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Initial Decision of an SEC Administrative Law JudgeIn the Matter of
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In the Matter of BARRY C. SCUTILLO, CPA,
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INITIAL DECISION |
| APPEARANCES: | Robert M. Fusfeld for the Division of Enforcement, Securities and Exchange Commission.
Jerome M. Selvers for Respondents. |
| BEFORE: | James T. Kelly, Administrative Law Judge |
The Securities and Exchange Commission (Commission or SEC) instituted this proceeding on April 1, 1999, pursuant to Rule 102(e)(1)(ii) of its Rules of Practice, 17 C.F.R. § 201.102(e)(1)(ii). The Order Instituting Proceedings (OIP) charged that Barry C. Scutillo (Scutillo), a certified public accountant (CPA) in Florida, and Mark F. Jensen (Jensen), a CPA in Utah, engaged in improper professional conduct in that they "intentionally, knowingly or recklessly" violated the applicable professional standards when auditing a public company. The alleged audit failures occurred in connection with an annual financial report filed with the Commission by Sky Scientific, Inc. (Sky) on June 15, 1994.
The OIP alleges that Respondents' audit of Sky's financial statements for the fiscal year ending February 28, 1994, was not conducted in accordance with generally accepted auditing standards (GAAS) and that the auditors failed to assure that Sky's financial statements were prepared in conformity with generally accepted accounting principles (GAAP).1 The audit was said to be deficient with respect to the valuation of certain certificates of deposit from a Russian bank that comprised Sky's major asset; the valuation of Sky's mineral properties; and the valuation of Sky's issuance of restricted stock and Form S-8 stock to purported consultants.
The Division of Enforcement (Division) contends that Respondents recklessly failed to see that most of Sky's assets were fictitious or massively overvalued in violation of basic accounting standards and that millions of dollars in expenses had not been recorded on Sky's books. It argues that Scutillo should be denied permanently the privilege of appearing or practicing before the Commission as an accountant and that Jensen should be denied the same privilege for two years. Respondents assert that their audit performance and their audit conclusions were reasonable. They maintain that the proceeding should be dismissed or, at most, that a censure should issue.
I held a public hearing in Washington, D.C., on June 5-8 and July 6-7, 2000. The parties have filed proposed findings of fact, conclusions of law, and briefs, and the matter is ready for decision.2 I base my findings and conclusions on the entire record and on the demeanor of the witnesses who testified at the hearing. I applied "preponderance of the evidence" as the applicable standard of proof. Steadman v. SEC, 450 U.S. 91, 97-104 (1981). I have considered and rejected all arguments, proposed findings, and conclusions that are inconsistent with this decision. Because Jensen has a settlement offer pending before the Commission, the findings and conclusions in this initial decision are not binding as to him.
FINDINGS OF FACT
Respondents. Scutillo, age forty-three, graduated from Aquinas College in 1978 and has been a CPA since 1981 (Tr. 7-8). He is currently licensed in Florida, New York, and Tennessee. He was employed as an auditor at Peat, Marwick & Co. from 1978 to 1988, eventually rising to the level of senior manager (Tr. 8). Scutillo is a certified fraud examiner and has taught various accounting courses (Tr. 536). He has been a partner in his current firm, Scutillo & Blake, of Fort Lauderdale, Florida, since 1988. In 1994, Scutillo & Blake had twelve professional employees and about 30% to 40% of the firm's work involved audits (Tr. 9). Scutillo was the partner in charge of the audit of Sky's financial statements for the fiscal year ending February 28, 1994 (Tr. 35). In 1994, Scutillo & Blake performed approximately ten to twelve audits, including two or three audits of public companies in addition to Sky (Tr. 9-10).
Jensen, age forty-eight, graduated from the University of Utah and has been a CPA since 1982 (Tr. 403-04). He is currently licensed in Utah. From 1979 to the present, he has been a staff accountant and partner at various accounting firms in Salt Lake City, Utah (Tr. 405-07). In 1994, Jensen was a partner in a firm that had six professional employees and earned about two-thirds of its income from auditing (Tr. 409-12). Jensen was designated as the concurring reviewer for the Sky audit.3 In addition to reviewing Scutillo's work papers in all critical audit areas and reading Sky's Form 10-K, he visited the client's mining properties (Tr. 23-24, 425-26, 429-33, 520-21; DX 93). Before the Sky audit, Jensen had been the partner in charge of about ten audits of public companies that filed reports with the SEC (Tr. 408).
Sky Scientific, Inc. Sky, formerly known as Winner's Circle, Inc. (Winner's Circle), was a California corporation organized in 1983 (DX 1 at 1, 36). On March 29, 1993, Winner's Circle merged with Sky. Sky's main office was located in Boca Raton, Florida (DX 1 at 5). W.A. Dorow, Jr. (Dorow) was Sky's chairman, chief executive officer, and a director. Jerry L. Foster (Foster) was Sky's senior vice president, chief financial officer, secretary, and a director (DX 1 at 51-52).
Sky's common stock was registered with the Commission pursuant to Section 12(g) of the Securities Exchange Act of 1934 (Exchange Act) and Sky made periodic filings with the Commission on Forms 10-Q, 10-K, and 8-K. Sky's common stock was traded over-the-counter (DX 1 at 22). At all times relevant to this proceeding, Sky purported to be engaged in the mining and processing of precious metals on properties located in California and Nevada (DX 1 at 1). From April 1993 to at least April 1994, Sky issued press releases with optimistic projections about its mining properties, operations, revenues, and earnings (DX 6, DX 8-DX 15, DX 20). In response, the bid price for its common stock increased, as did the daily trading volume (DX 129).4
Winner's Circle and Sky experience difficulty retaining auditors. BDO Seidman audited Sky's financial statements for the period ending July 31, 1992 (RX 6). At the time, Sky was not a public company. This was the only audit BDO Seidman performed for Sky (RX 16 at ¶ 3).
On April 7, 1993, Ernst & Young modified its outside auditor's report on the financial statements of Winner's Circle for the fiscal year ended February 29, 1992 (DX 21). Ernst & Young added an emphasis paragraph that raised a question about the ultimate ability of Winner's Circle to continue as a going concern.5 One day later, Winner's Circle dismissed Ernst & Young and engaged Weinberg & Company (Weinberg) of Boca Raton as outside auditor for the company's 1993 financial statements (DX 1 at 49, DX 21).
Weinberg's audit report on the 1993 financial statements of Winner's Circle, dated May 15, 1993, had been unqualified. However, on October 25, 1993, Weinberg modified its report (DX 1 at unnumbered page between pages 30-31). The modification raised questions about the firm's ability to continue as a going concern. Effective November 17, 1993, Sky (as successor to Winner's Circle) dismissed Weinberg as its independent accountant (DX 24).
On November 23, 1993, Sky engaged Norman Cutler (Cutler), CPA, of Boca Raton as its outside auditor (DX 25). On December 15, 1993, Sky dismissed Cutler (DX 26).
Effective December 15, 1993, Sky engaged Joel S. Baum (Baum), CPA, of Coral Springs, Florida, to audit its 1994 financial statements (DX 75 at 34). On May 16, 1994, some two weeks before the filing deadline, Sky dismissed Baum and engaged Scutillo & Blake (DX 30).
Scutillo accepts Sky as an audit client. Scutillo learned of Sky's need for his accounting services in early 1994 through Richard P. Greene (Greene), a Fort Lauderdale attorney he had known for several years (Tr. 13, 541-42, 992-94). At the time, Greene was outside corporate and securities counsel for Sky (Tr. 991-92; RX 1A at 195). Greene previously had referred other audit and consulting clients to Scutillo, and he did not express any concerns to Scutillo about the integrity or honesty of Sky's management (Tr. 13, 541-42, 994). Scutillo had also known Dorow for three years (RX 17). He characterized Dorow's general demeanor as "volatile at times" and "very impatient" (Tr. 183-84).
Scutillo knew that Sky's financial records were in poor shape (Tr. 36, 75, 427, 628), that Sky had switched in-house controllers three times over the past year (Tr. 62-63; DX 44, item A9), and that Foster, the firm's chief financial officer, was located in Richmond, Virginia, far from Sky's corporate headquarters in Boca Raton (Tr. 618; RX 1A at 460-61). As the 1994 audit commenced, Baum had been engaged as Sky's outside auditor. Scutillo was assisting Baum by obtaining financial data from Sky, and creating summaries and prepared-by-client schedules (Tr. 14-15, 17, 74-75).
In early May 1994, Dorow and Foster asked Scutillo to take over the audit from Baum (RX 1A at 633). Scutillo agreed to do so on May 16, 1994 (Tr. 29-30). He knew that Sky had engaged three prior audit firms in the past year (Tr. 64-66). Scutillo's work papers identified the reason for the eleventh-hour switch as "personality problems between [Baum and Dorow]" (RX 17).
At the hearing, Scutillo portrayed Baum's dismissal as purely a staffing issue. Scutillo noted that Baum and Cutler were each sole practitioners. He also knew that Baum had spent virtually no time on the 1994 Sky audit engagement, and was relying on a subcontracted temporary auditor, Steven Jacobs (Jacobs), to perform the necessary procedures (Tr. 33, 72, 627). Scutillo and Sky's management believed that Baum lacked the resources to complete the audit engagement (Tr. 71-72, 626-27). Scutillo also testified that he took comfort from language in Sky's Forms 8-K that there had been no disagreements between Sky and the predecessor auditors (Tr. 625-27).
Scutillo persuaded himself that Sky was not auditor-shopping. His testimony is not accepted as credible, however, given the large number of auditor switches in a short period of time, and the fact that Sky's dismissals of Ernst & Young and Weinberg had followed closely on the heels of revisions that added going concern qualifications to previously unqualified audit reports. This was a clear warning to Scutillo that Dorow fired auditors who failed to see things his way.
Scutillo spoke with Jacobs, who did not express any concerns about the integrity of Sky's management or point to any substantive auditing disagreements between Sky and himself (Tr. 628). Scutillo did not contact Baum (Tr. 32-33; RX 17). Scutillo also did not contact Cutler, reasoning that Cutler had never rendered an audit opinion on Sky's financial statements (Tr. 67-68). Scutillo sent Daryl Joyce (Joyce), an associate at his firm, to Weinberg's office to review Weinberg's work papers (Tr. 334, 339; RX 1A at 333-37). Scutillo also determined that Weinberg had no auditing disagreements with Sky and no concerns about the integrity of Sky's management (Tr. 542, 596-98).
Scutillo reached an understanding with Dorow about three matters before accepting the engagement. First, because neither Scutillo nor anyone else at his firm had experience auditing a mining company, Scutillo informed Dorow that he would need to engage another auditing firm with relevant mining experience to participate in the engagement (Tr. 10-11, 15-16, 545). Second, Scutillo advised Dorow that filing the audited financial statements with the Commission by the May 31, 1994, due date would be "totally impossible," and that Sky would have to seek an extension until June 15, 1994 (Tr. 34, 543-44, 593-94). Third, Scutillo informed Dorow that a going concern qualification on the 1994 financial statements was likely (Tr. 16).
The audit engagement letter of May 16, 1994, did not memorialize any of these understandings. The omissions are noteworthy, because the letter "constitute[d] the complete and exclusive statement of agreement" between auditor and client and "superced[ed] all proposals oral or written and all other communication, with respect to the terms of the engagement between the parties" (RX 1A at 175-77). The audit engagement letter did contain standard language advising Sky management that "an audit is subject to the inherent risk that material errors, irregularities, or illegal acts, including fraud or defalcations, if they exist, will not be detected" (Tr. 548, 558-59; RX 1A at 175).
Scutillo's staffing decisions. Scutillo selected two junior accountants from his firm to assist in the Sky audit. Joyce had approximately ten years of experience with Coopers & Lybrand, where he had served as an in-charge accountant (Tr. 544-45). David Santos (Santos) had approximately five years of experience, including audits of public companies. Both Joyce and Santos had been with Scutillo & Blake for about a year (Tr. 35).
Scutillo turned to Jensen to provide the mining company audit experience he needed (DX 90, DX 91, RX 1A at 268-75, RX 17). He had known Jensen since 1991 or 1992 and was impressed with Jensen's practice (Tr. 16, 577). Scutillo also knew that Jensen's partner, Gordon Jones (Jones), had more mining-related experience than Jensen did and that Jones would also be available as a resource (Tr. 20; DX 90). Scutillo wanted Jensen not only to serve as the concurring reviewer, but also to accompany him on a planned visit to Sky's mining properties (Tr. 18-19; DX 90).
Scutillo did not question Jensen closely about the nature of Jensen's experience in mining company audits (Tr. 20-21). He understood that Jensen had personally participated in "a handful" of such audits (Tr. 19-20). At the hearing, Jensen portrayed his actual experience with mining companies as considerably more limited than Scutillo assumed it to be. Jensen could identify only one mining company audit that his firm had conducted before the Sky audit (Tr. 414-15, 421). Jones had been the engagement partner on that occasion and Jensen had assisted him (Tr. 420). Jensen had never been the engagement partner on a mining company audit and Scutillo never asked him if he had (Tr. 20-21, 418, 420).
Scutillo told Jensen that he was under "big time pressure" to complete the Sky audit (Tr. 426-27). At the hearing, Scutillo equivocated when asked if he made this remark (Tr. 34-35). Both Respondents testified that the June 15, 1994, filing deadline did not have an impact on their audit judgments (Tr. 526, 592).
Nature of the work performed. Scutillo & Blake typically used audit checklists prepared by McGladrey & Pullen, a national accounting firm. It then supplemented those checklists with additional forms published by Commerce Clearing House and Practitioner's Publishing Company, and tailored the forms to the specific audit client (Tr. 18, 109, 111, 119, 122, 549, 551). Scutillo followed this practice during the Sky audit.
Respondents identified as critical audit areas the valuation of Sky's transaction with a Russian bank, the valuation of Sky's mineral properties, and Sky's issuance of convertible preferred stock (Tr. 47-48, 77-78, 429; DX 59, item 4, DX 89). Scutillo calculated the audit gauge, or materiality threshold, at $468,000 (Tr. 135-36; DX 48).
On June 1 and 2, 1994, Scutillo and Jensen visited some of Sky's mining properties in Nevada and California (Tr. 684, 686-87; DX 107). At all other times from May 16, 1994, to June 15, 1994, Scutillo worked on the engagement in Florida and Jensen conducted his concurring review in Utah. Jensen did not personally prepare any work papers. Nor did he do any field work, other than visit the mines. Respondents communicated with each other by telephone, facsimile, and overnight courier (Tr. 40, 45, 429, 450, 519, 575-76; DX 93).
Through June 1994, Scutillo & Blake spent over 560 hours on the Sky engagement and billed fees of $40,000 (Tr. 594-95; RX 1A at 289, RX 19). Scutillo & Blake devoted another 144 hours to the Sky engagement in July, August, and September 1994, and billed Sky an additional $10,725 (RX 19). Jensen spent over fifty-five hours on the Sky engagement in May, June, and August 1994, and billed $4,960 (RX 1A at 310-14, RX19).
Russian bank certificates of deposit. On February 28, 1994, a Sky subsidiary incorporated in Delaware bought $40 million of dollar-denominated certificates of deposit (CDs) from Bank Sinektika of Moscow, Russia, in exchange for four million shares of the Sky subsidiary's preferred stock (DX 1 at 31, DX 127, RX 1A at 512-14). The CDs represented more than 50% of the total assets claimed by Sky on its balance sheet (Tr. 136). The purchase agreement bore the signatures of Dorow and Hillel Sher (Sher), a resident of Hollywood, Florida, traveling on a South African passport (DX 127 at ¶ 9). The purchase agreement identified Sher as "attorney in fact" for the Russian bank. As noted above, Respondents considered this transaction to be a critical audit area.
