she currently serves as executive vice president and planning director. The Media Edge is a media buying and planning firm that places more than $3.2 billion annually in advertising and promotion for approximately seventy clients worldwide. Kaufman is a member of the American Association of Advertising Agencies Marketing and New Technologies Committee, the Media Standards and Research Subcommittee of the Coalition of Advertiser Supported Information and Entertainment. She is also a chairperson of the Business Publications Audit Bureau Interactive Measurement Advisory Council. (RX 600 at 1, Addendum.)
Kaufman considered and relied upon Spectrum's advertising agreements with Megahertz, Apex, and U.S. Robotics, and her knowledge and experience in media buying in preparing her expert report (RX 600 at 2.) According to that report:
The basic question I address is whether it was customary for a second brand such as Spectrum, in exchange for the right to be included in another brand's advertising, to place a monetary value on such inclusion. The second question is, if this is a reasonable assumption, whether industry accepted methods exist to make such valuations. My opinion extends only to whether, having knowledge of the manner in which Spectrum's name would be, or had been, included in these materials and the extent and media through which the counter-party had or would place advertising, the value of the advertising rights purchased by Spectrum could be measured with reasonable certainty, either at the time the contract was entered into or after the advertising and promotion was completed.
(RX 600 at 2.)
Kaufman discussed a number of cooperative advertising techniques, including ingredient branding. In her opinion, the advertising program outlined in Spectrum's advertising agreements conformed to typical cooperative advertising programs, and could be valued with a reasonable degree of certainty by an advertising professional. (RX 600 at 3-7.) She concluded:
In my experience, it is a routine and common practice in the advertising industry for a secondary brand to place a value on advertising contained within another brand's advertisements. The value of such [cooperative] advertising can be predicted with a reasonable degree of accuracy at the outset of a [cooperative] advertising program based upon the advertising plans of the primary brand, and can be verified after the advertisements have run. There are a number of settled methodologies generally accepted in the advertising industry to establish a fair market value for such advertising. In my opinion, armed with some basic information about the advertising plan and budget of Spectrum's licensees, advertising professionals could establish a monetary value for the type of advertising programs described in the Spectrum agreements with a reasonable degree of certainty.
. . . .
Based on my knowledge of the agreements and the companies involved, the value of the advertising program to Spectrum should be assessed based on the impressions being delivered to Spectrum through the advertisements and the benefit to Spectrum from the association with its better known licensees . . . . Because there is some amount of processional judgment in evaluating the goodwill benefiting Spectrum from these associations, reasonable advertising professionals could reach different conclusions as to the ultimate value of Spectrum's portion of the advertising program. In my opinion, however, industry professionals, apply these generally accepted valuation techniques and methods of audience research and evaluation, would agree on an appropriate valuation within a relatively small dollar range.
(RX 600 at 2-3, 7-8.)
Dr. Charles Cox
Dr. Charles Cox (Cox) testified as an expert in financial economics on behalf of Respondents. Since 1989, Cox has been senior vice president of Lexecon, Inc., a consulting firm specializing in the application of economic analysis to legal and regulatory matters. From 1982 through 1983, he was Chief Economist at the SEC. From 1983 to 1989, he was a Commissioner, and was acting Chairman of the SEC in 1987. Prior to his service at the Commission, he taught economics at the undergraduate and graduate levels at Ohio State University and Texas A&M University. Cox holds a masters degree and PhD in economics from the University of Chicago. (Tr. 3254-56; RX 614.)
Cox was asked to examine the economic evidence pertaining to materiality issues. (Tr. 3260.) Cox reviewed news articles concerning Spectrum, including those regarding Spectrum's agreements with Megahertz, Apex, and U.S. Robotics. He reviewed Spectrum's quarterly reports and other documents relevant to this proceeding, including expert reports. He also collected stock price data and studied the relationship between stock price movements and disclosures made by Spectrum. (Tr. 3260-61.) Cox formed two opinions in connection with this matter: (i) accounting changes are economically material to security prices only if they affect the disclosure of important information not already available to investors, and (ii) the economic evidence did not support the conclusion that Spectrum's accounting for the Apex, Megahertz, and U.S. Robotics transactions was material to the price of Spectrum's stock. (Tr. 3261.)
Ronald J. Murray
Ronald J. Murray (Murray) testified as an expert witness on behalf of Respondents in the areas of auditing and accounting. Prior to his retirement on September 30, 1996, he was a partner with Coopers & Lybrand. He served as the National Director of Accounting and SEC Services, which is the senior technical partner for accounting, financial reporting, and SEC matters. His responsibilities included handling the firm's relations with the FASB, the International Accounting Standards Committee, the AICPA, and regulatory bodies such as the SEC. He was also responsible for the firm's internal publications on accounting, financial reporting, SEC matters, and policy manuals. Other responsibilities included being in charge of the firm's accounting, auditing, and SEC consulting function for handling client problems. He has had experience in dealing with issues similar to the ones in this proceeding and providing advice at interim. (Tr. 3416-19.)
From 1967 to 1970, Murray was a practice partner and audit partner in the New York City office of Coopers & Lybrand. (Tr. 3421-22.) In 1970, he became an Accounting, Auditing and SEC consulting partner. In 1983, he became Director of Accounting, Auditing and SEC Consulting. He was also in charge of the consulting function, and partners who were in positions similar to that of a practice director at Arthur Andersen reported to him. He served as Director of Accounting and SEC Technical Services. He has served on various professional committees, including ACSEC from 1982 to 1985 and the EITF from 1987 to 1996. (Tr. 3422-23.)
Murray was engaged to render an opinion on whether the advice Respondents gave Spectrum complied with GAAP and whether Respondents acted with due professional care in rendering the interim advice. (Tr. 3424-25; RX 578, 787.) In Murray's opinion, the advice that Steinberg gave to Spectrum, after consultation with Geron, complied with GAAP. Furthermore, he opined that Respondents acted with due professional care. (Tr. 3429.) Like Holder, Murray stated that as long as the Spectrum's proposed accounting treatment was within GAAP, Respondents could not declare it to be incorrect. (Tr. 3514-15.)