The terms of the transaction were highly unusual. First, the transaction could be revoked by Sky if Sky's auditors did not approve it (Tr. 143-44). In relevant part, the agreement stated (DX 127 at ¶ 13):
In the event that, for whatever reason, the assets herewith conveyed to [Sky] by the Bank are deemed by [Sky's] auditors to be not auditable, and thereby not eligible to appear as an asset at full value on [Sky's] balance sheet, it is [Sky's] sole option at that time to unilaterally rescind this transaction free of penalty or payment.
Second, there was a substantial rate differential between the CDs, which would accrue interest at 11.25% annually, and the preferred stock, which would pay dividends at 4.25% or less.6 Assuming the preferred stock remained stable in value, the difference made the transaction disproportionately beneficial to Sky and disproportionately detrimental to the bank. Third, the Russian bank was not required to pay interest or principal to Sky for four years. Rather, it would transfer the interest to an escrow account and pay it to Sky upon maturity (DX 127 at ¶ 3). The locus of the escrow account-whether in Florida or Russia-was not identified. Fourth, the CDs stated on their face that they had been obtained for dollar deposits, when, in fact, they had been obtained for preferred stock (DX 123).
Respondents knew that the CD transaction was highly unusual and that it had occurred on the last day of Sky's fiscal year (Tr. 79-80, 136).7 They were concerned about whether the Russian bank had the ability to pay Sky $40 million plus interest in four years (Tr. 478-79). Scutillo also knew that Sky had defaulted in the past on interest payments on its notes and dividend payments on its preferred stock (Tr. 64; DX 1 at 43-44, note 10). Sky offered what Scutillo considered a plausible explanation for the CD transaction: it represented a foot-in-the-door for Sky's anticipated involvement in Russian mining activities (Tr. 664-65, 896; DX 75 at 7, RX 1A at 515-22). In addition, Scutillo took comfort from Sky's management representation letter, which stated that "the documentation covering the CD with the Bank Sinektika is complete and is operable under its present terms. There are no known impediments to its full performance and operations" (Tr. 564-65; DX 3 at ¶ 10).
The audit of this transaction consisted of four steps. First, Scutillo inspected the CDs and the purchase agreement. As noted above, however, there were obvious discrepancies as to the dividend rate and whether Sky had paid in cash or in preferred stock. There is no evidence that Scutillo caught or questioned the discrepancies. In addition, proof of Sher's authority to act for the Russian bank was conspicuously missing. Sher's authority was allegedly memorialized in exhibits to the purchase agreement (DX 127 at ¶ 9). Those exhibits did not appear in the auditors' work papers or anywhere else in the record, and Scutillo could not recall if he ever saw them (Tr. 142-43).
Second, Scutillo received a facsimile copy of a standard bank confirmation from Sher on June 9, 1994. Scutillo left the impression that Baum had requested the confirmation before Scutillo took over the engagement, but Scutillo had no idea about where or to whom Baum had directed his request (Tr. 163-64; but see RX 1B at 722, stating "confirmation requested").8 The facsimile copy came from Sky's office and the cover sheet was nothing more than a handwritten letter from Sher on plain stationery. Sher promised that he would forward the original confirmation to Scutillo as soon as it arrived from Moscow (DX 125). Scutillo discussed the facsimile confirmation with Sher, but he did not document that conversation in his work papers. His follow-up telephone calls to Sher were unsuccessful-Sher was either not at home or not available (Tr. 186-87). Scutillo knew of Bank Sinektika's mailing address, telephone number, facsimile number, and telex number in Moscow (Tr. 151; DX 122). However, he never made direct contact with the Russian bank to discuss the missing original confirmation or to verify Sher's authority (Tr. 147, 149). Scutillo never did receive an original confirmation (Tr. 146-48).
Third, Scutillo attempted to determine whether the Russian bank had sufficient capital to support its issuance of $40 million in CDs (Tr. 170-71). Scutillo received an unaudited financial statement for the Russian bank, either from Sher or from Sky (Tr. 167-68, 171, 480; DX 122).9 The document was in English. It did not state whether it had been prepared in accordance with GAAP or in accordance with a comprehensive basis of accounting other than GAAP. Scutillo then directed his junior auditors to perform a mathematical calculation, converting rubles into dollars at the exchange rate published in the newspaper (Tr. 169, 670; RX 1B at 727). After completing this exercise, Scutillo concluded that the bank had enough assets to issue $40 million in CDs. To address his concern that the Russian bank's financial statement was not audited, Scutillo telephoned an international banking consultant. According to Scutillo, that consultant "made some calls and was advised" that Russian banks were not required to have audited financial statements (Tr. 171-73). Scutillo did not know whom the consultant called. He did not document his communication with the consultant in the work papers (Tr. 172).
Fourth, Scutillo talked with Greene, Sky's outside corporate and securities attorney, about the CDs. According to Scutillo, Greene confirmed that he was not only aware of the transaction, but had participated in the negotiations (Tr. 166, 650). Scutillo also said that Greene was aware that Sher was an agent of the bank, and he had met personally with Sher and another representative of the bank (Tr. 166, 650-52). Greene also confirmed that Sky's subsidiary had validly issued the preferred shares in exchange for the CDs (Tr. 620). Scutillo never asked Greene for anything in writing about Greene's meeting with Sher and the other bank representative (Tr. 156). Scutillo documented parts of his conversation with Greene in the audit work papers (DX 121):
Barry Scutillo contacted Richard Greene, [Sky's] SEC attorney, to insure that he was familiar with the CD agreement between [Sky] and Bank Sinektika. Richard advised us that he was not only very familiar with the transaction, but also met with representatives from the Russian bank when the agreements were being completed.
The Division alleges that this work paper entry is bogus (Div. Prop. Find. # 442; Posthearing Conference of Jan. 9, 2001, at Tr. 23-24). Alterations in or additions to the work papers would be extremely probative of "guilty knowledge," particularly if they were made after the conclusion of the audit. I decline to make the requested finding, not because I have great faith in the integrity of the work paper in question, but because I have doubts about Greene's candor, as well as Scutillo's. The fact that Greene is an attorney lends no additional weight to this document. See infra p. 51. Taking Scutillo's testimony in its most favorable light, Greene simply provided some comfort as to Bank Sinektika's existence. Greene did not address the proper valuation of the CDs.
Greene's own testimony hardly supported Scutillo's account. Greene denied that he had been involved in preparing the purchase agreement (Tr. 1015, 1020). He acknowledged that he briefly met Sher and another representative of the Russian bank because Sky had asked him to do so. According to Greene, there were no substantive discussions at that meeting. Greene took no steps to verify the identities of his visitors (Tr. 1003-05). He neglected even to obtain business cards (Tr. 1008).10
Respondents also testified about a telephone call between Jensen, Scutillo, and Dorow shortly before the audit was completed. Scutillo stated he was comfortable booking the CDs at their full claimed value at the time of the call (Tr. 178, 180). Jensen's testimony was quite different. According to Jensen, both Respondents had grave doubts about the CDs but were pressured by Dorow to record them at full value. Jensen spoke with his partner Jones about the CDs and decided that both he and Jones were uneasy with the transaction (Tr. 480, 486). Jensen told Scutillo that the CDs did not "pass the smell test" (Tr. 181, 480-82). Scutillo and Jensen advised Dorow that they had concerns about whether the CDs should be recognized on the financial statements and that they were considering additional auditing steps (Tr. 481). Dorow assured the auditors that the CDs were valid and reminded them that the June 15 filing deadline was approaching. He also instructed the auditors not to knock themselves out when performing additional audit steps, and he emphasized that rescinding the transaction was not an option (Tr. 481-82). Jensen characterized the telephone conversation with Dorow as a "high pressure" situation (Tr. 482, 488). I credit Jensen's version of the conversation and reject Scutillo's, to the extent that there are inconsistencies.
A few days later, Jensen and Scutillo talked again about the CDs. Scutillo considered establishing a reserve against the CDs, but concluded that there was no need for a reserve and no basis for determining an appropriate amount (Tr. 184-85, 483). He then told Jensen that, because there was no evidence that the CDs were invalid, they should remain on Sky's financial statements as assets worth $40 million (Tr. 483-88). Jensen agreed with that valuation (Tr. 468). Scutillo could not recall the exact words he spoke to Jensen, but he did not contradict the substance of Jensen's testimony (Tr. 185-86).
Scutillo was concerned primarily with making appropriate disclosures about the CDs rather than adjusting their valuation on the balance sheet (Tr. 139-40, 180). The audited financial statements treated the CDs as a non-current, restricted asset, offered footnote disclosure of their uninsured status, and incorporated the CD transaction into the report's going concern qualification (DX 1).
Mineral properties. Respondents also considered the appropriate valuation of Sky's mining properties to be a critical audit area. Sky owned or leased several mines, but this proceeding focuses on only three of them: Evergreen, Berry, and Danner.11 Sky had acquired its interest in Evergreen and Berry for preferred stock with a face value of $5.5 million and $8 million, respectively. It had acquired its interest in Danner for $14 million face value preferred stock and $2 million in promissory notes. By the time of the audit, Sky was already delinquent in paying dividends of $445,000 on some of that preferred stock (Tr. 192-93; DX 1 at 44). It was also delinquent on several other notes (DX 1 at 40-41).
Scutillo knew that Sky's preferred stock did not trade publicly, and that Sky's dividend payments were delinquent (Tr. 193, 213). He testified that he found it impossible to assign any value to Sky's preferred stock and promissory notes under the circumstances (Tr. 209). It is unclear whether Scutillo meant that he could not perform the audit procedure, or that, having performed the procedure, he found insufficient evidence to justify a valuation greater than zero. The work papers do not show the audit procedures performed. Scutillo nonetheless believed that the "cost" of Sky's mines was the face value of the preferred stock issued to acquire them (Tr. 209-10). This belief found some support in the 1992 reports of two prior Sky auditors, BDO Seidman and Weinberg.12 Scutillo also observed that Sky sold the Berry mine in late 1994 to Inland Pacific Resources, Inc. (IPR) for convertible preferred stock with a stated value of $8.5 million, an amount greater than the carrying value of Berry on Sky's books as of February 28, 1994 (Tr. 898, 960; DX 75 at 4, RX 11 at 5). Scutillo had no idea whether IPR's financial statements were audited, whether its stock had any market value, or even if its stock was publicly traded (Tr. 229-32).
Sky's technical staff estimated ore reserves, ore recovery, and the cost of mining, milling, refining, and overheads per ton at some of these properties (RX 1C at 1310-23 (Danner)). Sky then engaged Charles H. Schultz (Schultz), an engineering geologist, to review and report on its staff's estimates at Evergreen and Berry (RX 1D at 1510-12, 1575-80). Sky used these estimates to prepare earnings projections on which it based its estimates of the net present value of the mines (DX 97-DX 99).13 Sky's estimates of the net present value of its mines were considerably higher than the face value of the preferred stock it issued to acquire them. Sky presented those estimates as pro forma earnings projections in the narrative portion of its 1994 Form 10-K, but the figures did not appear in the audited financial statements.
The audit of the mining properties involved several steps. First, Scutillo read the reports of Sky's employees and Schultz and sent them to Jensen (Tr. 41-42, 189; DX 92).
Scutillo and Jensen then visited three mine properties (Berry, Danner, and Tallulah) to verify their existence (RX 1B at 740-41). Three Sky employees accompanied them on the site visits: Raymond J. Bowkus (Bowkus), Sky's director of mining operations; Michael J. Skopos, Sky's chief geologist; and Dennis S. Bal, Sky's chief geological engineer.14 The three employees drove Respondents to the locations of each of the mineral properties and explained the reasons for selecting each of the specific areas on each mineral property.
There was no equipment or operations at Danner and Berry (Tr. 94-95, 201). Scutillo observed processing activities at Tallulah, or at least he thought he did.15 However, Scutillo did not see any tailings, or waste rock, which would provide evidence of recent operations. He did not ask Jensen or the three Sky employees why, if Tallulah had been operating full-time, there was no tailings pile at the end of the processing plant (Tr. 199).
Scutillo gave equivocating testimony about how active Jensen was while Respondents inspected the mining properties (Tr. 202-08). Because of a disability, Jensen was physically unable to keep up with Scutillo on the walking tour (Tr. 205, 501-05). The record is silent as to whether Scutillo knew of Jensen's disability before the site visits.
Scutillo and Jensen also met with representatives of the Springer Mining Company, a subsidiary of General Electric Corporation (General Electric), to observe operations at the Springer mine and mill and to confirm a letter of intent by Sky to buy the Springer mine and mill from General Electric (Tr. 194; RX 1A at 345-49, 555-57). Sky's intended acquisition of the Springer mine was important in that its consummation, coupled with additional funding, would allow Sky to commence significant processing activities (Tr. 689, 999-1000; DX 1 at 1-2). Scutillo's work papers stated: "The Tallulah facility certainly allows for the processing of ore but the [General Electric] plant would greatly enhance [Sky's] processing capabilities" (DX 107). Some time after the audit, however, the Springer transaction collapsed (Tr. 194, 1019; DX 75 at 3).16 The Springer transaction did not appear on Sky's 1994 balance sheet, but it was discussed in the notes to the 1994 financial statements (Tr. 194-95; DX 1 at 47).
At the conclusion of the site visits, Scutillo advised Bowkus that he needed additional information from Schultz. Scutillo wanted Schultz to expand his analysis and conclusions as to Sky's net present value calculations, the mining techniques to be used, their appropriateness, and the reasonableness of Sky's extraction cost estimates as compared to industry standards (Tr. 201-02; DX 107).
Schultz responded in letters to Dorow, dated June 4, 1994 (DX 109-DX 111). He also wrote a longer report on Danner (RX 1C at 1305-09). The letters stated that Schultz had reviewed in detail all previous reports about Evergreen, Berry, and Danner, had made a personal geological and engineer's assessment, and that recovery cost estimates fell within industry standards. The letters did not discuss Sky's net present value calculations, and Scutillo never followed up with Schultz to make sure Schultz's letters applied to Sky's net present value calculations (Tr. 380-81). In fact, Scutillo and Jensen never spoke to Schultz (Tr. 90, 191, 492).
Respondents knew nothing of Schultz's professional reputation, beyond what Sky's employees had told them (Tr. 341, 348-51, 371-73, 492-93, 690). Schultz, who had a prior professional relationship with Sky and one of its employees, provided no references (Tr. 334, 690). Scutillo checked with the State of California and learned that Schultz was validly licensed as a registered geologist and a certified engineering geologist (Tr. 588-89; RX 1A at 279). Jensen knew of no additional inquiries that Scutillo made about Schultz (Tr. 492-93).
The auditors then reviewed Sky's net present value calculations, which Sky had incorporated into its draft Form 10-K (Tr. 42-43, 327-30; DX 97-DX 99, RX 1B at 731). Joyce found the assumptions underlying the calculations to be reasonable and Scutillo concurred. Scutillo never asked Jensen if Jensen had analyzed the underlying data to see if they supported Schultz's conclusions (Tr. 716).
Scutillo told Jensen that the net present value calculations were "off the scale" when compared to Sky's claimed cost of acquiring the mines (Tr. 497). Jensen and Jones devoted nineteen hours to reviewing the audit between June 6 and June 15, 1994 (RX 1A at 313). However, the record does not show that Jensen offered any response to Scutillo, or added any additional assurances to the audit of the mining properties during this period.
The net present value calculations assumed that full-scale mining operations would begin almost immediately (DX 1 at 10, 15). However, other evidence available to the auditors showed that assumption to be unrealistic. For one thing, Sky had no cash to pay for start-up costs. For another, there were environmental hurdles to overcome. With respect to Evergreen, Sky's Form 10-K stated: "Beginning in October 1993, federal law has required that a watershed assessment be performed prior to any new development in a watershed wilderness area. [Sky] extended its operations plan and is prepared to begin operations when the assessment is completed. The Forest Service [of the U.S. Department of Agriculture] estimates this may take from one to three years" (DX 1 at 25). Scutillo's work papers also recognized that the "client must satisfy certain requirements of [the] Watershed Act before it begins mining" (DX 63 at 5).
Despite the language in the Form 10-K and the work papers, Scutillo assumed that parts of Evergreen could be mined immediately (Tr. 89-90). Note 3 to the audited financial statements recited: "[Sky] anticipates that mining of this property will commence by September 1, 1994" (DX 1 at 38). Scutillo based his assumption on a statement in Schultz's report, but he never asked Schultz if his report took the watershed assessment into account (Tr. 89-90).
In the management representation letter, Dorow and Foster informed Scutillo that Sky had an undisputed right to mine or extract ore from Evergreen, Berry, and Danner in accordance with the respective agreements covering the properties (DX 3 at ¶ 10). They also advised Scutillo that Sky would commence significant mining operations during the fiscal year ending February 28, 1995, and that such operations should enable Sky to generate operating income that would satisfy the going concern qualification (DX 3 at ¶ 13). Scutillo did not attempt to reconcile the conflict between Sky's Form 10-K and the management representation letter (Tr. 722).
Scutillo also requested Greene to check Sky's title to the mines (Tr. 388-90; DX 103). Greene spoke with a Nevada attorney and contacted the Bureau of Land Management, U.S. Department of the Interior, before drafting a letter to Scutillo (Tr. 997-98). In his letter, Greene stated that the Nevada attorney had confirmed that Sky had the legal right to mine the Danner properties (DX 96 at ¶ 2). Greene also wrote that the Nevada attorney had confirmed that there was "a high probability" that Sky was able to mine legally at Berry. As to Evergreen, Greene wrote that the claims were recorded and the fees were paid. He then stated that Sky "appears to have a legal right to mine the property" (DX 96 at ¶ 3).17
Scutillo could not recall any follow up conversations with Greene to resolve the ambiguities in Greene's letter, or to address the inconsistency between Greene's letter and the watershed assessment referenced in Sky's Form 10-K (Tr. 391, 394-96). Had he done so, he would have learned that Greene got much of his information from Sky itself and that Greene's telephone call to the Bureau of Land Management confirmed only the name on the title and not the right to mine (Tr. 1017-20).
Scutillo believed that the net present value calculations were a valid method of determining the fair value for the Danner, Berry, and Evergreen mines. He concluded that since the "market value" of the mines, as shown by the net present value calculations, was higher than the "cost," as shown by the face value of the preferred stock and notes Sky issued to acquire the mines, he would accept the lower "cost" valuation as the fair value of the properties in the audited financial statements (Tr. 213-14, 226, 229, 637-38).
Unrecorded expenses: shares issued for services rendered. During fiscal year 1994, Sky issued over 14.7 million shares of common stock, thereby increasing its outstanding common stock from about 1.6 million shares to about 16.3 million shares (Tr. 55; DX 1 at 31, 44). Sky issued the stock to pay for the services it received from consultants and to compensate its management and employees (Tr. 100-01). For example, Greene received 105,000 shares (Tr. 114-15; DX 81). However, Sky did not record as an expense the difference between the prices paid by the recipients of the stock and the market value of the stock when issued.
Scutillo did not consider this to be a critical audit area. In fact, he did not even focus on the issue until the Commission's staff brought it to his attention during the investigation of Sky (Tr. 111-12). Jensen claimed that he briefly considered the expense issue, but he did not share his "internal[ ] thought" with Scutillo (Tr. 458).
Scutillo obtained a schedule from Sky that identified all common stock issued during the year, and the amount paid by the recipient (Tr. 103-04; DX 81). The management-prepared schedule did not calculate the difference between the amount paid and the market price of the stock. Scutillo knew from reading Sky's Form 10-K that bids for Sky's common stock had ranged from a high of $4.25 to a low of $0.47 per share, much higher than the prices paid by the recipients for their shares (Tr. 51; DX 1 at 23, DX 81).
Respondents knew from conducting other audits where expenses resulting from the issuance of stock had been involved that they needed to address the shares-for-services issue (Tr. 461, 673). In addition, the forms used on the Sky audit reminded Respondents of the need to address such expenses. One checklist form discussed the requirement for the balance sheet to disclose stock issued at a discount (DX 65, item 43). Another checklist form alerted the auditors to consider the "treatment of deferred compensation arising from the sale of capital stock to officers or employees at prices below market" (DX 68 at 1328). The auditors marked both as "not applicable." The work papers also noted that "a significant amount was paid to consultants [but] there was no computation to show how these payments were determined" (RX 1B at 930). Scutillo and Jensen simply made no effort to determine if expenses should be recorded in connection with Sky's issuance of common stock. Both testified that they were guilty of an "omission" or an "oversight" in failing to tailor the McGladrey & Pullen audit program to the specific demands of the Sky audit (Tr. 108-14, 458-59, 462, 672-73).
Norman Black (Black), a staff accountant with the Commission, prepared a summary exhibit estimating the magnitude of the unrecorded expenses related to Sky's issuance of common stock during fiscal year 1994 (DX 32). In making his calculations, Black used the closing bid price from the day before Sky issued the stock and he compared that figure with the price the employee or consultant paid for the stock (Tr. 294-98; DX 33, DX 129). If the price paid was less than the market price and the stock was unrestricted, Black recorded the full difference as an expense to Sky (Tr. 298-300). If the stock was restricted, Black performed two additional calculations, one assuming a 25% discount from the market price and the other assuming a 50% discount (Tr. 301-02). Using this methodology, Black calculated the total unrecorded expenses on Sky's financial statements as ranging between $7.7 million and $10.6 million (DX 32). Two of the Division's expert witnesses opined that the methodology underlying Black's calculations was reasonable (Tr. 819-23, 878-82; DX 42 at 4, DX 128 at 10).
Respondents challenged the relevance and accuracy of Black's calculations. They cited Judge Mahony's determination that the price of Sky's stock had been manipulated and that certain of the consulting services had not been performed. Sky Scientific, 69 SEC Docket at 962-63. After the audit, Respondents learned that Sky had issued some stock as a prepayment for future services (Tr. 676). On that basis, they also contended that Black's figures should have been amortized over several years (Tr. 676; Resp. Br. at 23-24). Respondents did not know of such matters at the time of the audit. They argued that once they learned about the problem, it was impossible to fix it by revising Sky's financial statements (Tr. 109-12, 302-16, 673-74, 923-34; RX 11 at 10). These claims are addressed below.
Sky's audited financial statements for 1994. Scutillo's largest adjustment to Sky's financial statements was reversing the $16 million Bowerman Mine transaction (Tr. 747-48; RX 1A at 235, item 38). He accomplished this by crediting mineral properties for $16 million and debiting notes payable by $250,000 and preferred stock by $15,750,000 (RX 1A at 124). See supra note 11. Scutillo made several other audit adjustments to correct errors, omissions, and misallocations by Sky's in-house accountants (RX 1A at 124-25, 228-37). He estimated that these other adjustments collectively increased Sky's net losses by approximately $600,000 (Tr. 747-48).
As of February 28, 1994, Sky claimed total assets of approximately $69.7 million, including $40 million in restricted CDs and $29.5 million in mining properties (DX 1 at 31).18 It had cash assets of $3,049. Its net sales for the year were zero (DX 1 at 33). It recorded no expenses in connection with its issuance of common stock in exchange for services. Scutillo & Blake issued its independent auditor's report, addressed to Sky's board of directors. The report bore a date of June 13, 1994, the last day of field work, but Scutillo did not deliver it to Sky until late in the day on June 14, 1994 (Tr. 31, 44). In relevant part, the report stated (DX 1):
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Sky . . . and Subsidiaries as of February 28, 1994, and the results of its operations and its cash flows for the year then ended in conformity with [GAAP].
The accompanying financial statements have been prepared assuming that [Sky] will continue as a going concern. As discussed in Note 19 to the financial statements, [Sky's] principle [sic] assets consist of investments in or leases for mineral properties consisting of unpatented mining claims and a restricted $40,000,000 certificate of deposit that raise substantial doubt about its ability to continue as a going concern. Management's plans in regard to these matters are also described in Note 19. The terms of the certificate of deposit are more fully described in Notes 1F and 4. The financial statements do not include any adjustments that might result from the outcome of these uncertainties.
Note 1F to the report stated in relevant part (DX 1 at 37):
[Sky's] certificates of deposit are maintained in an overseas financial institution, which is not insured by the Federal Deposit Insurance Corporation or any other similar regulatory institution.
Note 3 to the report stated (DX 1 at 38):
The prepaid lease represents the costs incurred to acquire the Evergreen claim. [Sky] anticipates that mining of this property will commence by September 1, 1994, accordingly, six months of the lease prepayments have been classified as current and the balance has been included in non-current assets.
Note 4 to the report stated (DX 1 at 38):
[Sky's] certificates of deposit matures [sic] on February 27, 1998. These funds are not available for use until their maturity date. The certificates accrue interest at 11.25% per annum. See note 10 on issuance of preferred stock.
Note 10D to the report stated (DX 1 at 43):
[Sky] issued 4,000,000 shares [of preferred stock] at $10 per share face value to a Russian Commercial Bank in exchange for $40,000,000 in Certificates of Deposit with a [four] year maturity date. The dividend rate is 4 1/4% payable quarterly and is cumulative with the first quarter only being deferred until the maturity date of the Certificate of Deposit.
Note 19 to the report stated in relevant part (DX 1 at 47):
The principle [sic] assets of [Sky] consist of investment in or leases for mineral properties consisting of unpatented mining claims. [Sky's] ability to recover the cost of those investments is dependent on the success of future development of the properties and its ability to obtain financing to bring the mining operations into profitable production.
Post-audit developments. Sky filed its Form 10-K with the Commission on June 15, 1994 (DX 1). Scutillo thereafter retained the original work papers, ostensibly to assist him in preparing Sky's tax return and Sky's Form 10-Q for the first quarter of fiscal year 1995 (Tr. 452, 724-25). While Scutillo provided some assistance with the Form 10-Q, he never completed either assignment.
Jensen, who ordinarily would have initialed the original work papers before the auditor's report was released, did not actually receive the full set of original work papers from Scutillo until August 22, 1994 (Tr. 46-47, 448-52; DX 59). This was more than two months after Sky had filed its Form 10-K with the Commission. Scutillo and Jensen considered Jensen's initialing of the original work papers to be a formality, because Jensen had already received copies of the work papers in the critical audit areas during the audit (Tr. 38-39, 46, 452, 521-22, 575-76). Jensen reviewed and initialed the original work papers and returned them to Scutillo on August 24, 1994 (Tr. 48-49; DX 89).
Carleen H. Achuff (Achuff), then a senior geologist on the Commission's staff, visited some of Sky's California and Nevada mining properties in late July 1994 (Tr. 275-76). At three of those properties, she found no evidence of current or recent mining activity, no equipment, and no personnel (Tr. 278-79; DX 39). At the Tallulah mine, she found equipment and personnel, but no current operations and no tailings that might evidence recent operations (Tr. 278-80).19
The Commission opened its investigation of Sky on August 26, 1994 (DX 113). Scutillo learned of the investigation shortly thereafter (Tr. 580). Scutillo's attorney subsequently made an effort to determine whether there really was a Bank Sinektika (Tr. 658-64, 699). The inquiry produced mixed results in November 1994: while the bank existed, it was in poor financial condition. Scutillo's attorney learned that Bank Sinektika was "one of the banks required by the Central Bank of Russia to post additional reserves, as a result of not meeting standard financial ratios" (RX 15). In pertinent part, the report from Moscow stated: "Sinektika has been on the black list for a long time."
On May 22, 1995, Scutillo & Blake resigned as Sky's independent accountants (DX 4, RX 13). In doing so, the firm specifically questioned Sky's accounting for restricted stock and stock issued to consultants (DX 5). Scutillo & Blake did not reissue its 1994 opinion in connection with the audit of the February 28, 1995 financial statements, as a result of issues raised by the Commission's investigation and Sky's failure to resolve those issues to Scutillo's satisfaction (RX 13).
Effective May 26, 1995, Sky engaged Grant-Schwartz Associates, CPAs, of Boca Raton as independent auditors for the fiscal year ending February 28, 1995 (DX 75 at 35). In addition to issuing an opinion on Sky's 1995 financial statements, the successor auditors proposed to issue their own opinion on the 1994 financials, based on Scutillo's work papers for the 1994 audit, as modified by certain adjustments to the stock-for-services expense. On advice of counsel, Scutillo & Blake simply waited for the new financial statements to be reissued without restating or withdrawing the 1994 opinion (Tr. 676-83; RX 14).
Expert witnesses. The Division offered William W. Holder (Holder), CPA, as its expert on GAAS. He also presented testimony on GAAP.20 Holder has earned a doctorate in business administration and a master's in accounting from the University of Oklahoma and is a professor of accounting at the University of Southern California (Tr. 759-61; DX 128).
Holder explained that the valuation of Sky's mining properties and related preferred stock required specialized skills other than in accounting and auditing (DX 128 at 3). He faulted Scutillo for making no effort to acquire evidence from outside sources about the professional reputation and standing of Schultz or to explore the known relationships between Schultz, Sky, and certain of Sky's employees. He also found the audit deficient because Scutillo never really understood Schultz's methods and assumptions and because Scutillo could not show that he had made Schultz aware of the uses to which his reports would be put. Because of these omissions, Holder concluded that Scutillo failed to meet the professional standards applicable to using the work of a specialist (DX 128 at 4-5).
Holder disagreed with Respondents' position that Sky's mining properties were appropriately recorded at the face value of the preferred stock issued to acquire them. In Holder's judgment, Scutillo should have insisted that Sky record its mining properties at the fair value of the stock or the properties, whichever was more clearly determinable (DX 128 at 3). However, even if Scutillo was correct in approving the use of the contract price for valuation, Holder opined that the substantial difference between the contract value and the net present value computed for the properties should have been investigated for reasonableness (DX 128 at 6). In Holder's view, the failure to address these matters "fell below the standards of the accounting profession."
As to the Russian CDs, Holder opined that deficiencies in the confirmation process and the lack of substantive evidence that the CDs were collectible represented "material departures from the applicable professional standards" (DX 128 at 7-9). Holder also concluded that, as to the unrecorded expenses arising from Sky's issuance of stock-for-services, the 1994 financial statements departed from GAAP and the audit failed to meet the relevant professional standards (DX 128 at 10).
Holder acknowledged that Scutillo made a substantial audit effort in certain areas, as evidenced by the work papers (Tr. 790). However, he found deficiencies not only in the documentation, but also in the procedures applied (Tr. 790). Holder opined that the audit was "substandard" as to elementary procedures and not simply as to matters of professional judgment (Tr. 768, 838). He concluded that there were "substantial deficiencies" in Sky's financial statements and in the professional services performed by Scutillo (DX 128 at 2).
Holder had very little to say about the professional standards applicable to Jensen, as distinguished from those applicable to Scutillo. He opined that a concurring reviewer has an obligation to identify and discuss significant accounting, auditing, and reporting issues with an engagement partner before an audit report is issued, and stated that the concurring reviewer must be satisfied with the resolution of those issues by the engagement partner (DX 128 at 10).