Murray focused on what Respondents knew between May 26,1993, and June 4, 1993, and concluded that Marino's oral representations were the principal source of information during this time.58 (Tr. 3430-32, 3434; RX 572, 573.) Respondents were entitled to rely on Spectrum's representations when issuing advice at interim as long as the representations seemed reasonable and did not conflict with the facts known to Respondents. (Tr. 3430.) Respondents did not have a responsibility to verify the representations regarding the value of the advertising. They had no reason to believe that the representations were unreasonable. (Tr. 3480-82.) However, it was appropriate for Respondents to tell Spectrum that the accounting advice would be subject to further review and testing at audit, including verification of the value of the advertising by independent specialists. This was evidence that Respondents had exercised an appropriate degree of professional skepticism. (Tr. 3479, 3481-82.)
Murray felt that Steinberg exercised the appropriate degree of professional skepticism when Spectrum informed him of the simultaneous payments under the license and advertising agreements. (Tr. 3490.) Contrary to Hoffman's view, Murray believed that the two separate payment streams under the license and advertising agreements made business sense. In the event of non-performance under the advertising agreement, the license agreement could aid in establishing damages. Furthermore, it provided additional leverage to Spectrum as the licensees' performance obligations ran into the future, whereas Spectrum had already completed performance. (Tr. 3442, 3491-92.)
Murray stated that, as represented to Steinberg, the tests for revenue recognition were met. (Tr. 3448-49; RX 508, 509.) The advice Respondents gave Spectrum regarding revenue recognition for the Megahertz and Apex license agreements was correct. (Tr. 3454-55.)
Steinberg correctly concluded that the value of the advertising was the key to assessing the substance of this transaction. He was also correct to insist that that the value assigned to the advertising represent its real value, which would be tested at audit.59 (Tr. 3490.) Murray stated it was proper for Spectrum to record the advertising payments as made and to capitalize the advertising as an asset. He reasoned that the advertising right was an asset as defined in FASB Concepts Statement No. 6. The contractual right to participate in the advertising involved a probable future economic benefit that Spectrum controlled as a result of a past transaction. The advertising had the capacity to contribute directly or indirectly to future net cash flows. (Tr. 3469; RX 492A.) See FASB Concepts Statement No. 6.
Murray stated that advertising experts could have valued the advertising. Since Spectrum had the right to advertise, he opined that Spectrum controlled the asset, even if there was uncertainty about the quantity of advertising. (Tr. 3518-21, 3526-27; RX 461, 478, 546.) Like Holder, Murray opined that Hoffman's proposed accounting treatment was not representationally faithful because it gave no value to the advertising assets acquired by Spectrum. It would have been inappropriate to link the agreements for accounting purposes. (Tr. 3540-41.) Hoffman's accounting treatment would understate income in the current year and overstate income in the future because not all operating expenses would be recorded in the proper period. (Tr. 3541-43.)
Further, Murray felt Hoffman's proposed accounting treatment would have improperly offset the receivables and payables in violation of FASB Technical Bulletin 88-2. (Tr. 3541-43.) The general rule is that receivables and payables should not be offset. Rather, they should be shown separately so the reader has a fair presentation of the company's financial position. This rule applies even if the cash is exchanged on the same day. (Tr. 3500-03; RX 466.)
Murray agreed that Steinberg's advice to amortize the advertising asset "dollar for dollar against the royalties" for a period no longer than three years was in accordance with GAAP. As did Holder, Murray noted that there was no preferred method of amortizing advertising assets. According to Murray, the methodical goal was to amortize the asset in a way that corresponded to the actual advertising being run. Respondents were reasonable in rejecting seventeen years as too long given the volatile nature of the high-tech industry. Three years was a reasonable time to amortize the asset. (Tr. 3472-74; RX 461.)
It was appropriate for Steinberg to recommend Spectrum conduct a quarterly test to ascertain the recoverability of the advertising costs. If the royalty stream was below projections, Spectrum would have to consider an accelerated write off of the advertising expense. A quarterly review would insure that the advertising asset continued to have the value it had when the transaction was recorded and would insure that the quarterly financial statements were properly prepared. (Tr. 3476.)
Murray concluded that the accounting advice Steinberg gave and the inquiries he made regarding the Apex transaction were reasonable. (Tr. 3480-82.) Murray opined that Respondents acted in accordance with professional standards, and the accounting advice, assuming that the upfront payments were made, was correct. (Tr. 3514-15.)
After reviewing DeMark's testimony regarding his knowledge of the technology, the performance (or lack thereof) under the agreements, and the consideration given to the advertising, Murray opined that KPMG's decision to restate Spectrum's results from the First Quarter and Second Quarter was based upon information unavailable to Respondents. KPMG's decision to restate did not affect adversely the advice given by Respondents. The circumstances had changed and KPMG made its decision to restate based upon a different set of facts. (Tr. 3553; RX 791-794, 797.)
IV. CONCLUSIONS OF LAW
The OIP alleges that Respondents, through the actions detailed above, caused Spectrum's violations of Section 13(a) of the Exchange Act and Rules 13a-13 and 12b-20 thereunder. The Division alleges that:
Steinberg and Geron each was a cause of Spectrum's violations because each concurred with Spectrum's proposed accounting treatment (Steinberg as to the Megahertz, Apex, and U.S. Robotics transactions; Geron as to the Megahertz and Apex transactions) when they knew or should have known that Spectrum's proposed accounting was not in conformity with [GAAP] and that Spectrum would use their concurrence to reflect the improper accounting treatment in its financial statements filed with the Commission.
(Div. Br. at 2.)
Section 21C(a) of the Exchange Act authorizes a cease and desist proceeding against a person that "is, was, or would be a cause of a [securities law] violation, due to an act or omission the person knew or should have known would contribute to such violation . . . ." The statutory language makes clear that in order to "cause" a violation, there must be: (1) a primary violation, (2) an act or omission by the respondent causing the violation, and (3) sufficient evidence that the respondent knew or should have known that his act or omission would contribute to the violation.
The Division argues that "cause" is defined broadly in Section 21C by the "knew or should have known would contribute" language of the statute and that "there is no authority for any liability-limiting ruffle or decoration, including `proximate,' being imposed on the simple term `cause. . . .' An act need only contribute to be a cause for cease and desist purposes" (Div. Br. at 36-37.)
However, in Berko v. SEC, 316 F.2d 137, 140 (2d Cir. 1963), the U.S. Court of Appeals for the Second Circuit noted that "cause," at least as used in Section 15 of the Exchange Act, "ha[d] not been the subject of detailed judicial construction."60 The Berko court cited R.H. Johnson & Co. v. SEC, 198 F.3d 690, 696 (2d Cir. 1952), where the court held that "cause" did not necessarily mean "an immediate or inducing cause."61 However, the Berko court continued, stating:
But neither [the R.H. Johnson] opinion nor the Commission nor common sense suggests that the statutory requirement should be deemed to have been met by a demonstration merely that the salesman's conduct was to some degree a factor in the revocation. More than this is required. The determination of the point at which the balance is to be struck must be made on a case-by-case basis because, as a leading authority in this area has pointed out, the "relevant factors [in determining `cause'], it would seem, are not too different from those which go to `public interest' under § 15(b). . . . In short, the determination calls for an exercise of expertise, discretion, and policy selection on the part of the Commission."
Berko, 316 F.2d at 140-41 (quoting 2 Loss Securities Regulation 1385 (2d ed. 1961)) (internal footnote omitted).
To the extent the Division argues that a "cause" for purposes of Section 21C does not have to be the proximate cause of a securities law violation, it is correct. However, it is incorrect to assert that any act which contributes to the violation is a "cause" of that violation for purposes of imposing liability pursuant to Section 21C of the Exchange Act.
The requisite mental state for "causing" liability pursuant to Section 21C of the Exchange Act was addressed by the Commission in KPMG Peat Marwick LLP, 74 SEC Docket 384 (Jan. 19, 2001), appeal pending, No. 01-1131 (D.C. Cir.). The Commission stated clearly that "negligence is sufficient to establish `causing' liability under Exchange Act Section 21C(a), at least in cases where a person is alleged to `cause' a primary violation that does not require scienter." KPMG, 74 SEC Docket at 421 (footnote omitted). The Commission noted that the phrase "should have known" appearing in Section 21C(a) was classic negligence language, and where the primary violations require negligence, there is no reason to give the phrase any other meaning. See KPMG, 74 SEC Docket at 421-22.
As I stated in the Order of September 11, 1998:
Based upon an analysis of the statutory language, the legislative history, and recent administrative interpretations, I conclude that the flexible intent and broad language of [Section 21C of the Exchange Act], as applied to these facts, permits the issuance of a cease and desist order based upon negligent conduct. Notwithstanding this, the Division still must establish a sufficient nexus between the Respondents' alleged conduct and the underlying violations, if any.
As applicable in this case, Section 13(a) of the Exchange Act and Rule 13a-13 placed a duty upon Spectrum to file quarterly reports on Form 10-Q. Rule 12b-20 obligated Spectrum to include any material information necessary to make required disclosures, in the light of the circumstances under which they were made, not misleading. "Courts interpreting Section 13 of the Exchange Act consistently have held that `the obligation to file truthful statements is implicit in the obligation to file.'" SEC v. Gallagher, No. CIV.A.87-3904, 1989 WL 95252, at *6 (E.D. Pa. Aug. 16, 1989) (quoting General Aircraft Corp. v. Lampert, 556 F.2d 90, 96 n.9 (1st Cir. 1977)); see also SEC v. Savoy Indus., 587 F.2d 1149, 1165 (D.C. Cir. 1978).
The OIP alleges that Spectrum violated Section 13(a) of the Exchange Act, and Rules 13a-13 and 12b-20 thereunder when it filed the First Quarter and Second Quarter Forms 10-Q containing materially false and misleading financial statements and inadequate disclosures concerning license and advertising transactions reflected in those quarters. (OIP ¶ 51.) Specifically, the Division alleges that Spectrum incorrectly accounted for the license and advertising agreements as separate and independent agreements.
The OIP alleges that Respondents were each a "cause" of Spectrum's alleged violations:
[B]y concurring in Spectrum's desired accounting treatment for its sham license and advertising transactions when they knew or should have known that the accounting treatment was improper and that Spectrum would use the improper accounting treatment in its filings with the Commission. The receivables and payables representing cash to be received from and to be paid to the licensees, in the same amounts and on the same dates, were bogus and the "advertising" asset was also bogus. Geron and Steinberg knew these facts. Further, they failed to exercise due care when concurring in Spectrum's improper accounting treatment.
(OIP ¶ 56).
The Division argues that "Section 21C does not include as a necessary element a violation of a professional standard of practice, i.e., the standard is the same for all persons, professional and non-professional alike . . . ." (Div. Reply at 34.) The Division states that the applicable standard of care is the one established by Section 21C of the Exchange Act, and that reliance on professional standards cases is misplaced in this proceeding. (Div. Reply at 36.) However, the Division alleges in the OIP that Respondents "failed to observe the standard of due care required by accountants." (OIP ¶ 10.) In a List of Accounting Rules, Regulations, Standards, Principals and Concepts filed on August 3, 1998, the Division claimed that "[i]n addition to the general standard under Section 21C of the Exchange Act, Article V of the Code of Professional Conduct of the [AICPA] establishes a standard of due care." The Division's expert also opined that Respondents have violated the AICPA standard. (Tr. 1910-12; DX 158 at 25-27.)
The Division is correct that this is not a professional standards case. Cf. Davy v. SEC, 792 F.2d 1418, 1422 (9th Cir. 1986) (distinguishing cases against accountants brought under substantive provisions of the securities laws and disciplinary actions against accountants pursuant to Rule 102(e)). Proof that Respondents violated applicable professional standards is not sufficient; the Division must prove that such violations caused Spectrum's alleged securities law violations. Generally speaking, "due care" under Article V of the AICPA Code of Professional Conduct "requires a member to discharge professional responsibilities with competence and diligence." AICPA Code of Professional Conduct Section 56-Article V: Due Care. Respondents' "professional responsibilities" in this case were to render advice at interim based upon representations made by Spectrum management.62
In arriving at their interim advice, the "matching" issue regarding the license revenues and advertising expenses, was a major consideration for Respondents. Their concern was whether Spectrum management could support the value of the advertising and whether the amount to be paid was reasonable. Spectrum had represented to Steinberg that the agreements were negotiated at arms length and that, at audit, the value of the advertising could be supported.
When considering the Megahertz transaction, Respondents concluded that if Spectrum's representations met revenue recognition criteria, there were no contingencies on performance that would prevent the immediate recognition of revenue. They believed that the accounting treatment Spectrum was requesting was within GAAP, but cautioned Spectrum that it had to demonstrate that the value of the advertising was in fact $1.25 million. If it could not, the revenue recognition criteria would not be met, and Spectrum could not record the $1.5 million license fee. They also addressed the time period over which the advertising payments were to be made. Respondents not only informed Spectrum that the issue of amortization of advertising was, at this point in time, unclear, but concluded that Spectrum's desired amortization period of seventeen years was too long. Ultimately three years was agreed upon. Steinberg also advised Spectrum that it would have to evaluate the deferred charge at least quarterly.