Leslie A. Patten (Patten), CPA, a consultant specializing in business valuations and litigation support, testified for the Division as an expert on GAAP (Tr. 873-74; DX 42). Patten opined that Sky's 1994 financial statements were not prepared in accordance with GAAP in that Sky: (1) materially overstated the value of its mineral properties and its Russian CDs, both acquired with preferred stock of no ascertainable value; and (2) materially understated the expense of issuing stock for services.
Geoffrey G. Snow (Snow), Ph.D., also testified for the Division. Snow is an economic geologist and a former vice president of the Society of Economic Geologists. He specializes in studying the distribution of mineral deposits, the availability of reserves, and the economic considerations involved in their recovery (Tr. 249, 251; DX 41).
Snow explained the differences between economic geologists, such as himself, and engineering geologists, such as Schultz (Tr. 251, 259). He opined that being an engineering geologist does not necessarily qualify one as knowledgeable about ore reserves and ore extraction costs.21 In Snow's judgment, Sky lacked any basis for claiming reserves on any of its mining properties (Tr. 263; DX 41 at 1). Although Sky reported that its mines were in production, Snow's analysis of Sky's 1994 Form 10-K persuaded him that Sky had never even carried out the necessary development-stage activities and was simply an exploration-stage mining company (DX 41 at 3-4).
Peter H. Burgher (Burgher), CPA, testified for Respondents. Burgher was formerly a partner at Arthur Young & Co. Since retiring from that firm in 1979, he has been a consultant and an expert witness in numerous accounting and auditing disputes (Tr. 899-900; RX 11).22
Burgher opined that the 1994 audit was planned adequately and documented appropriately in the work papers. He considered Scutillo's assistants to be properly trained and supervised. He believed that Scutillo devoted substantial time to the Sky engagement. Burgher considered the going concern qualification in the audit report and the reversal of certain of management's treatments of transactions to be evidence of Scutillo's independence from Sky.
Burgher maintained that Scutillo proved his "conservatism" by recommending that Sky not book accrued interest from the CDs on its 1994 financial statements (RX 11 at 6, 8; Resp. Br. at 27). This claim is frivolous. No interest had accrued as of February 28, 1994 (RX 1A at 122).
Burgher acknowledged that, had he been engaged to audit the Russian bank transaction, he would have sought some form of independent confirmation of the existence and size of Bank Sinektika. However, he viewed the lack of such an audit step to be merely an omission, and not an intentional or extreme departure from the required standard of care (RX 11 at 14). Burgher believed that Scutillo behaved responsibly in his approach to the audit of Sky's mining properties by acknowledging his lack of training and experience, and engaging Jensen to assist in the audit, provide the necessary mining experience, and act as a concurring reviewer. While subsequent events exposed management fraud and lies to Scutillo, Burgher noted that an auditor is not an insurer and his report does not constitute a guarantee.
Finally, Burgher criticized the opinions of the Division's experts because those opinions did not express the view that the Sky audit had been "reckless" within the meaning of Rule 102(e). In pertinent part, Burgher's report stated (RX 11 at 13):
[W]hile both [Holder's and Patten's reports] express opinions that [Scutillo's] work was negligent neither expresses an opinion or provides support for the contention that [he] was "reckless." In fact neither sets forth opinions to support a contention that [Scutillo] conducted an "extreme departure" from ordinary standards of care. One report refers to "substantial deficiencies" in the audit but carefully refrains from use of the term "reckless" and does not state any "extreme departure(s)." The other simply states his opinion that [Sky's] 1994 financial statements depart from GAAP but he also fails to mention "recklessness" or any "extreme departure."
Burgher's own evaluation was that the 1994 Sky audit, taken as a whole, was not reckless. He expressed no view in his report as to whether Respondents were or were not reckless as to any specific asset or liability (Tr. 980). He concluded (Tr. 981):
[M]y belief is [Scutillo and Jensen] did what they should have done and then some more. . . . I would have done something else. But just because they didn't do everything they could have done doesn't mean it was a bad audit.
DISCUSSION AND CONCLUSIONS
1. In attempting to show that Scutillo was at least reckless, the Division has assumed a formidable burden of proof.
Rule 102(e) provides the Commission with a means to ensure that the professionals on whom it relies in executing its statutory duties perform their tasks diligently and with a reasonable degree of competence. The Commission has stated that it did not promulgate the rule to augment its enforcement arsenal, but simply to protect the integrity of its administrative processes from future harm that would result from continuing professional misconduct. See William R. Carter, 47 S.E.C. 471, 472-78 (1981) (discussing the background and operation of Rule 2(e), the predecessor of Rule 102(e)).23
Although there is no express statutory provision authorizing the Commission to discipline the professionals appearing before it, three reviewing courts have held that the rule was validly promulgated under the Commission's broad authority to adopt those rules and regulations necessary for carrying out its designated functions. See Sheldon v. SEC, 45 F.3d 1515, 1518 (11th Cir. 1995); Davy v. SEC, 792 F.2d 1418, 1421 (9th Cir. 1986); Touche Ross & Co. v. SEC, 609 F.2d 570, 577-82 (2d Cir. 1979).
Scienter And Rule 102(e)
The mental state required to violate the Commission's rule against improper professional conduct has been a point of considerable controversy. Representatives of the accounting profession, some prior Commissioners, and various legal commentators have argued that sanctioning an accountant for negligence extends beyond the realm of protective discipline and thrusts the Commission into substantive regulation over a professional's work-a function they view as reserved to the state boards of accountancy and professional organizations. Cf. SEC v. Pros Int'l, Inc., 994 F.2d 767, 769 (10th Cir. 1993) ("The SEC's authority does not extend to general regulation of the accounting profession . . . ."); SEC v. Arthur Young & Co., 590 F.2d 785, 788 (9th Cir. 1979). These critics have suggested that the text of Rule 102(e)(1)(ii) must be read in its entirety and that, just as an accountant cannot "negligently" be lacking in character or integrity or act unethically, so too, an accountant cannot "negligently" engage in improper professional conduct. They have contended that it is unfair for the Commission to apply a more stringent standard for accountants (sanctioning them for negligence) than for attorneys (sanctioning them only for recklessness or knowing misconduct).
In Davy, 792 F.2d at 1422, the U.S. Court of Appeals for the Ninth Circuit stated that "there may be cases where the SEC should not be empowered to determine the standards by which accountants, or attorneys for that matter, are to be judged" but it concluded that Davy's breaches of GAAP and GAAS were "so clear and so uncontroverted that any vagueness in the Rule is not at issue here."
In David J. Checkosky, 50 S.E.C. 1180 (1992), a majority of the Commission found that two accountants had engaged in improper professional conduct in violation of former Rule 2(e). It suspended them from practice for two years. The Commission stated that "a mental awareness greater than negligence is not required" to establish a violation of the rule, but it "noted" that the two accountants' conduct "did in fact rise to the level of recklessness." 50 S.E.C. at 1197.
In Checkosky v. SEC, 23 F.3d 452 (D.C. Cir. 1994) (Checkosky I), the court of appeals remanded the case to the Commission, holding that the agency had failed adequately to explain the standard of conduct it had applied under the rule. There was a very brief opinion of the court; each of the three judges also issued a separate expression of views. All three judges found substantial evidence to support the Commission's findings that the two accountants had failed properly to interpret GAAP and to act in accordance with GAAS. They differed on whether the violations of GAAP and GAAS constituted negligence or recklessness and whether negligence was sufficient for sanctions under the rule.
On remand, the Commission affirmed the suspensions. David J. Checkosky, 52 S.E.C. 1177 (1997). The majority opinion found that "improper professional conduct by accountants encompasses a range of conduct" and that the rule "does not mandate a particular mental state." 52 S.E.C. at 1190-91. It concluded that the accountants had behaved recklessly, but at the same time insisted that negligent deviations from GAAP or GAAS could violate Rule 102(e).
The two accountants again petitioned for judicial review, and again argued that the Commission had failed to articulate an intelligible standard for "improper professional conduct" under Rule 102(e). In Checkosky v. SEC, 139 F.3d 221 (D.C. Cir. 1998) (Checkosky II), the court of appeals again remanded. The court found that, notwithstanding the prior remand, the Commission had failed to offer an adequate explanation of the mental state that violated the rule. Citing the Commission's "persistent failure to explain itself" and "the extraordinary duration" of the proceedings, Checkosky II, 139 F.3d at 222, 227, the court determined that further proceedings would be futile. It instructed the Commission to dismiss the charges.
In response to Checkosky II, the Commission instituted a notice-and-comment rulemaking proceeding to "clarify" the standard of intent it would apply when determining whether accountants engage in improper professional conduct. Proposed Amendment to Rule 102(e) of the Commission's Rules of Practice, 67 SEC Docket 1006 (June 18, 1998) (Proposed Amendment). It adopted an amendment on October 19, 1998, and specified three types of conduct that would constitute improper professional conduct by an accountant under Rule 102(e)(1)(ii). Amendment to Rule 102(e) of the Commission's Rules of Practice, 68 SEC Docket 707 (Rule Amendment).
New Rule 102(e)(1)(iv)(A) defined "improper professional conduct" by an accountant to mean "[i]ntentional or knowing conduct, including reckless conduct, that results in a violation of applicable professional standards." In addition, new Rule 102(e)(1)(iv)(B) defined "improper professional conduct" by an accountant as "[e]ither of the following two types of negligent conduct: (1) A single instance of highly unreasonable conduct that results in a violation of applicable professional standards in circumstances in which an accountant knows, or should know, that heightened scrutiny is warranted[; or] (2) Repeated instances of unreasonable conduct, each resulting in a violation of applicable professional standards, that indicate a lack of competence to practice before the Commission." Rule Amendment, 68 SEC Docket at 709.
The notice of proposed rulemaking requested the public to comment on what definition of "recklessness" would be appropriate. Proposed Amendment, 67 SEC Docket at 1009. Several commenters suggested the definition of "recklessness" used in cases brought under Section 10(b) of the Exchange Act and Rule 10b-5. In adopting the rule amendment, the Commission agreed: "Although the standards of professional practice are not fraud based," for purposes of consistency, "recklessness" in the amended rule "should mean the same thing as courts have defined `recklessness' to mean under the antifraud provisions." Rule Amendment, 68 SEC Docket at 710.
Retroactive Application Of Rule 102(e)(1)(iv)(A)
Respondents argue that the Commission is estopped from retroactively applying Rule 102(e)(1)(iv)(A) to professional conduct that occurred in 1994 (Answer at 2; Resp. Br. at 35-40). They believe that the Commission must measure their 1994 professional conduct against the pre-1998 version of Rule 102(e)(1), the version the Commission has stated "does not mandate a particular mental state."
In promulgating the amended rule, the Commission stated that the purpose it served and the relief it provided are forward-looking. For those reasons, it said that it would use the clarified standard "in all cases considered after the amendment's effective date . . . regardless of when the conduct in question occurred." Rule Amendment, 68 SEC Docket at 708. The Commission did not specifically state that the amended version of the rule would be applied retroactively, but only that the clarified "standard" would be used "regardless of when the conduct in question occurred."
The OIP in this case charges that Respondents "intentionally, knowingly or recklessly violated applicable professional standards." However, the OIP only cites to Rule 102(e)(1)(ii), not to Rule 102(e)(1)(iv)(A). If the wording of the OIP was designed to finesse a troublesome issue-by omitting any suggestion that the 1998 rule amendment was being applied retroactively-that subtlety has apparently been lost on the Division. In its pleadings, the Division states this proceeding was brought pursuant to Rule 102(e)(1)(iv)(A) (Div. Pretrial Memorandum at 1, 15; Div. Br. at 2, 49).24 Based on the Division's representations, I conclude that the 1998 rule amendment is being applied to pre-1998 conduct.
Application of a statute to conduct that occurred before its issuance is disfavored, but it is permissible if the provision simply embodies the law in existence at the time of the conduct and thus does not attach new legal consequences to events completed before its enactment. See Landgraf v. USI Film Prods., 511 U.S. 244, 269-70 (1994); SEC v. First Pac. Bancorp, 142 F.3d 1186, 1193 n.8 (9th Cir. 1998). Where the intervening statute authorizes or affects the propriety of prospective relief, application of the new provision is not retroactive. See Landgraf, 511 U.S. at 273.
However, absent clear Congressional intent, an agency may not give retroactive effect to statutes or rules that impair rights a party possessed when he acted, increase a party's liability for past conduct, or impose new duties with respect to transactions already completed. See Landgraf, 511 U.S. at 280; see also Koch v. SEC, 177 F.3d 784, 789 (9th Cir. 1999) (holding that the Remedies Act did not authorize the Commission to impose a penny stock bar on an individual whose alleged misconduct predated enactment of that statute); Upton v. SEC, 75 F.3d 92, 98 (2d Cir. 1996) (stating that, because there was "substantial uncertainty" in the Commission's interpretation of a rule, the respondent did not have reasonable notice that his conduct might violate the rule); Carter, 47 S.E.C. at 508 (declining to find "improper professional conduct" by two attorneys because the applicable standards "have not been so firmly and unambiguously established that we believe all practicing lawyers can be held to an awareness of generally recognized norms" and because "the Commission has never articulated or endorsed any such standards").
In the two and one-half years since it adopted the rule amendment, the Commission has held that the clarified standard of intentional or knowing conduct by an accountant, including reckless conduct, "is not novel and was not created by the amendment to Rule 102(e). Rather, it is a standard that we have used in proceedings that predate both the Checkosky opinion and [the respondent's] own 1995 conduct." Albert Glenn Yesner, CPA, 70 SEC Docket 2743, 2748 (Oct. 19, 1999); Russell Ponce, 73 SEC Docket at 465 n.52, 467 n.57; see also Potts, 151 F.3d at 812-13 (recklessness by a concurring review partner). But see Checkosky II, 139 F.2d at 225-26 ("[T]he Commission had to make a choice. There is no justification for the government depriving citizens of the opportunity to practice their profession without revealing the standard they have been found to violate."); Yesner, 70 SEC Docket at 2752 (Johnson, Comm'r, dissenting) (criticizing the Commission's majority for treating the relevant version of Rule 102(e)-the one that existed prior to the October 1998 amendment-as if it had a severable "recklessness" element that survived Checkosky II).
The Commission opinions in Yesner and Ponce stand for the proposition that intentional, knowing, or reckless conduct that did not comply with the applicable professional standards was "improper professional conduct" under Rule 102(e) before and after the Rule Amendment. Both opinions state that the "recklessness" standard was "not novel." Those opinions are binding on Administrative Law Judges, and are followed here. If Scutillo contends that he had no idea, prior to October 19, 1998, that reckless violations of professional auditing standards would be treated as "improper professional conduct," or if he believes that Checkosky II, Koch, Upton, or Carter compel a different result on the retroactivity or fair notice issues, he must ask the Commission to reconsider its position.
Scienter And Auditing Under The Federal Securities Laws
The term "scienter" refers to "a mental state embracing intent to deceive, manipulate, or defraud." Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 n.12 (1976). The Division can establish scienter by proving either actual knowledge or recklessness. See David Disner, 52 S.E.C. 1217, 1222 & n.20 (1997); cf. In re Software Toolworks, Inc., Sec. Litig., 50 F.3d 615, 628 (9th Cir. 1994); In re Phar-Mor, Inc., Sec. Litig., 892 F. Supp. 676, 685 (W.D. Pa. 1995). Recklessness is narrowly defined. It involves not merely simple, or even inexcusable negligence, but an extreme departure from the standard of ordinary care and which presents a danger of misleading buyers or sellers that is either known to the actor or is so obvious that the actor must have been aware of it. See SEC v. Steadman, 967 F.2d 636, 641 (D.C. Cir. 1992); Hollinger v. Titan Capital Corp., 914 F.2d 1564, 1569-70 & n.7 (9th Cir. 1990) (en banc); Hackbart v. Holmes, 675 F.2d 1114, 1117-18 (10th Cir. 1982); Sundstrand Corp. v. Sun Chem. Corp., 553 F.2d 1033, 1044-45 (7th Cir. 1977). Recklessness is a lesser form of intent, not a greater degree of ordinary negligence. It is not just different from negligence in degree, but also in kind. See Sanders v. John Nuveen & Co., 554 F.2d 790, 793 (7th Cir. 1977).