Marino represented to Steinberg that the Apex agreements were essentially the same as the Megahertz agreements and Spectrum sought the same accounting treatment. Steinberg advised Spectrum that, assuming Apex was creditworthy, accounting for revenue recognition would be the same as that utilized for the Megahertz agreements. Geron also noted that a three-year payment stream allowed Spectrum a closer matching of the cash outflows and the expense recognition for the advertising payments than in the Megahertz transaction. This would give Spectrum more control over the quality and quantity of the advertising. Although Respondents did not know the quantity, quality, or asserted value of the advertising, Steinberg believed that the value of the advertising would be the amount set out in the advertising agreement.
Holder opined that Respondents complied with applicable professional standards, considered the correct issues, and exhibited the appropriate degree of professional skepticism and professional judgment. I credit his testimony to support my conclusion that Respondents did not violate the standard of due care imposed by the AICPA Code of Professional Conduct.
The Division, relying on Hoffman's testimony, argues that Spectrum's accounting for the license and advertising agreements violated GAAP by breaching the accounting concept of substance over form. This concept requires that the accounting reflect the economic substance of the transaction. Hoffman opined that the installment payments under the license and advertising agreements had no economic significance and should not have been recorded as revenue.63 She further opined that the advertising was not an asset under GAAP at the time the agreements were executed because Spectrum had no way to require advertising, or control the quantity or quality of any advertising. In her view, the substance of the transactions at issue was merely an exchange of cash and the various agreements should be offset. As a result of this erroneous accounting, Spectrum's First Quarter and Second Quarter Forms 10-Q contained false and misleading financial statements and inadequate disclosures regarding the agreements at issue.
Hoffman, however, agreed that the license agreements were substantive agreements, but stated that there was no substance to the advertising agreements, because the value of the advertising could not be determined at the time the agreements were made. She concluded that receivables and payables were not created, but agreed that booking receivables and payables was consistent with the terms of the agreements. For example, only the $250,000 from the Megahertz agreement should have been recorded as revenue because the license installment payments did not meet the criteria for revenue recognition.
Hoffman did not have the expertise to evaluate the advertising. She did not seek an expert's opinion because she concluded that the advertising could not be valued. However, Respondents produced two expert witnesses in advertising who collectively opined that the advertising agreements did have substance and the advertising could have been valued. Adamson reviewed samples of advertisements placed by Spectrum's licensees that incorporated references to Spectrum's technology and concluded the advertisements were consistent with industry practice. Kaufman opined that the advertising program set forth in the Megahertz, Apex, and U.S. Robotics advertising agreements conformed to typical cooperative advertising programs, and could have been valued with a reasonable degree of certainty by an advertising professional. I credit their opinions and conclude that the advertising to be performed under the advertising agreements could have been valued at the time the agreements were made. I do not credit Hoffman's contrary opinion.
Searfoss opined that Respondents' approach regarding revenue recognition for the license fees was reasonable. He further opined that the advertising was an asset that could have been amortized because Spectrum controlled the valuable right to participate in the advertising. He considered the signed advertising agreements evidence of a past transaction, and the probability that the licensees would advertise was a future economic benefit. Spectrum could withhold payments if it were not allowed to participate in advertising without losing its right to license payments because there was no right of offset. He believed that based on the information given to him, it was reasonable for Steinberg to believe the advertising was worth $1.25 million and could be treated as an asset and amortized over three years.
Searfoss described the substance of the transaction as the exchange of cash for license and advertising rights, and not merely the exchange of cash. Based upon this conclusion, it would not have been representationally faithful to account for the transactions on the basis of cash flow alone because the agreements should have been accounted for separately. He also opined that the receivables and payables should not have been offset because three of the four criteria under FASB Technical Bulletin 88-2 had not been met.
Holder likewise disagreed with Hoffman's opinion that Spectrum's accounting for the transactions violated the principle of substance over form, or that the payables and receivables should have been offset. His opinion was that the parties wanted to exchange valuable rights and the structure of the transactions did not change the substance. He opined was that it was proper to recognize revenue because it was earned and realizable. Like Searfoss, Holder's opinion was that Spectrum's right to participate in Megahertz's advertising was a valuable right that Spectrum controlled, it met the definition of an asset, and it could have been valued with expert assistance. He agreed with Steinberg's advice to capitalize the asset and amortize it over three years.
Murray agreed that it was proper for Respondents to rely on Spectrum's representations and they acted with appropriate professional care and skepticism. Respondents' accounting advice was in accordance with GAAP. He agreed with Searfoss and Holder that the test for revenue recognition was met. He also agreed that the advertising could have been valued and it was proper to record it as an asset and amortize it.
I credit the more thoroughly reasoned opinions of Searfoss, Holder, and Murray that the advice Respondents gave at interim was consistent with GAAP, such that the receivables were properly recorded as revenue and the advertising was properly recorded as an asset that could have been amortized over three years. Unlike Hoffman, these experts considered that the advertising could have been valued and that Respondents recognized the need to exercise professional judgment rather than assume that the transactions merely involved an exchange of cash.
The Division further alleges that Steinberg caused Spectrum's violations by drafting and revising "inadequate" disclosures about these transactions in the footnotes to the financial statements in the First Quarter and Second Quarter Forms 10-Q. (OIP ¶ 57.) Steinberg suggested changes, but not all were accepted by Spectrum. Searfoss opined that the footnotes disclosed the net effect of the transactions, and were reasonable and adequate. He did not consider it relevant that the payment amounts and dates were not set out. Holder stated that the footnotes complied with professional standards, were clearly worded, concise, complete, and conveyed the substance of the transaction. The Division offered no evidence to support the allegation that the footnote disclosures were inadequate. I credit the opinions of Holder and Searfoss that the transactions were adequately described in the footnotes.
I credit the opinions of the Respondents' experts and conclude that the Division has failed to prove by a preponderance of the evidence that Spectrum's accounting for the recognition of revenue and an advertising asset rendered the First Quarter and Second Quarter Forms 10-Q materially false or misleading or impacted on the price of Spectrum's stock. Notwithstanding the advice of KPMG to restate the First Quarter and Second Quarter, Respondents clearly informed Spectrum that if the advertising agreements had substance, Spectrum's proposed accounting was proper though not conservative.64 Respondents also informed Spectrum that the recoverability of the advertising asset would need to be reviewed at least quarterly. When similar agreements were disclosed, Spectrum was advised that the accounting was aggressive, and could result in increased scrutiny. Spectrum alone made the choice to employ the accounting treatment actually used.
However, Spectrum did violate Section 13(a) of the Exchange Act and Rules 13a-13 and 12b-20 thereunder when it reported the Apex and U.S. Robotics agreements in the incorrect quarters. However, I conclude that Respondents did not cause these violations. Steinberg reasonably relied upon the representations of several members of Spectrum's management and legal counsel as to when these agreements were signed. His uncontradicted testimony, which I credit, is that he did not know until much later that the Apex and U. S. Robotics agreements were not signed in the quarters for which they were reported. There is no evidence Geron had any knowledge that the agreements were not correctly reported.
I conclude, therefore, that the Division has failed to prove that Respondents caused Spectrum's violations of Section 13(a) of the Exchange Act and Rules 13a-13 and 12b-20 thereunder. Accordingly, the OIP must be dismissed.
V. RECORD CERTIFICATION
Pursuant to Rule 351(b) of the Commission's Rules of Practice, 17 C.F.R. § 201.351(b), I certify that the record includes the items set forth in the record index issued by the Secretary of the Commission on March 13, 2000, as revised on April 3, 2000.
VI. ORDER
IT IS ORDERED that the proceeding against Respondents Jeffrey M. Steinberg and John Geron be, and hereby is, DISMISSED.
This Initial Decision shall become effective in accordance with and subject to the provisions of Rule 360 of the Commission's Rules of Practice, 17 C.F.R. § 201.360. Pursuant to that rule, a petition for review of this decision may be filed within twenty-one days after service of the 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 decision upon him, unless the Commission, pursuant to Rule 360(b)(1), determines on its own initiative to review this Initial Decision as to any party. If a party timely files a petition for review, or the Commission acts to review as to a party, the Initial Decision shall not become final as to that party.
______________________________
Robert G. Mahony
Administrative Law Judge
| 1 | I will refer to the transcript as "(Tr. ___.)." I will refer to the Division of Enforcement's (Division) exhibits as "(DX ___.)," and to Respondents' exhibits as "(RX ___.)." I will refer to the Division's Post-Hearing Memorandum as "(Div. Br. ___.)," the Respondents' Joint Post-Trial Brief as "(Resp. Br. ___.)," and the Division's Post-Hearing Reply Memorandum as "(Div. Reply ___.)." |
| 2 | The engagement partner most often is the audit partner. The engagement partner has overall responsibility for the client and is the client's principal point of contact. The audit partner is responsible for the conduct of the audit, including the work done by the engagement team. The audit partner frequently attends the client's board and audit committee meetings. (Tr. 1541-44.) At the time of the hearing, there were approximately 1000 partners at Arthur Andersen, 500 of which were audit partners. (Tr. 2212.) |
| 3 | The OIP makes no allegations that Respondents committed or caused any securities law violation with respect to Spectrum's transaction with AT&T. |
| 4 | During the relevant period, Respondents were not auditing Spectrum and relied on Spectrum management's representations made in conversations with respect to all relevant transactions. (Tr. 1180.) |
| 5 | The patent license agreement between Spectrum and AT&T stated that the initial fee of $150,000 "shall be credited against future royalty obligations of AT&T." (DX 70 at 8.) |
| 6 | He agreed that this was a "risk area" with respect to the financial and accounting environment at Spectrum. Steinberg explained that use of the term "risk area" was planning terminology as set out in his March 1, 1993, "General Risk Analysis and Planning Memorandum" regarding the March 31, 1993, Spectrum year-end audit. It meant an area or issue that would need more time and attention than it would if Spectrum were a larger, more sophisticated company. It did not question the integrity of Spectrum's management. (Tr. 1554-57; DX 72.) |
| 7 | Geron spoke with Steinberg about Spectrum on three occasions: May 26, May 27, and June 2, 1993. Each call lasted about one hour. During the first call, Steinberg gave Geron background information on Spectrum as Geron was not familiar with the company. The majority of the first call involved the AT&T transaction, although the Megahertz transaction was discussed. The second call involved mostly the Megahertz transaction, although the AT&T transaction was discussed. The Apex transaction was referenced briefly during these calls. Geron did not recall the specifics of the third call, or any contact with Steinberg on June 4 or 5, 1993. (Tr. 2218-20.) |
| 8 | Steinberg had previously concluded that because the Megahertz agreements were not signed until May 1993, they could not be recognized in the March 31, 1993, year-end financial statements. They would have to be recognized in the First Quarter. Geron agreed with this conclusion. (Tr. 2228-29.) |
| 9 | Geron described the four criteria as: (i) whether Spectrum had fully performed; (ii) whether Megahertz had conditions to its payment obligations; (iii) whether Megahertz was able to make its required payments; and (iv) whether this was an ongoing royalty or a prepaid royalty. (Tr. 2261-62.) |
| 10 | It is Arthur Andersen's policy that an engagement partner prepare a Memorandum to the Files to document any consultation with a practice director. (Tr. 2402.) |
| 11 | The conclusions represented interim advice, and were not based on the result of any auditing work. These interim conclusions would be subject to verification at audit. (Tr. 2402-03.) |
| 12 | Geron understood that the advertising was considered an asset as each payment was made. (Tr. 2290.) Geron stated that based upon the rights obtained in the advertising agreement, this met the definition of an asset as set out in FASB Statement of Financial Accounting Concepts No. 6, Elements of Financial Statements (FASB Concepts Statement No. 6). (Tr. 2290-2302; RX 492, 492A.) |
| 13 | The June 4, 1993, memorandum noted that the letter of intent dated March 29, 1993, should not control with respect to revenue recognition in fiscal year 1993. Rather, the signing of the Megahertz agreements in the First Quarter governed. (DX 79.) |