The contours of auditing recklessness are particularly troublesome because an audit by nature involves considerable estimation and judgment exercised against materials prepared by others. See Bily v. Arthur Young & Co., 834 P.2d 745, 762 (Cal. 1992) ("An auditor is a watchdog, not a bloodhound. As a matter of commercial reality, audits are performed in a client-controlled environment.").
The type of recklessness that is actionable against an outside auditor must approximate an actual intent to aid in the fraud being perpetrated by the audited company. See Decker v. Massey-Ferguson, Ltd., 681 F.2d 111, 120-21 (2d Cir. 1982). Scienter requires more than evidence that an outside auditor has misapplied accounting principles. The Division must prove that the accounting practices were so deficient that the audit amounted to no audit at all, or an egregious refusal to see the obvious, or to investigate the doubtful, or that the accounting judgments which were made were such that no reasonable accountant would have made the same decisions if confronted with the same facts. See SEC v. Price Waterhouse, 797 F. Supp. 1217, 1240 (S.D.N.Y. 1992). If a respondent shows that his accounting decisions were reasonable, he negates the Division's attempt to establish scienter. See In re Worlds of Wonder Sec. Litig., 35 F.3d 1407, 1426 (9th Cir. 1994).
The case law is clear about what is not sufficient to establish scienter.25 First, violations of GAAP, by themselves, do not constitute circumstantial evidence of scienter. See Chill v. General Electric Co., 101 F.3d 263, 270 (2d Cir. 1996); Lovelace v. Software Spectrum Inc., 78 F.3d 1015, 1020-21 (5th Cir. 1996); Software Toolworks, 50 F.3d at 626-27; Worlds of Wonder, 35 F.3d at 1426; Serabian v. Amoskeag Bank Shares, Inc., 24 F.3d 357, 362 (1st Cir. 1994). The same is true for violations of GAAS, standing alone. See Danis v. USN Communications, Inc., 73 F. Supp. 2d 923, 941 (N.D. Ill. 1999); Marksman Partners, L.P. v. Chantal Pharm. Corp., 46 F. Supp. 2d 1042, 1049 n.5 (C.D. Cal. 1999), aff'd, 2000 U.S. App. LEXIS 21708 (9th Cir. Aug. 22, 2000) (unpublished table decision); In re Health Mgmt., Inc. Sec. Litig., 970 F. Supp. 192, 203 (E.D.N.Y. 1997). Second, it is not enough for the Division to show that a reasonable accountant "would, might, or should have handled the matter differently." Price Waterhouse, 797 F. Supp. at 1241. Third, an accountant's scienter may not be inferred solely from the magnitude of the client's fraud. See Reiger v. Price Waterhouse Coopers, LLP, 117 F. Supp. 2d 1003, 1013 (S.D. Cal. 2000); In re Livent, Inc., Sec. Litig., 78 F. Supp. 2d 194, 217 (S.D.N.Y. 1999). Fourth, an auditor's desire to receive professional fees, or to profit from a continuing relationship with a client, does not suffice as evidence of scienter. See Melder v. Morris, 27 F.3d 1097, 1103 (5th Cir. 1994); DiLeo v. Ernst & Young, 901 F.2d 624, 629 (7th Cir. 1990); Health Mgmt., 970 F. Supp. at 202; Price Waterhouse, 797 F. Supp. at 1242 & n.60. Fifth, scienter is not established by demonstrating an auditor's lack of curiosity, or by using hindsight. See Chill, 101 F.3d at 270; Software Toolworks, 50 F.3d at 627; DiLeo, 901 F.2d at 628.
In contrast, the courts have been willing to infer scienter when GAAP or GAAS violations are combined with other circumstantial evidence of recklessness. First, scienter will exist when an auditor ignores multiple "red flags" that should have heightened his professional skepticism. See Danis, 73 F. Supp. 2d at 941-42; Miller v. Material Sciences Corp., 9 F. Supp. 2d 925, 928-29 (N.D. Ill. 1998); Health Mgmt., 970 F. Supp. at 203; Van de Velde v. Coopers & Lybrand, 899 F. Supp. 731, 737 (D. Mass. 1995); In re Leslie Fay Cos., Inc. Sec. Litig., 871 F. Supp. 686, 699 (S.D.N.Y. 1995), modified on other grounds, 918 F. Supp. 749 (S.D.N.Y. 1996). Second, scienter may be based on the magnitude of the reporting errors, if the accused was in a position to detect the errors. See Chu v. Sabratek Corp., 100 F. Supp. 2d 815, 824 (N.D. Ill. 2000); Chalverus v. Pegasystems, Inc., 59 F. Supp. 2d 226, 234 (D. Mass. 1999) (collecting cases); In re Miller Indus., Inc. Sec. Litig., 12 F. Supp. 2d 1323, 1332 (N.D. Ga. 1998); In re Leslie Fay Cos., Inc. Sec. Litig., 835 F. Supp. 167, 175 (S.D.N.Y. 1993) (holding that "tidal waves of accounting fraud" raise an inference of scienter for an accountant). The magnitude of an underlying fraud will also support an inference of scienter if it enhanced the auditor's suspicion of specific transactions or made the overall fraud glaringly conspicuous. See Reiger, 117 F. Supp. 2d at 1013. Third, scienter may be found if unusual transactions have been completed at or near the end of an accounting period, or if the audited company has violated its own internal policies in a way that violated GAAP. See Provenz v. Miller, 102 F.3d 1478, 1490 (9th Cir. 1996); In re Ikon Office Solutions, Inc. Sec. Litig., 66 F. Supp. 2d 622, 630-31 (E.D. Pa. 1999); Chalverus, 59 F. Supp. 2d at 234-35; In re Cirrus Logic Sec. Litig., 946 F. Supp. 1446, 1458 n.10 (N.D. Cal. 1996); Van de Velde, 899 F. Supp. at 734-36. Fourth, scienter may be found if there is evidence that the accused participated in drafting misleading documents. See Software Toolworks, 50 F.3d at 629.
Materiality, GAAS, GAAP, And Scienter
The cases cited above, holding that scienter may be inferred in part from the magnitude of the reporting errors, offer judicial recognition of the close relationship between materiality and scienter under the antifraud provisions of the securities laws. The converse is equally true: immaterial errors will not support an inference of scienter. See Coates v. Heartland Wireless Communications, Inc., 55 F. Supp. 2d 628, 638 (N.D. Tx. 1999) ("It cannot be strongly inferred that a person who conceals immaterial information acts with intent to defraud."); Geiger v. Solomon-Page Group, Ltd., 933 F. Supp. 1180, 1191 (S.D.N.Y. 1996) (holding that it cannot be conscious misbehavior or recklessness for a defendant to fail to disclose information in a prospectus that is not material). In fact, because materiality is an element of a Rule 10b-5 offense, the courts often will not even consider the thorny issue of scienter if the materiality of an alleged misstatement or omission has not been established. See Press v. Quick & Reilly, Inc., 218 F.3d 121, 130 (2d Cir. 2000); Grossman v. Novell, Inc., 120 F.3d 1112, 1125 (10th Cir. 1997).
The Commission has rejected a suggestion that the filing of a materially false or misleading document should always be a threshold requirement for a finding of improper professional conduct by an accountant under Rule 102(e). In so ruling, the Commission reasoned:
[A]n accountant can demonstrate a lack of competence even if his conduct did not result in the filing of a false or misleading document. An auditor who fails to audit properly under GAAS-whether recklessly or highly unreasonably-should not be shielded [from a Rule 102(e) proceeding] because the audited financial statements fortuitously turned out to be accurate or not materially misleading.
Rule Amendment, 68 SEC Docket at 711. GAAS consists of three general standards, three standards of field work, and four standards of reporting. Certain activities subject to GAAS concern matters other than submitting documents. Thus, materiality is simply not relevant to such GAAS issues as the auditor's technical training and proficiency, or the auditor's need to maintain an independent mental attitude. In other situations, whether "materiality" is an "element of the offense" will depend on whether it is an element of the specific professional standard alleged to have been violated. See Robert D. Potts, CPA, 65 SEC Docket 1376, 1385-87 (Sept. 24, 1997), aff'd, 151 F.3d 810 (8th Cir. 1998); see also Greebel v. FTP Software, Inc., 194 F.3d 185, 205 (1st Cir. 1999) (GAAP violations); In re Segue Software, Inc., Sec. Litig., 106 F. Supp. 2d 161, 169-71 (D. Mass. 2000) (GAAP violations); Ponce, 73 SEC Docket at 460-61 (GAAP violations).
The applicable professional literature is to the same effect. The statements interpreting GAAS recognize that materiality "underlie[s] the application of all [GAAS], particularly the standards of field work and reporting." AU § 150.03; see also AU § 150.04 ("The concept of materiality is inherent in the work of the independent auditor."); AU § 312.03 ("The concept of materiality recognizes that some matters, either individually or in the aggregate, are important for fair presentation of financial statements in conformity with [GAAP], while other matters are not important."); AU § 312.08 ("The auditor should consider audit risk and materiality both in (a) planning the audit and designing auditing procedures and (b) evaluating whether the financial statements taken as a whole are presented fairly, in all material respects, in conformity with [GAAP]."); see also AU §§ 312.13, 326.23, 411.06, 420.02, 431.02, 508.08.
Accordingly, to prove improper professional conduct where the allegation is the expression of a faulty opinion on the client's financial statements taken as a whole, the Division must demonstrate materiality. Although the present OIP is silent on the question of materiality, the Division argued that the GAAP violations in Sky's financial statements involved material amounts (Tr. 874; DX 42 at 1, 4; Div. Prop. Find. ## 157, 306; Div. Br. at 36, 45-46; Div. Reply Br. at 2; Posthearing Conference of Jan. 9, 2001, at Tr. 20-21). Respondents contested the point at the hearing, but not in their posthearing filings. Scutillo calculated the audit gauge, or materiality threshold, at $468,000. While that figure is not binding on the Commission, it is binding on him. Errors above that level cannot be ignored as "immaterial" to the audited financial statements.
Scienter Cannot Properly Be Inferred From Evidence
Of Nothing More Than Repeated Auditing Negligence
As stated in Sanders, 554 F.2d at 793, recklessness is a lesser form of intent, not a greater degree of ordinary negligence, and it differs from negligence not only in degree, but also in kind. See McLean v. Alexander, 599 F.2d 1190, 1198 (3d Cir. 1979) ("[N]egligence, whether gross, grave or inexcusable cannot serve as [a] substitute for scienter."); Reiger, 117 F. Supp. 2d at 1014 ("[N]o degree of negligence can satisfy the substantive element of scienter, or raise a strong inference of scienter under the [PSLRA.]").
The Commission assesses an auditor's performance in light of the "total audit environment." Ernst & Ernst, 46 S.E.C. 1234, 1262 (1978). Of course, it is theoretically possible that the more negligent acts an auditor commits during a given interval, the likelier it may be that the auditor knew he was creating risk of a greater degree and a different kind. But the courts have not been receptive to such hair-splitting. Cf. Wells v. Monarch Capital Corp., [1998 Supp.] Fed. Sec. L. Rep. (CCH) ¶ 90,110 at 90,152 (1st Cir. 1997) (holding that the fact that the outside auditors made "many mistakes" did not support a finding of scienter). Given Checkosky I and Checkosky II and the Commission's determination not to wade into this swamp in the 1998 rulemaking,26 the Division cannot bootstrap its way to victory in an auditing recklessness case by stringing together separate acts of auditing negligence.
The OIP does not allege auditing negligence. If the evidence shows nothing more than auditing negligence, dismissal would be appropriate. In these circumstances, the Division cannot pursue a Rule 102(e)(1)(iv)(A) recklessness theory based on nothing more than evidence of multiple Rule 102(e)(1)(iv)(B)(2)-type negligence. If that is what the Commission had intended to allow in its 1998 rulemaking, it would have said so explicitly. To the extent that the Division's evidence proves only negligence, even repeated instances of negligence, I have not considered that evidence as probative on the question of whether "the total audit environment" shows that Scutillo was reckless.
Not All Missed Audit Clues Are "Red Flags"
That Demonstrate "Recklessness"
The Division cannot establish scienter by labeling every missed audit clue, no matter how slight, as a separate "red flag." The courts have required considerably more precision than that. See Reiger, 117 F. Supp. 2d at 1012 (holding that purported "red flags" consisted of documents which, if properly reviewed pursuant to GAAP or GAAS, would have raised an inference of gross negligence, but not fraud); In re MicroStrategy Sec. Litig., 115 F. Supp. 2d 620, 653-54 (E.D. Va. 2000) (holding that the probative value of allegations that an auditor ignored "red flags" is a function of the nature and number of such flags); Cheney v. Cyberguard Corp., 2000 U.S. Dist. LEXIS 16351, at *43-44 (S.D. Fla. July 31, 2000) (finding alleged "red flags" insufficient to support a strong inference of scienter). As explained in Reiger, 117 F. Supp. 2d at 1012 (footnote and citations omitted):
Plaintiffs rely on several decisions handed down by district courts . . . that found a strong inference of scienter by combining accounting improprieties with an accountant's alleged disregard of "red flags." . . . The warning signs in these cases more closely resembled "smoking guns" than "red flags." Each case included specific facts suggesting the independent accountant consciously entertained doubts about the veracity of its client's financial disclosures, either from a client or third party informing the accountant of the client's fraud, or from contemporaneous statements made by the accountant.
2. Certain evidence will not be considered in determining whether Scutillo was reckless.
Hindsight Does Not Count
At the hearing and in its pleadings, the Division referred to several matters that only came to light after the 1994 audit had been completed. Some of the matters are simply irrelevant to the charges in the OIP, and they have the potential to "poison the well." As to others, the case law and the applicable professional standards make clear that a determination of an auditor's recklessness cannot be based on hindsight. See Reiger, 117 F. Supp. 2d at 1013; see also AU § 316.08 ("[T]he subsequent discovery that a material misstatement exists in the financial statements does not, in and of itself, evidence inadequate planning, performance, or judgment on the part of the auditor."). For those reasons, I have given no consideration to the following in determining whether Scutillo was reckless:
Just as the Division may not use hindsight to prove recklessness, so too, Scutillo may not use hindsight to negate recklessness. In determining liability, I have not considered Scutillo's evidence of the following:
Foreign Law
The Division presses for the admission into evidence of the May 30, 1995, statement from Koslov and three attachments to that statement (Tr. 5-7, 239-47; DX 114; Div. Br. at 11-12).27 Scutillo opposes any consideration of these documents (Resp. Br. at 43). I deferred a ruling at the hearing. I now conclude that DX 113 should be admitted into evidence, but that DX 114 should not.
DX 114 has several aspects. The signed English-language version of Koslov's statement (DX 114 at 500236-37) was apparently translated from the Russian-language original (DX 114 at 500238-39) through Pegasus Translations of Bethesda, Maryland. I use the term "apparently" because the translator was not identified.28
Attachment A to Koslov's statement is a seven-page document in the Russian language, for which no verbatim English translation has been provided (DX 114 at 500240-46). According to the English-language version of Koslov's statement, Attachment A is a Russian Bank Letter dated February 10, 1992, which established uniform rules for the issuance and redemption of deposit and savings certificates for all banks of the Russian Federation. Koslov's statement briefly summarized the provisions of the Russian banking law and then reached conclusions concerning the CDs in Attachment B based on that summary.