| 14 | Chess gave approval for the final agreements to be signed, which had been reviewed by Apex's lawyer. Chess understood that Apex was obligated to make quarterly payments on dates specified in the license agreement. (Tr. 310-13.) Chess did not know Respondents and never spoke to either of them, or any one else at Arthur Andersen, regarding Spectrum. He had no knowledge regarding anything Spectrum may have told Respondents about what went on in the negotiations, or what Respondents may have known about the negotiations. |
| 15 | Leedom has represented Spectrum with respect to intellectual property matters since 1986. He participated in drafting the Megahertz, Apex, and U.S. Robotics license and advertising agreements. (Tr. 645.) In Leedom's opinion, each agreement represented a separate commitment with real obligations between parties that were represented by counsel. Leedom stated that there was nothing illegitimate about having the payments arranged the way they were and these were not sham transactions. The parties did not intend to have a "rigged" or fraudulent appearance of cash flows by merely exchanging payments. (Tr. 678-79.) |
| 16 | On June 30, 1993, Marino showed Steinberg the Apex financial statements "as of May 31" and represented that Apex was a modem manufacturer with whom Spectrum was interested in executing license and advertising agreements. (Tr. 1145.) Marino had previously told Steinberg that there was a three-year payment structure, and after reviewing Apex's financial statements, Steinberg did not believe that Apex would have difficulty making corresponding quarterly payments of about $120,000. |
| 17 | According to Steinberg, the proposed exchange of $1.5 million on the same day was not the substance of the transaction. He regarded the substance of the transaction to be the exchange of a technology license and advertising services. (Tr. 1171, 1185.) He denied the contention that he tried to "override" the substance of the transaction by advising Spectrum to "look out" for the appearance or form of the transaction. (Tr. 1175.) |
| 18 | On July 15, 1993, Steinberg spoke with Marino and emphasized that the value of the advertising was critical. Marino emphasized that Spectrum went into negotiations with the hope of getting advertising and promotional support from the licensees. Spectrum did want a seven figure fee for the technology, but they also wanted the licensees to advertise and promote Spectrum's technology. (Tr. 1334-35.) |
| 19 | In a memorandum of the conversation with Marino, Leedom, and Rule, Steinberg noted that the continuing royalties due pursuant to the license agreement was reasonable. (Tr. 1191; DX 89, 89A.) The Apex royalties were higher than the Megahertz royalties. Apex also appeared to be profitable, which was the basis for his comment that Apex had "substance." (Tr. 1191-92; DX 89.) |
| 20 | Based on Steinberg's prior advice, if the Apex agreements had not been signed by June 30, 1993, they could not have been recorded in the First Quarter. (Tr. 1181.) During two conversations with six different people, including Spectrum's chief financial officer, controller, patent counsel, SEC counsel, and general counsel, it was represented to Steinberg that Spectrum had signed agreements with Apex as of June 30, 1993. (Tr. 1330-31.) He understood that the issue of bankruptcy protection language was the only open item. (Tr. 1330-31, 1346, 1353.) When he received the draft advertising agreement, he believed it to be a reprint of the signed agreement with the proposed modification inserted. This explained why the copy he received was not signed. The First Quarter Form 10-Q, which Steinberg reviewed in mid-August 1993, stated that the Apex agreements were signed in the First Quarter. This was consistent with the representations made to Steinberg. (Tr. 1354.) As of August 1993, Steinberg did not know that the Apex transactions were recorded in the wrong quarter. (Tr. 1355.) |
| 21 | Geron felt that if the payments were made on one day, Spectrum would not be able to influence or control the advertising and promotional support that Apex would be doing for them in the future. This was inadvisable from a business perspective. (Tr. 1272, 1287.) Respondents also discussed the need for the technology to be accepted in the market so that both Megahertz and Apex would continue to advertise. (Tr. 1326-27.) |
| 22 | Steinberg never saw the Megahertz or U.S. Robotics agreements. (Tr. 1457.) |
| 23 | In his investigative testimony, Steinberg stated that in his discussions with Geron "probably later on in July when we were looking at the draft of the agreement," they revisited revenue recognition questions and the advertising question to be sure the facts were consistent. Steinberg testified that the context of his investigative testimony was that he may have mentioned to Geron that he had seen Apex's financial statements. Steinberg was unsure if the financial statements were audited, but they must be considered to reach a conclusion regarding revenue recognition. (Tr. 1314-15.) |
| 24 | The OIP makes no allegations that Respondents committed or caused any securities law violation with respect to Spectrum's transaction with Rockwell. |
| 25 | The advisory partner is a senior partner assigned to Arthur Andersen's public clients. This partner affords the client a point of contact or person to consult with other than the engagement partner. He assists the engagement partner, but does not have ultimate responsibility for the final audit report. (Tr. 1462-63.) |
| 26 | At the time Spectrum moved its headquarters from Dallas to Manhasset, Arthur Andersen's Dallas office was working on Spectrum's March 31, 1993, year-end audit. Because it was late in the fiscal year, 1993 was treated as a transition year. Therefore the Dallas manager continued with the audit. This gave the Long Island office time to become acquainted with Spectrum. (Tr. 963-64, 1543-44.) |
| 27 | Manire acknowledged that the agreements were in two separate documents, but he considered them "part and parcel of the same agreement." He agreed that there was no right of offset in the agreements. (Tr. 521.) U.S. Robotics never produced products incorporating Spectrum technology. No payments were ever made under the license or advertising agreement, and no advertising was ever performed. (Tr. 496-97, 522, 529.) U.S. Robotics stopped production development during negotiations for the acquisition of Megahertz. Megahertz already had a license from Spectrum, and was selling a product incorporating Spectrum's technology. (Tr. 512, 532.) Manire did not know the Respondents and had never spoken to anyone at Arthur Andersen in connection with the matters involved herein. (Tr. 516.) |
| 28 | Teri took notes at the meeting. (Tr. 1412; DX 101.) |
| 29 | Peoples' understanding of the Megahertz transaction was consistent with Respondents' understanding: Spectrum had executed a license agreement whereby Megahertz got a non-exclusive right to use Spectrum technology for an upfront payment of $1.5 million. The $1.5 million would be recognized as revenue when the license agreement was signed. Royalties from subsequent unit sales would be paid to Spectrum and recognized when the units were sold. There was an advertising agreement that would remain in existence as long as the technology was viable. Spectrum's name would be used in Megahertz's advertising, and Spectrum would pay a sum to Megahertz. Spectrum was to recognize the payable for the advertising and set up a deferred charge for the advertising. The deferred charge would be recognized as an asset. (Tr. 2603-04, 2608-09.) The payments under the two agreements were to be made simultaneously and there was no legal right of offset. (Tr. 2604-05; RX 478.) The agreements would be accounted for as two separate agreements. |