Attachment B to Koslov's statement consists of eighteen pages of documents in English. They are photocopies of CDs provided to Koslov by the Division. The first CD, made out to Sky, has already been accepted into evidence elsewhere (DX 123, RX 1B at 722-23). The other CDs were made out to entities other than Sky, were issued before February 28, 1994, and were for terms of five years. The Division has not even suggested that these other CDs are relevant to this case.
Attachment C to Koslov's statement is a two-page Russian-language document, for which no verbatim English translation has been provided. According to the English-language version of Koslov's statement, Attachment C is the Auditing Record of the Sinektika Commercial Bank, drawn up by the Bank of Russia on December 26, 1994.29
Under Rule 320 of the Commission's Rules of Practice, 17 C.F.R. § 201.320, an Administrative Law Judge "may" receive relevant evidence and "shall" exclude all evidence that is irrelevant, immaterial, or unduly repetitious. Because the Division seeks to admit DX 114 for the truth of the matters asserted therein, I also consider the Commission's position on hearsay. In determining when to admit and whether to rely on hearsay evidence, the Commission has consistently evaluated its probative value, its reliability, and the fairness of its use. See Harry Gliksman, 71 SEC Docket 892, 901 (Dec. 20, 1999), appeal filed, 9th Cir., Nos. 00-70141 and 00-70258; Charles D. Tom, 50 S.E.C. 1142, 1145 (1992). The Commission has expressed a preference for inclusiveness in doubtful cases. See City of Anaheim, 71 SEC Docket 191, 193 (Nov. 16, 1999). While the Federal Rules of Civil Procedure and the Federal Rules of Evidence do not govern the Commission's administrative proceedings, they often provide helpful guidance on issues not directly addressed by the Commission's Rules of Practice. Cf. Yanopoulos v. Dept. of Navy, 796 F.2d 468, 471 (Fed. Cir. 1986).
First, it is fundamentally unfair to opposing parties and to decision makers to offer a foreign language document without a verbatim translation by a qualified interpreter.
In several non-adjudicative contexts, the Commission has refused to accept foreign language documents or has required them to be accompanied by English-language translations. See, e.g., 17 C.F.R. § 232.306(a) (EDGAR filings) ("Foreign language documents shall not be filed with the Commission in electronic format. A fair and accurate English translation of any required document shall be filed. A written representation to that effect shall be included in the English translation document . . . ."); 17 C.F.R. § 288.4(c) (reports filed by the African Development Bank) ("The report shall be in the English language. If any exhibit or other paper or document or report is in a foreign language, it shall be accompanied by a translation into the English language."); 17 C.F.R. § 289.4(c) (reports filed by the International Finance Corporation) (same).
The practice of other federal agencies in their adjudicative proceedings is the same. See 8 C.F.R. § 3.33 (immigration proceedings) ("Any foreign language document offered by a party in a proceeding shall be accompanied by an English language translation and a certification signed by the translator that must be printed legibly or typed. Such certification must include a statement that the translator is competent to translate the document, and that the translation is true and accurate to the best of the translator's abilities."); see also Haekal v. Refco, Inc., [1999-2000 Transfer Binder] Comm. Fut. L. Rep. (CCH) ¶ 28,262, at 50,574 n.13 (Sept. 29, 2000) (CFTC reparation proceedings) ("Any party that submits a document to the record in a foreign language must provide a reliable translation or the document will not be considered.").
The practice of the federal courts is also the same. See SEC v. Antar, 15 F. Supp. 2d 477, 498 n.15 (D.N.J. 1998) (holding that Hebrew documents were not admissible because there was "no indication from the defendants as to who may have prepared the purported translation of the documents into English, or whether the translator [was] qualified"); Zenith Radio Corp. v. Matsushita Elec. Ind. Co., Ltd., 513 F. Supp. 1100, 1135 (E.D. Pa. 1981), aff'd in part and rev'd in part on other grounds, 723 F.2d 238 (3d Cir. 1983), rev'd on other grounds, 475 U.S. 574 (1986) (refusing to consider foreign language documents when plaintiffs failed to offer translations).
The Division has failed to lay a proper foundation for entering DX 114 into evidence. As to the English-language version of Koslov's statement, the Division has neither identified the translator nor set forth the translator's qualifications. Cf. Fed. R. Evid. 604 and 702. As to Russian-language Attachments A and C, the Division has not shown that the English-language summation in Koslov's statement offers a fair and accurate rendition of the full Russian-language text. Indeed, the Division has not shown why a brief summation of a foreign language document should be considered an acceptable substitute for a verbatim translation under any circumstances.30 DX 114 thus fails to meet the "reliability" standard in Gliksman and Tom.
Second, the Division has not shown the relevance of DX 114 to the narrow issue in this case: whether Scutillo recklessly engaged in improper professional conduct during the 1994 Sky audit. Certainly, Koslov's statement and attachments are relevant to the broader questions of whether Sher may have duped Dorow and Respondents about the validity of the CDs or whether Sher and Dorow, acting together, may have duped Respondents. Attachment B is relevant to the broader question of whether others may have been duped before Respondents were duped. But such proof would not assist the Division's case, and I seriously doubt that the Division offered the documents for that purpose. Rather, the Division insinuates that: (1) the audit failed because Scutillo never made inquiry into the Russian banking laws governing CDs, and (2) Scutillo should have learned facts about Russian banking laws in June 1994 that the Division's investigation of Sky only brought to light in May 1995. There is no merit to either argument. The Division has not established that an auditor has a duty under the applicable professional standards to know foreign banking law because of his training as an accountant. Nor has it even alleged that Scutillo had a duty under AU § 336.03(d) to hire a specialist in Russian banking law to interpret those requirements for him.
As the Division observes, Koslov's statement was received into evidence in the companion administrative proceeding. See Sky Scientific, 69 SEC Docket at 955 n.23. The ultimate issue to be decided in this case is considerably narrower than the wide-ranging fraud issues in Sky Scientific. There is no suggestion that the admission of the exhibit in that proceeding is binding here.
Third, it is fundamentally unfair to Scutillo to admit expert opinion testimony on foreign law without reasonable written notice and without affording Scutillo an opportunity to cross-examine the expert.
Under Federal Rule of Civil Procedure 44.1:
A party who intends to raise an issue concerning the law of a foreign country shall give notice by pleadings or other reasonable written notice. The court, in determining foreign law, may consider any relevant material or source, including testimony, whether or not submitted by a party or admissible under the Federal Rules of Evidence. The court's determination shall be treated as a ruling on a question of law.
Five months before the hearing, the Division gave copies of its proposed exhibits, including DX 113 and DX 114, to Respondents. Two months before the hearing, the Division informed Respondents that it intended to show that the auditors "failed to confirm . . . the validity of the CDs under Russian banking regulations" (Div. Pretrial Memorandum at 11). But having told Respondents and me what it intended to do, the Division did not inform Respondents or me of how it proposed to do it. The Division never filed a motion for a determination of foreign law. It never asked Respondents to stipulate to the accuracy of its summary translation. It never raised the issue of foreign law at any of the prehearing conferences. It never designated Koslov as one of its experts. The Division's intent to rely solely upon DX 114 became apparent only at the start of the hearing. I conclude that the one-sentence reference to Russian banking regulations in the Division's pretrial memorandum does not constitute "reasonable written notice" within the meaning of Rule 44.1.
There can be little doubt that Koslov's statement offered expert opinion testimony. The heart of his statement was the opinion that the CDs in Attachment B "are in violation of many formal requirements of Attachment A, item 5" (DX 114 at ¶¶ 3-6). In Koslov's view, these defects rendered the CDs invalid.
Expert opinion testimony is no longer an invariable necessity in establishing foreign law. See Curtis v. Beatrice Foods Co., 481 F. Supp. 1275, 1285 (S.D.N.Y. 1980), aff'd, 633 F.2d 203 (2d Cir. 1980) (unpublished table decision). However, the Division elected to use expert opinion testimony to make its point here. Having done so, the Division was obliged to bring its chosen expert to the hearing for cross-examination by Respondents.
The Administrative Procedure Act (APA) recognizes that the opportunity to cross-examine is an important safeguard of the accuracy and completeness of testimony in agency adjudications. See 5 U.S.C. § 556(d); cf. Texas-Capital Contractors, Inc. v. Abdnor, 933 F.2d 261, 269 (5th Cir. 1990); Warner-Lambert Co. v. Heckler, 787 F.2d 147, 161-63 (3d Cir. 1986).
The Division cannot escape its APA obligations by choosing an expert witness who resides abroad and then invoking Rule 235(a)(2) of the Commission's Rules of Practice, 17 C.F.R. § 201.235(a)(2), to shield the foreign expert from cross-examination. Granted, Koslov was out of the country at the time of the hearing and there has been no suggestion that the Division procured his absence. However, Rule 235(a)(2) may be applied only if the absent witness's prior sworn statement is "otherwise admissible." Koslov's statement is not. Surely the Division would not suggest that if, instead of using Snow, it had engaged a Canadian geologist to evaluate and opine on Sky's mineral properties, that expert's report would have been admissible without cross-examination because the expert was home in Canada at the time of the hearing.
The five-year old Koslov statement was not the only way the Division could have presented proof of Russian banking law and the applicability of that law to the CDs in this case. The Division did not suggest that there were no other experts on Russian banking law available to it.
I reject the Division's fallback argument that DX 114 should be admitted into evidence, with the burden then shifting to Respondents to produce their own foreign law evidence to rebut Koslov's opinion (Tr. 243). I agree with Respondents that it would have been virtually impossible for them to obtain evidence about the state of affairs in Russian banking law in 1994 at the last minute (Tr. 245-46). There is no sound reason to shift the burden to Respondents to refute evidence that should not be accepted in the first place.
Finally, the judicial decisions interpreting Rule 44.1 provide that, if a plaintiff does not prove foreign law, the trial judge may treat it as a failure to prove an element of the plaintiff's case. See Bel-Ray Co., Inc. v. Chemrite (Pty.) Ltd., 181 F.3d 435, 440 (3d Cir. 1999); Carey v. Bahama Cruise Lines, 864 F.2d 201, 205 (1st Cir. 1988); Bartsch v. Metro-Goldwyn-Mayer, Inc., 391 F.2d 150, 155 n.3 (2d Cir. 1968). While the second sentence of the Rule empowers a federal court to determine the foreign law on its own, it does not oblige the court to do so. By analogy to Rule 44.1, I decline to address the issue of Russian banking law on my own motion.
Holder's Testimony On Redirect Concerning Recklessness
In his written report, Holder expressed the view that Respondents did substandard work in violation of the applicable professional standards (DX 128 at 1, 3-10). He said that his work was continuing and he reserved the right to modify his report (DX 128 at 2).
Holder never did revise his report, even after Burgher specifically made an issue of Holder's determination not to express an opinion that Respondents had been reckless. At the hearing, Holder amplified his report somewhat. He explained that, in his view, Respondents' improper professional conduct involved fundamental auditing procedures, and not merely gray areas of professional judgment (Tr. 768). Division counsel took Holder through Burgher's written report, line-by-line, identifying areas in which Holder disagreed with Burgher (Tr. 769-82). Recklessness was never mentioned. The Division's direct examination on this point concluded with the following (Tr. 782):
Division Counsel: Anything else in Mr. Burgher's report that you disagree with?
Holder: Not that comes to mind sitting here.
Holder was generally persuasive in establishing that the audit violated GAAS. I have cited his report and testimony for that proposition below. However, the Division must prove recklessness in order to prevail under the OIP. The case law provides that violations of GAAP and GAAS, by themselves, do not establish recklessness.
In those circumstances, it was not immediately clear to me why the Division had engaged an expert, elicited testimony about GAAP and GAAS violations, and then stopped, as if nothing more were necessary. At a sidebar conference, I asked counsel if either intended to question Holder about recklessness. Respondents expressed no interest in doing so, but the Division agreed to raise the subject on redirect (Tr. 828, 863-64).
After a recess, Holder explained that he had not been asked to address recklessness in his written report and that his assignment had been simply "to identify instances of substandard conduct in the audits of these financial statements, [and] any departures from GAAP and . . . GAAS" (Tr. 853-54). He expressed discomfort in attributing motives to conduct and he balked at being asked to read minds (Tr. 861). However, when read a definition of recklessness from the case law, he opined that Respondents' departures from the applicable professional standards had been so great as to be inexplicable and met the definition provided (Tr. 845-46, 861-62).
Respondents objected to any consideration of that testimony, contending that it came as an unfair surprise (Tr. 862-65, 1024-29; Resp. Prop. Find. ## 121-22, 153-61; Resp. Br. at 9-10, 44-45). After reviewing the transcript, I agree with Respondents. Holder never revised his written report, even after Burgher had challenged his refusal to opine that Respondents had been reckless. When the parties' roles were reversed, the Division was vigilant to ensure that Burgher did not expand his hearing testimony beyond the matters he had covered in his written report (Tr. 701-02). In reaching my decision, I have not relied upon Holder's testimony to the effect that Respondents were reckless.
3. Sky's financial statements violated GAAP.
Paragraph III.FACTS.4 of the OIP alleges that Respondents engaged in improper professional conduct by failing to assure that Sky's financial statements complied with GAAP. Scutillo's audit report represented that Sky's 1994 financial statements were presented fairly, in all material respects, in conformity with GAAP. The evidence shows that they contained significant departures from GAAP, in that assets were materially overstated and expenses were materially understated.
The Applicable Accounting Principles
Accounting Principles Board Opinion No. 16, Business Combinations (1970) (APB Opinion No. 16) and Opinion No. 29, Accounting for Nonmonetary Transactions (1973) (APB Opinion No. 29) provide guidance for recording the acquisition of assets in exchange for stock. The parties agree that these opinions are relevant to the question of whether Sky violated GAAP in valuing its Russian CDs and its mining properties.
Under APB Opinion No. 16 at ¶ 67(a), an asset acquired by exchanging cash or other assets should be recorded at cost-that is, at the amount of cash disbursed or the fair value of other assets distributed. Under APB Opinion No. 16 at ¶ 67(c), an asset acquired by issuing shares of stock of the acquiring corporation is recorded at the fair value of the asset, that is, shares of stock issued are recorded at the fair value of the consideration received for the stock.
The preferred measure of cost in such transactions is the fair value of the asset acquired. Id. at ¶ 67(c). However, restraints on measurement have led to the practical rule that assets acquired for other than cash, including shares of stock issued, should be stated at cost when they are acquired and cost may be determined either by the fair value of the consideration given or by the fair value of the property acquired, whichever is the more clearly evident. Id. at ¶ 67.
APB Opinion No. 29 is similar in its wording. The cost of a nonmonetary asset acquired in exchange for another nonmonetary asset is the fair value of the asset surrendered to obtain it. APB Opinion No. 29 at ¶ 18. The fair value of the asset received should be used to measure the cost if it is more clearly evident than the fair value of the asset surrendered. Id. However, general agreement exists that a nonmonetary transaction, regardless of form, should not be recorded at fair value if fair value is not determinable within reasonable limits. APB Opinion No. 29 at ¶¶ 17, 20. Fair value should be regarded as not determinable within reasonable limits if major uncertainties exist about the realizability of the value that would be assigned to an asset received in a nonmonetary transaction accounted for at fair value. APB Opinion No. 29 at ¶ 26. If neither the fair value of a nonmonetary asset transferred nor the fair value of a nonmonetary asset received in exchange is determinable within reasonable limits, the recorded amount of the nonmonetary asset transferred from the enterprise may be the only available measure of the transaction. Id.