| 30 | Geron never knew of the U.S. Robotics transaction. (Tr. 2388.) Testimony regarding the U.S. Robotics transaction was offered only as to Steinberg. (Tr. 475.) This was the first time Steinberg learned of the U.S. Robotics transaction. He stated that if the transaction was similar to the Megahertz and Apex transactions, he would expect Spectrum to account for it in the same manner. (Tr. 1406, 1457-58, 1491, 1530-35.) Spectrum never consulted Steinberg regarding the U.S. Robotics transaction, nor did he express a particular opinion on the subject. When Steinberg later saw the Second Quarter Form 10-Q, he noticed that the U.S. Robotics transaction was recorded in the Second Quarter. In November 1993, after Arthur Andersen was terminated as auditor, he learned that the U.S. Robotics transaction was not actually signed until October 25, 1993. (Tr. 1403-05.) |
| 31 | Peoples stated that the accounting treatment is selected by the client. The accountant must accept the client's choice if it complies with GAAP, even if the accountant would prefer another method. (Tr. 2617-18.) No one from Arthur Andersen stated that the accounting treatment for the Megahertz and Apex transactions was not consistent with GAAP, only that it was aggressive. This was the first time the outside directors were told that Arthur Andersen considered the accounting treatment aggressive. (Tr. 1709-10.) |
| 32 | Steinberg emphasized the same points as Peoples regarding the transactions he was aware of at the audit committee meeting. In his investigative testimony, Steinberg stated that the transactions had to "break properly" for the accounting to be supportable. By "break properly," Steinberg meant that by entering more transactions structured like the Apex and Megahertz transactions, Spectrum was increasing the chance for unforeseen problems with production, advertising, or market acceptance to render the accounting unsupportable under GAAP. (Tr. 1413-18.) |
| 33 | Peoples expressed concern because he learned of other agreements similar to the Apex and Megahertz agreements for the first time at the audit committee meeting. (Tr. 2615-16.) |
| 34 | The need for economic substance was not a new issue. Steinberg had made the same observation at the end of May 1993, and had discussed this with Spectrum at great length. (Tr. 1450-51.) |
| 35 | In his investigative testimony, Steinberg testified that he and Teri prepared the questions and the answers. (Tr. 1466.) |
| 36 | In making his suggestions for disclosure in the footnotes, Steinberg did not focus on the terms of the particular agreements. Rather, he focused on the disclosures made in an attempt to explain the accounting ramifications. By looking at the relevant footnotes, a reader would learn more about what was in the balance sheet and income statements. Any description of the terms of the agreements would have come from Spectrum's officials and/or its counsel. (Tr. 1757-58.) |
| 37 | Since 1992, Trott has been the partner in charge of the accounting group in the Department of Professional Practice at KPMG. The Department of Professional Practice is KPMG's executive office that interacts with the FASB, the SEC, the AICPA and other entities. The office also advises and counsels KPMG engagement teams on accounting and auditing issues. (Tr. 705-06.) |
| 38 | DeMark considered Spectrum's accounting treatment aggressive, but acknowledged that aggressive accounting is not necessarily inconsistent with GAAP. (Tr. 872, 875.) |
| 39 | When DeMark used the term "offset," he was using it in the layman's sense to indicate concurrent payments, not a legal right of offset. (Tr. 883.) Trott did not recall if there was legal right of offset. (Tr. 739-40.) |
| 40 | In evaluating substance over form, DeMark agreed that he relied on professional judgment and experience, which involves a subjective element. (Tr. 887.) Trott agreed that the exercise of professional judgment, such as here, involves a subjective element, and that reasonable professionals can disagree on subjective matters. (Tr. 740-41.) |
| 41 | On February 8, 1994, KPMG resigned as auditor for Spectrum. On May 9, 1994, BDO Seidman became Spectrum's auditor for the fiscal year ended March 31, 1994. In those financial statements, Spectrum did not recognize the non-cash portion of the revenue for the license transactions. (DX 145 at 48-49.) |
| 42 | At the time, Trott had not formed an opinion about whether Arthur Andersen acted reasonably based on what it knew. (Tr. 746-48.) |
| 43 | Pleus served as a director and general counsel for Spectrum beginning in 1992 and then as director for investor relations until he resigned in February 1994. (Tr. 916-17.) As director for investor relations, he responded to stockholder inquiries regarding Spectrum, including questions on Spectrum's public information, and Spectrum's position on various topics. (Tr. 919.) Pleus also recalled a discussion he had with Steinberg just prior to July 15, 1993, the execution date reflected in the Apex agreements. The crux of the conversation was that Spectrum had two agreements which "ran together" and wanted to be sure they were drafted in accordance with GAAP, and that it would be "suitable and proper" to include the upfront license fee in the company's earnings. (Tr. 922, 925-26.) |
| 44 | The proposal regarding Apex and a one-day payment structure reinforced Hoffman's view that the agreements lacked separate substance. Although this proposal was discussed, it was never carried out. (Tr. 1880-81.) Hoffman also testified that the accounting violated GAAP because the Apex agreements were not signed until July 15, 1993, but were recorded in the First Quarter which ended June 30, 1993. (Tr. 1893.) |
| 45 | Hardy testified that Megahertz would not have agreed to make a $10 million payment because he felt that Megahertz's obligation to make payments under the license agreement was independent of Spectrum's obligation under the advertising agreement. (Tr. 413, 2123; RX 523.) Megahertz would not have agreed to that kind of potential liability. (Tr. 2123.) |
| 46 | FASB Technical Bulletin 88-2 sets out four criteria, all of which must be met, to determine the right of offset. They are: (i) each of two parties owes the other determinable amounts, (ii) the reporting party has the right to set off the amount owed with the amount owed by the other party, (iii) the reporting party intends to set off, and (iv) the right of set off is enforceable at law. (Tr. 2105-14; RX 466.) |
| 47 | "Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events." FASB Concepts Statement No. 6 ¶ 25. |
| 48 | "Probable is used with its usual general meaning rather than in a specific accounting or a technical sense . . . and refers to that which can reasonably be expected or believed on the basis of available evidence or logic but is neither certain or proved." FASB Concepts Statement No. 6 ¶ 25 n.18. |
| 49 | APB Opinion No. 29 states that where there is an exchange of non-monetary assets, the cost of the non-monetary asset acquired should be based upon the fair value of the asset surrendered. However, the fair value of the asset received should be used to measure cost if it is more clearly evident than the fair value of the asset surrendered. A gain or loss should be recognized on the exchange. |