When a company issues stock in exchange for services, it must record as an expense the difference between the market price of the stock and the money received in exchange for the stock. The value of the services received must also be recorded as an expense. Patten, Holder, and Burgher agreed on these points (DX 42 at 4, DX 128 at 9-10, RX 11 at 6). See Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (1972) (APB Opinion No. 25) at ¶¶ 10, 18.31
Discussion
For the auditors to assure that Sky's financial statements complied with GAAP, they needed evidence of the fair value of the assets received (the Russian CDs and the mining properties) or the assets surrendered (the convertible preferred stock).
Fair valuing Sky's convertible preferred stock. The convertible preferred stock of Sky's subsidiaries did not trade publicly. Sky lacked cash, had no revenues, and was already delinquent in paying dividends on preferred stock and interest on notes previously issued. Sky and Winner's Circle had going concern qualifications on their amended 1992 and 1993 audit reports, and Sky was about to have another such qualification on its 1994 audit report. There was no evidence of the marketability of the convertible preferred stock under any circumstances. As a result, the $10 per share assigned value of the stock did not necessarily represent its current fair value. Neither Sky management nor the outside auditors obtained an appraisal. The work papers did not describe what procedures, if any, Scutillo applied to test Sky's valuation of these shares. In fact, there was no valuation of Sky's convertible preferred stock independent of the assets for which those shares were exchanged.
Patten testified that the valuation of assets based on an arbitrarily assigned value for non-trading preferred stock violated GAAP because such a practice allowed the parties effectively to establish their own value for the assets (DX 42 at 1). Respondents offered no evidence to the contrary. The Division argues that the carrying amount of Sky's preferred stock in these circumstances should have been zero or, at most, a nominal amount (Tr. 770-71, 773, 815; Div. Br. at 18-19). I agree.
Fair valuing the Russian CDs. Holder testified that the valuation of the CDs depended, in part, upon the ability of the Russian bank to pay Sky (DX 128 at 7). Patten opined that the fair value of the CDs was uncertain because neither Sky nor the auditors were able to evaluate the Russian bank's ability to pay (DX 42 at 3). Burgher testified that, had he been engaged to examine the Russian bank transaction, he would have sought some form of independent confirmation of the existence and size of the bank (RX 11 at 14). I agree with Patten that the CDs should have been recorded on Sky's financial statements at a nominal amount under the circumstances.
However, based on the information available to Scutillo in May and June 1994, I do not agree with Patten's testimony that GAAP required an appropriate reserve to be added to the 1994 financial statements (DX 42 at 3).32 Statement of Financial Accounting Standards No. 5, Accounting for Contingencies (1975) (FASB No. 5) sets forth the standards of financial accounting and reporting for loss contingencies. FASB No. 5 defines a loss contingency as an existing condition, situation, or set of circumstances involving uncertainty as to possible loss to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur. Resolution of the uncertainty may confirm the loss or impairment of an asset or the incurrence of a liability. FASB No. 5 at ¶ 1.
When a loss contingency exists, the likelihood that future events will confirm the loss or impairment of an asset or the incurrence of a liability can range from "probable" to "reasonably possible" to "remote." FASB No. 5 at ¶ 3. "Probable" means that the future events are "likely" to occur; "reasonably possible" means that the chance of the future events occurring is "more than remote but less than likely"; and "remote" means that the chance of the future events occurring is "slight." Id.
An estimated loss from a loss contingency must be accrued by a charge to income only if two conditions are met: (1) information available prior to issuance of the financial statements indicates that it is "probable" that an asset had been impaired or a liability had been incurred at the date of the financial statements; and (2) the amount of loss can be "reasonably estimated." FASB No. 5 at ¶ 8. If no accrual is made for a loss contingency because one or both of these conditions are not met, disclosure of the contingency must be made when there is at least a "reasonable possibility" of incurring a loss. FASB No. 5 at ¶ 10.
The purpose of the two conditions in FASB No. 5 at ¶ 8 is to require accrual of losses when they are reasonably estimable and relate to the current or a prior period. The requirement that the loss be reasonably estimable is intended to prevent accrual in the financial statements of amounts so uncertain as to impair the integrity of the financial statements. The Financial Accounting Standards Board has concluded that disclosure is preferable to accrual when a reasonable estimate of loss cannot be made. Further, even losses that are reasonably estimable should not be accrued if it is not probable that an asset has been impaired or a liability has been incurred at the date of an enterprise's financial statements because those losses relate to a future period, rather than the current or a prior period. FASB No. 5, Appendix C at ¶ 59.
The Division has not shown that the two conditions of FASB No. 5 at ¶ 8 existed and that a reserve belonged on Sky's 1994 financial statements. Patten opined about the need for an appropriate reserve, but he did not offer a specific figure (DX 42 at 3). Nor did he classify the loss contingency as "probable." Scutillo considered creating a reserve, but found that he was unable to make a reasonable estimate of its amount (Tr. 184-85, 483). Neither of the Division's accounting experts opined that Scutillo was wrong in his analysis of this issue. See Steadman, 967 F.2d at 645 (holding that there is no obligation under FASB No. 5 to attempt to quantify a contingent obligation through rough guesses or speculation).
Given Patten's generic testimony on the reserve issue, the Division's failure to demonstrate that both criteria in FASB No. 5 at ¶ 8 had been satisfied, and the guidance provided by the D.C. Circuit's 1992 opinion in Steadman, I do not find that GAAP required a reserve to be added to the 1994 financial statements.
Fair valuing Sky's mining properties. Reports prepared by or provided to Sky pertaining to the value of the three mining properties did not cite any comparable transactions. However, the consideration paid by Sky roughly contemporaneously for Tallulah was inconsistent with the much larger sums Sky claimed as the fair value of Danner, Berry, and Evergreen (DX 92). Tallulah, which Scutillo described as Sky's operating mine, was on Sky's books for an "insignificant" amount (Tr. 190; DX 92). The auditors never examined this apparent valuation inconsistency. Under the circumstances, Patten opined that GAAP required that Danner, Berry, and Evergreen should not have been recorded at more than a nominal amount, regardless of what the parties to the transactions had represented to one another as the value of the assets (DX 42 at 3). I agree.
In the narrative section of its Form 10-K, Sky claimed that its mining properties had net present values significantly greater than the values appearing on its audited financial statements (DX 1 at 6-21). The Division has shown that those hypothetical calculations were based on unrealistic assumptions and that significant discrepancies existed between the claimed net present value of the mines and the claimed "cost" of the stock issued to acquire them. However, the net present value calculations appeared only in the narrative section of Sky's Form 10-K. They did not appear in the audited financial statements or in the auditor's opinion. Scutillo's audit report was limited to expressing an opinion on whether Sky's financial statements, taken as a whole, complied with GAAP. The audit report did not express an opinion on the forward-looking pro forma financial data in the narrative section of Sky's Form 10-K. Accordingly, no GAAP issues are presented by the net present value calculations.
Stock for services expenses. Patten and Holder opined that Sky violated GAAP when it failed to record such expenses on its financial statements (DX 42 at 4, DX 128 at 10). Burgher disagreed. He contended that once an auditor has placed a going concern qualification in an audit report, the reader of the financial statements has been alerted that the company may not make it, and additional expenses do not matter (Tr. 926-28; RX 11 at 4, 10). I accept the testimony of Patten and Holder as more persuasive than that of Burgher. Financial statements must be "presented fairly" under GAAP. The numbers are important. It is inappropriate for Respondents to suggest that, because a company has reported substantial losses, additional losses in material amounts need not be disclosed on the theory that they would be irrelevant to the users of the financial statements (Tr. 132-34, 775-76). Respondents have not pressed this analysis in their brief.
Burgher also testified that it would have been inappropriate to book such expenses in Sky's 1994 financial statements because it was later alleged that Sky's stock price had been manipulated and that bona fide services had not been performed for some of the stock issued. In his judgment, revised financial statements with additional calculations valuing the shares-for-services expense would likely have been no more reliable than the financial statements originally issued (RX 11 at 10; Resp. Br. at 22-25).
Burgher confused the question of what GAAP required in the original financial statements with the wholly separate issue of whether GAAS required revised financial statements once the auditors learned of the possible price manipulation and other securities law violations. Only the former question is relevant on the liability issues here. I accept the testimony of Patten and Holder on this point, as well. If an accountant does not know about a fraud, he must estimate fair value with the available information. The subsequent allegations that the price of Sky's stock had been manipulated and that services had not been performed for some of the shares issued is not relevant to the question of whether Sky's financial statements were "presented fairly" when issued (Tr. 781-82, 823-27, 879-82). Cf. Andrews v. Comm'r, 135 F.2d 314, 318 (2d Cir. 1943) ("[T]he `fair market value' of securities often consists of what honest and willing dupes (or, to use Americanese, `suckers') were actually paying for similar securities on a `rigged' market."); W.T. Grant Co. v. Duggan, 94 F.2d 859, 861 (2d Cir. 1938) (rejecting a claim that exchange prices were greatly inflated during the boom market of 1929 in excess of their actual value and finding it immaterial that the market crashed shortly after a security was valued).
There was unquestionably a difference between the value of the services employees and consultants rendered and the value of the stock they received. However, quantifying the expense understatement is difficult. The Division, relying on Black's calculations, estimated the understatement as ranging from approximately $7.7 million to approximately $10.6 million (DX 32). Respondents, using different discount assumptions for valuing restricted stock and contending that certain payments should have been amortized over several years, asserted that the true figure was closer to $2 million (Resp. Br. at 23-24). They presented no evidence to substantiate that assertion. The dispute does not require a precise mathematical resolution. Giving Respondents the generous benefit of the doubt, and assuming, without deciding, that Respondents' lower figure is the more accurate, the amount of the expense understatement was still clearly material to Sky's financial statements, and the failure to record expenses at that level still violated GAAP.
4. Scutillo violated GAAS.
Paragraph III.FACTS.3 of the OIP alleges that Scutillo violated GAAS by failing to plan or perform appropriate audit procedures, failing to maintain control over the confirmation request and response process, failing to obtain sufficient competent evidential matter, and failing to exercise due professional care.
The OIP draws no distinction between the GAAS applicable to Scutillo, as audit engagement partner, and the GAAS applicable to Jensen, as the concurring reviewer. It proceeds from the premise that Respondents were co-equal in their responsibilities under GAAS.
The Applicable Professional Standards
GAAS consists of three general standards, three standards of field work, and four standards of reporting. AU § 150.02. The OIP alleges that Respondents violated the third general standard and the first and third standards of field work. The third general standard requires that due professional care be exercised in the performance of the audit and the preparation of the report. The first standard of field work requires that the work be adequately planned and assistants, if any, be properly supervised. The third standard of field work requires that sufficient competent evidential matter be obtained through inspection, observation, inquiries, and confirmations, to afford a reasonable basis for an opinion regarding the financial statements under audit.33
The OIP's allegation that Scutillo failed to maintain control over the confirmation request and response process involves an auditing procedure, rather than an auditing standard. "Procedures" relate to acts to be performed, whereas "standards" deal with measures of the quality of the performance of those acts and the objectives to be attained by the use of the procedures undertaken. AU § 150.01. The discrepancy is not significant, because the auditing procedure in question relates to an auditing standard that was identified in the OIP-the third standard of field work.
The professional qualifications required of the independent auditor are those of a person with the education and experience to practice as such. AU § 110.03. They do not include those of a person trained for or qualified to engage in another profession or occupation. Although the independent auditor is informed in a general manner about matters of commercial law, he does not purport to act in the capacity of a lawyer and may appropriately rely upon the advice of attorneys in all matters of law. Id. GAAS do not require that an auditor authenticate documents, nor is the auditor trained to do so. AU § 316.07.
In the observance of GAAS, the independent auditor must exercise his judgment in determining which audit procedures are necessary in the circumstances to afford a reasonable basis for his opinion. AU § 110.04. His judgment is required to be the informed judgment of a qualified professional person. Id. Since the auditor's opinion on the financial statements is based on the concept of reasonable assurance, the auditor is not an insurer and his report does not constitute a guarantee. AU § 316.08. The subsequent discovery that a material misstatement exists in the financial statements does not, in and of itself, evidence inadequate planning, performance, or judgment on the part of the auditor. Id.
When a change of auditors takes place, communications between predecessor and successor auditors are guided by AU § 315. The initiative in communicating rests with the successor auditor. AU § 315.02. Inquiry of the predecessor auditor is a necessary procedure because the predecessor may be able to provide the successor with information that will assist him in determining whether to accept the engagement. AU § 315.04. The successor auditor should make specific and reasonable inquiries of the predecessor regarding matters that the successor believes will assist him in determining whether to accept the engagement. His inquiries should include specific questions regarding, among other things, facts that might bear on the integrity of management; on disagreements with management as to accounting principles, auditing procedures, or other similarly significant matters; and on the predecessor's understanding as to the reasons for the change of auditors. AU § 315.06. To evaluate the consistency of the application of accounting principles with the prior year, the successor auditor may make specific inquiries of the predecessor and review the predecessor's work papers. AU § 315.08.
If a successor auditor is replaced before completing an audit engagement and issuing a report, and another auditor is considering accepting the engagement, the auditor who is considering accepting the engagement should communicate with both the original auditor and the successor auditor. AU §§ 9315.01-.02. In such circumstances, the second successor auditor should make specific and reasonable inquiries of each predecessor auditor regarding matters that the successor believes will assist him in determining whether to accept the engagement. Inquiring of only one of the predecessor auditors would not result in a full response because the circumstances surrounding each change in auditors may be different and the predecessor auditors may have different knowledge about the potential client. In addition, inquiring of each predecessor is relevant since both auditor changes occurred after the issuance of the most recent audit report. AU § 9315.03.
In planning an audit, the auditor is required to obtain knowledge of his client's business, so that he can identify areas that need special attention. AU §§ 311.06-.08.
An audit of financial statements in accordance with GAAS should be planned and performed with an attitude of professional skepticism. The auditor neither assumes that management is dishonest nor assumes unquestioned honesty. AU § 316.16. Where the auditor has determined there is a significant risk in evaluating the financial statements, the auditor requires more or different evidence to support material transactions than would be the case in the absence of such risk. Transactions that are both large and unusual, particularly at year-end, should be selected for testing. AU § 316.20.
The nature, timing, and extent of the procedures to be applied on a particular engagement are a matter of professional judgment to be determined by the auditor, based on the specific circumstances. AU § 326.13. However, the procedures adopted should be adequate to achieve the audit objectives developed by the auditor, and the evidential matter obtained should be sufficient for the auditor to form conclusions concerning the validity of the individual assertions embodied in the components of the financial statements. Id.
The validity of evidential matter depends upon the circumstances under which it is obtained. When evidential matter can be obtained from independent sources outside an entity, it provides greater assurance of reliability for the purposes of an independent audit than that secured solely within the entity. AU § 326.19(a). Representations from management are part of the evidential matter the independent auditor obtains, but they are not a substitute for the application of those auditing procedures necessary to afford a reasonable basis for his opinion on the financial statements. AU § 333.02.
The independent auditor's objective is to obtain sufficient competent evidential matter to provide him with a reasonable basis for forming an opinion. AU § 326.20. The amount and kinds of evidential matter required to support an informed opinion are matters for the auditor to determine in the exercise of his professional judgment after a careful study of the circumstances in the particular case. In the great majority of cases, the auditor finds it necessary to rely on evidence that is persuasive rather than convincing. Id.