| 50 | Searfoss acknowledged that an expert might have to be consulted to determine the reasonable value of the advertising. |
| 51 | Examples of assets that involve uncertainty due to the potential for the exercise of discretion of others are: (i) ownership rights in credit card or other customer lists, (ii) purchasing existing patent rights, (iii) movie rights to a book, (iv) mortgage strips, (v) franchise rights, (vi) ownership interest in high technology equipment, (vii) ownership of inventory, (viii) a limited partnership interest, and (ix) ownership of less than 20% of a closed corporation. Uncertainties as to the market's reaction to any of these does not preclude them from being considered assets because they are based upon contract rights. (Tr. 2736-39.) |
| 52 | According to Searfoss, when there is no authoritative guidance, professional judgment is involved and the accounting for transactions may be handled differently. |
| 53 | The principle of representational faithfulness reflects a measurement process. The accountant looks at the facts and circumstances and reaches a professional judgment as to the appropriate accounting, insuring that what is being presented faithfully represents the reality of the matter at issue. (Tr. 2683-84; RX 566.) See FASB Concepts Statement No. 2 ¶ 59. |
| 54 | Searfoss understood that there were two separate contractual agreements, but there was no legal right of offset. It would have been inappropriate for Spectrum to offset the payables and receivables, because three of the four criteria under FASB Technical Bulletin 88-2 were not met. (Tr. 2687-89; RX 466.) The agreements represented reciprocal transactions and he was not concerned that they were negotiated at the same time. (Tr. 2675-76.) |
| 55 | The general standard of the accounting profession is to acquire "sufficient relevant data" when rendering any service as an accountant. The standards of field work under GAAS hold an auditor to the higher standard of obtaining "sufficient competent evidential matter" through "inspection, observation, inquiries and confirmations to afford a reasonable basis for an opinion regarding the financial statements under audit." (Tr. 2996-98; DX 184, RX 757.) The "sufficient relevant data standard" is less rigorous. It does not require that evidence be gathered, but only that relevant data be obtained. In many cases, that information can be oral or written and obtained from the client. (Tr. 2998.) In this case, Respondents were relying on oral representations from Spectrum from May 26, 1993, to June 4, 1993. Subsequently, documents were provided and additional oral representations were made. Holder found that Respondents' reliance on the oral representations and documents was consistent with the "sufficient relevant data" standard. (Tr. 3000.) |
| 56 | Holder stated that "representational faithfulness" is an attempt to present on paper what is happening in the "real world." See FASB Concepts Statement No. 2 ¶ 59. |
| 57 | Geron also testified that a client may adopt an accounting method for legitimate transactions that is in conformity with GAAP even if it is against the advice of an outside auditor. The auditor can recommend a different approach, such as a more conservative approach, but cannot make the client change if the chosen method is within GAAP. (Tr. 2449-51; RX 545.) Cf. FASB Concepts Statement No. 2 ¶ 93. Based upon what Spectrum had represented about the transactions at issue, and assuming the truthfulness of the representations, Arthur Andersen could not require Spectrum to take a more conservative approach, as long as the accounting was within GAAP. (Tr. 2451-52.) |
| 58 | Murray understood that the Respondents received more information about the Megahertz transactions than the Apex transactions. |
| 59 | Murray stated that in order to account for the transaction properly, the value of the advertising had to be known. (Tr. 3495.) |
| 60 | See also Simon M. Lorne & W. Hardy Callcott, Administrative Actions Against Lawyers Before the SEC, 50 Bus. Law. 1293, 1309 (Aug. 1995) ("`Causing' liability under the Remedies Act poses several questions that the SEC has not yet finally resolved. . . . [One question] is the issue of how close a nexus must there be between the `cause' and the underlying violation.") |
| 61 | In KPMG Peat Marwick LLP, 74 SEC Docket 384 (Jan. 19, 2001), appeal pending, No. 01-1131 (D.C. Cir.), the Commission supported its findings regarding "causing" liability by comparison to the analogous provisions found in Section 15(c)(4) of the Exchange Act. |
| 62 | The Division argues that the "obligation imposed by Section 21C . . . is not limited by professional standards concerning `year end' or `at interim' work. (Div. Reply at 36 n.26.) Whether Respondents committed sufficient acts necessary to "cause" Spectrum's alleged violations, and whether Respondents knew or should have known such acts would contribute to the violation, is obviously determined in light of the fact that the advice was given at interim. |
| 63 | In its posthearing filings, the Division makes numerous references to the negotiations between Spectrum and its licensees to support the argument that the agreements between Spectrum and the licensees were merely exchanges of cash. However, Hardy, Chess, Manire, and Leedom were all Division witnesses and their testimonies, which are not contradicted and which I credit, do not support the Division's position. They all agreed that the parties had separate obligations under the various license and advertising agreements. Although Manire acknowledged that the agreements were in two separate documents, he considered them "part and parcel of the same agreement." He agreed, however, that there was no right of offset between the agreements. The licensees' obligations to pay under the license agreements were not contingent upon Spectrum's ability to pay under the corresponding advertising agreements. In addition, the agreements did not contain any terms stating that the payments were intended to be offsetting, or should have been offset pursuant to FASB Technical Bulletin 88-2. In any event, there is no evidence Respondents had knowledge of the negotiations or any of the statements made therein. |
| 64 | KPMG advised Spectrum that the accounting for the transactions at issue was incorrect and that it should restate its financial statements for the First Quarter and Second Quarter because it concluded that the revenue streams under the Megahertz, Apex, and U.S. Robotics agreements should be netted to determine net revenue. Trott was not aware of any advertising, but believed that any advertising benefits should be considered a non-monetary exchange. Because the agreements were, in his view, linked, he did not make an inquiry about whether the advertising could be valued. Employees of KPMG noted that only one of the agreements had begun to generate a royalty stream and Spectrum had additional developmental work to do before saleable units can be produced by the licensee. These events had not occurred when Respondents gave their opinion about how to account for the agreements several months earlier. KPMG's determination was made in the context of a year-end audit, whereas Respondents' advice was given at interim, and in reliance upon Spectrum management's representations. Respondents were not auditing Spectrum, and were not required to verify management's representations. |
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