An auditor typically works within economic limits; his opinion, to be useful, must be formed within a reasonable length of time and at reasonable cost. AU § 326.21. The auditor must decide, again exercising professional judgment, whether the evidential matter available to him within the limits of time and cost is sufficient to justify expression of an opinion. Id.
The independent auditor should be thorough in his search for evidential matter and unbiased in its evaluation. AU § 326.23. In designing audit procedures to obtain competent evidential matter, he should recognize the possibility that the financial statements may not be presented in accordance with GAAP. In developing his opinion, the auditor should give consideration to relevant evidential matter regardless of whether it appears to corroborate or to contradict the assertions in the financial statements. To the extent the auditor remains in substantial doubt about any assertion of material significance, he must refrain from forming an opinion until he has obtained sufficient competent evidential matter to remove such substantial doubt, or he must express a qualified opinion or a disclaimer of opinion. Id. See generally AU § 508.38 (defining a qualified opinion); AU § 508.70 (defining a disclaimer of opinion).
Confirmation is the process of obtaining and evaluating a direct communication from a third party in response to a request for information about a particular item affecting financial statement assertions. AU § 330.04. The auditor should exercise an appropriate level of professional skepticism throughout the confirmation process. AU § 330.15. If an entity has entered into an unusual or complex transaction and the combined assessed level of inherent and control risk is high, the auditor should consider confirming the terms of the transaction with the other parties in addition to examining documentation held by the entity and confirming amounts. AU §§ 330.08, 330.25.
The auditor should direct the confirmation request to a third party whom the auditor believes is knowledgeable about the information to be confirmed. AU § 330.26. If information about the respondent's objectivity and freedom from bias with respect to the audited entity comes to the auditor's attention, the auditor should consider the effects of such information on designing the confirmation request and evaluating the results, including determining whether other procedures are necessary. AU § 330.27. In addition, there may be circumstances (such as for significant, unusual year-end transactions having a material effect on the financial statements) in which the auditor should exercise a heightened degree of professional skepticism relative to these factors about the respondent. In these circumstances, the auditor should consider whether there is sufficient basis for concluding that the confirmation request is being sent to a respondent from whom the auditor can expect the response will provide meaningful and competent evidence. Id.
During the performance of confirmation procedures, the auditor should maintain control over the confirmation requests and responses. AU § 330.28. Maintaining control means establishing direct communication between the intended recipient and the auditor to minimize the possibility that the results will be biased because of interception and alteration of the confirmation requests or responses. Id.
There may be situations in which the respondent, because of timeliness or other considerations, responds to a confirmation request other than in a written communication mailed to the auditor. AU § 330.29. When such responses are received, additional evidence may be required to support their validity. To restrict the risks associated with facsimile responses and treat the confirmations as valid audit evidence, the auditor should consider taking certain precautions, such as verifying the source and contents of a facsimile response in a telephone call to the purported sender. In addition, the auditor should consider requesting the purported sender to mail the original confirmation directly to the auditor. Id.
In assessing whether a confirmation response reduces the audit risk of a financial statement assertion to an acceptably low level, the auditor should consider the materiality of the balance and the inherent and control risks associated with assertions. If the balances are material and the transactions from which they arose are unusual, complex, or outside the normal course of business, the auditor should evaluate carefully the degree of reliance placed on third party confirmations and consider the possibility of collusion or negligence by the third party. The auditor should exercise the appropriate level of professional skepticism in designing, performing, and evaluating the results of confirmation procedures and should not place undue reliance on confirmation evidence in circumstances of high risk. See Audit Risk Alert-1993, General Update on Economic, Regulatory, Accounting and Auditing Matters, issued by the Auditing Standards Division of the AICPA (DX 131).34
The auditor's use of a specialist in performing an audit of financial statements in accordance with GAAS is guided by AU § 336. A specialist is a person or firm possessing specialized skill or knowledge in a particular field other than accounting or auditing. AU § 336.01. The auditor's education and experience enable him to be knowledgeable about business matters in general, but he is not expected to have the expertise of a person trained for or qualified to engage in the practice of another profession or occupation. AU § 336.02. During the audit, however, an auditor may encounter matters potentially material to the fair presentation of financial statements in conformity with GAAP that require special knowledge and that, in his judgment, require using the work of a specialist. Id.
The auditor may use the work of a specialist as an audit procedure to obtain competent evidential matter. AU § 336.04. However, GAAS do not permit the auditor simply to acquiesce in the opinion of the specialist. The auditor should satisfy himself concerning the professional qualifications and reputation of the specialist by inquiry or other procedures. AU § 336.05. The auditor should consider: (1) the professional certification, license, or other recognition of the competence of the specialist in his field; (2) the reputation and standing of the specialist in the views of his peers and others familiar with his capability or performance; and (3) the relationship, if any, of the specialist to the client. Id.
Ordinarily, the auditor should attempt to obtain a specialist who is unrelated to the client. However, when the circumstances warrant, work of a specialist having a relationship to the client may be acceptable. AU § 336.06.
The auditor, the client, and the specialist should have an understanding as to the nature of the work to be performed by the specialist. AU § 336.07. Preferably, the understanding should be documented and should cover, among other things, the objectives and scope of the specialist's work; the specialist's representations as to his relationship, if any, to the client; the methods or assumptions to be used; and the specialist's understanding of the auditor's corroborative use of the specialist's findings in relation to the representations in the financial statements. Id.
If the specialist is related to the client, the auditor should consider performing additional procedures with respect to some or all of the related specialist's assumptions, methods, or findings to determine that the findings are not unreasonable or he should engage an outside specialist for that purpose. AU § 336.08.
If the auditor determines that the specialist's findings support the related representations in the financial statements, he may reasonably conclude that he has obtained sufficient competent evidential matter. AU § 336.09. If there is a material difference between the specialist's findings and the representations in the financial statements, or if the auditor believes that the determinations made by the specialist are unreasonable, he should apply additional procedures. Id. A matter that has not been resolved will ordinarily cause the auditor to conclude that he should qualify his opinion or disclaim an opinion because the inability to obtain sufficient competent evidential matter as to an assertion of material significance in the financial statements constitutes a scope limitation. Id.
Under AU § 550.04, the auditor's responsibility with respect to information in another document, such as a Form 10-K, does not extend beyond the financial information identified in his report, and the auditor has no obligation to perform any procedures to corroborate other information contained in such a document. However, the auditor should read the other information and consider whether such information, or the manner of its presentation, is materially inconsistent with information, or the manner of its presentation, appearing in the financial statements. If the auditor concludes that there is a material inconsistency, he should determine whether the financial statements, his report, or both require revision. If he concludes that they do not require revision, he should request the client to revise the other information. If the other information is not revised to eliminate the material inconsistency, he should consider other actions such as revising his report to include an explanatory paragraph describing the material inconsistency, withholding the use of his report in the document, and withdrawing from the engagement. The action he takes will depend on the particular circumstances and the significance of the inconsistency in the other document. Id.
Discussion
GAAS are not satisfied by using a set of forms, following a checklist, or accumulating a lot of paper. GAAS are a set of standards that require an auditor, among other things, to plan, conduct field work, evaluate the results obtained, and think. Scutillo violated GAAS here because he did not design and implement procedures reasonably calculated to obtain the competent evidential matter he needed.
Scutillo partially ignored the guidance of AU § 315 when he failed to communicate with Baum and Cutler, the two immediate predecessor auditors. While Scutillo offered an explanation for his actions (Tr. 32-33, 67-68), his explanation cannot be accepted as persuasive, given the unambiguous wording of AU §§ 9315.01-.03. In contrast, Scutillo communicated with Jacobs and Weinberg and reviewed Weinberg's 1993 audit work papers. These aspects of his planning and preparation were appropriate and demonstrated partial compliance with AU § 315.
The Division established that during the audit, Scutillo did not read press releases that Sky had issued in fiscal year 1994 (Tr. 90-96, 98; DX 6, DX 8, DX 10-DX 15, DX 20). While Scutillo was obliged to know his client's business pursuant to AU §§ 311.06-.08, his failure to read the press releases does not establish a breach of GAAS on this record. Sky had issued the press releases before it engaged Scutillo as its outside auditor. The releases did not suggest to the reader that Scutillo or any independent predecessor auditor had offered assurances about the information Sky was publishing. In their prepared reports, neither of the Division's expert witnesses identified Scutillo's failure to read Sky's press releases as a GAAS violation. The Division's effort to cure that omission at the hearing was not successful: Holder testified that it was very common for auditors to read press releases relating to a company's financial statements, but he was unaware of any professional standard that obligated the auditor to do so (Tr. 763).
I agree with Holder that the audit of the Russian bank transaction violated GAAS in several respects (DX 128 at 8-9). Scutillo failed to obtain sufficient competent evidential matter to establish that Sher had authority to act for Bank Sinektika, or that Bank Sinektika had the ability to pay Sky when the CDs matured. Although Scutillo was confronted with an unusual year-end transaction having a major impact on Sky's financial statements, he never sent out a confirmation request of his own, never considered tailoring the standard bank confirmation form to the broader needs of the Sky audit, never inquired into the terms of the underlying transaction, ignored irregularities on the face of the documents he inspected, and failed to communicate with the bank's home office in Moscow. In each of these areas, Scutillo failed to maintain control of the confirmation process. Jensen offered a timely initial warning that the transaction did not "pass the smell test." Once Dorow advised him not to "knock himself out," Jensen backed off.
I reject Scutillo's argument that the alternate procedure of inspecting the underlying documents made the confirmation process unnecessary. Scutillo's inspection missed many obvious discrepancies, and failed to meet the auditing standard requiring due professional care. While Scutillo's audit program prompted the auditor to "inspect or confirm," an unsatisfactory inspection hardly eliminated the need to confirm.
I also reject Scutillo's claim that he was entitled to rely on Sher's authority to act for the Russian bank because attorney Greene had vouched for Sher. First, Greene's testimony failed to support Scutillo on several critical points. Greene was Respondents' witness; the failure of proof on this issue must count against Respondents. Second, Scutillo never asked Greene for a letter explaining Greene's dealings with Sher. The omission is conspicuous, because Scutillo did ask Greene to provide a letter relating to Sky's mineral properties. Third, Scutillo can draw no comfort from AU § 110.03, which permits auditors to rely on the advice of attorneys in all matters of law. The existence and scope of an agent's authority to act for a principal presents a question of fact, not law. See Anetsberger v. Metro. Life Insur. Co., 14 F.3d 1226, 1234 (7th Cir. 1994); Nat'l Football Scouting, Inc. v. Cont'l Assurance Co., 931 F.2d 646, 649 (10th Cir. 1991); Parmenter v. FDIC, 925 F.2d 1088, 1094 n.4 (8th Cir. 1991).
Scutillo had ample opportunity to confirm Sher's actual authority on his own. Formal instruments that delineate the extent of an agent's authority, such as powers of attorney, can be assumed to spell out the intent of the principal with a high degree of particularity. See Restatement (Second) of Agency § 34 cmt. h (1958). Scutillo violated the applicable professional standards when he failed to request a copy of Sher's power of attorney from Sky or from the bank's home office in Moscow. He cannot fill the void by claiming that Greene assured him of Sher's apparent authority. For apparent authority to exist, there must be some conduct on the part of the principal to give rise to the inference of the agent's authority. Id. §§ 8 cmt. a, 27. Scutillo could not reasonably look to the purported agent (Sher) to confirm his own authority. Nor could he reasonably look to a representative of a third party (Greene, as attorney for Sky) to explain the principal's assurances about the authority of its purported agent.
Scutillo also failed to exercise due care and to maintain an attitude of professional skepticism when he relied on unaudited financial statements of Bank Sinektika, when he failed to document in the work papers his purported communication with an international banking consultant, and when he reasoned that the CDs were valid because there was insufficient evidence to persuade him that they were invalid.35
The Division makes repeated references to Scutillo's purported failure to authenticate the Russian bank's financial statements (Tr. 168-72, 478-79; Div. Prop. Find. ## 159, 161, 327, 455; Div. Br. at 14, Div. Reply Br. at 2). Under AU § 316.07, however, an auditor has no duty to authenticate documents (Tr. 800). The Division also makes a different argument: that discrepancies appearing on the face of the Russian bank's financial statements-the absence of a statement that the document had been prepared in accordance with GAAP, the claim that there were substantial off-the-books assets, the reference to Atlantic Bancorp as a guarantor-should have prompted further scrutiny by Scutillo. I agree that, absent performance of additional audit procedures to resolve these discrepancies, the Russian bank's financial statements were not competent evidential matter.
Scutillo's decision to telephone Sher after receiving the facsimile confirmation on June 9 was a reasonable audit step. However, Scutillo violated GAAS when he omitted to ask Sher where Sher had obtained the confirmation, when he chose not to document his conversation with Sher in the work papers, and when he issued his audit report without having obtained the original confirmation that Sher had promised to provide. At the very least, Scutillo should have been more skeptical once Sher started to become unavailable to follow-up telephone inquiries (Tr. 186-87). Scutillo could have held up his audit report beyond the June 15, 1994, due date. Indeed, this is what he testified he would do in appropriate circumstances (Tr. 592) ("[W]e would not compromise . . . the audit procedures that we deem necessary, and if it means the client misses a deadline, then they [sic] miss a deadline."). In the alternative, he could have issued a qualified report or a disclaimer of opinion by the June 15 deadline.
I agree with Holder that Scutillo could not reasonably rely on Schultz as a "specialist" (DX 128 at 4-5). Scutillo learned of Schultz's professional reputation solely from Sky's management and employees. He never spoke to Schultz. Scutillo maintained that Schultz's reports demonstrated his independence from Sky (Tr. 341-42; DX 47, item 2), but I do not credit that assessment. Scutillo never specifically confirmed the nature and scope of Schultz's engagement. The work papers did not evaluate the impact of Schultz's preexisting relationship to Sky and its employees. While Scutillo confirmed that Schultz was duly licensed as an engineering geologist, he did not appreciate that engineering geologists possess different skills from economic geologists, and that the latter's skills were more relevant here. Scutillo never really understood the nature of the work performed by Schultz, or the methods and assumptions upon which Schultz relied. These omissions violated AU § 336 because, at the time they occurred, Schultz was addressing matters "potentially material" to the fair presentation of the financial statements in conformity with GAAP. AU § 336.02.
Holder also opined that the large difference between the net present value calculations and the contract value of the preferred stock should have caused Scutillo to reconsider the scope of the audit and to design and apply additional procedures (DX 128 at 6). Sky was essentially representing that it had purchased or leased its mining properties at bargain prices. The magnitude of the alleged bargain called for Scutillo's professional skepticism. At some point during the audit, Scutillo determined that the values presented in the financial statements for the mineral properties had been stated at the lower of cost or market value and were reasonable. He was wrong about the applicable accounting principles and he was wrong about "cost." However, even significant changes in the assumptions for the net present value calculations, such as a higher discount rate or lower reserves, would have still resulted in net present values that would have been higher than the "cost" of the mines, as carried on the financial statements. No GAAP violation can be attributed to the net present value calculations and forward-looking pro forma income statements appearing in the text of Sky's Form 10-K.
The Division has not argued that there was a material inconsistency between the mine "cost" figures in the audited financial statements and the hypothetical net present value calculations in the text of Sky's Form 10-K that required revision of the financial statements or the audit opinion. Nor has it alleged that Respondents were required to approach Sky management to request revision of the Form 10-K, to consider adding an explanatory paragraph to the audit report, to withhold the use of the audit report in the Form 10-K, or to withdraw from the engagement under AU § 550.04. The OIP does not allege that Respondents violated GAAS because the pro forma results were not reconciled to the GAAP results. The Division has demonstrated that Scutillo never questioned management's assertion that mining at Evergreen would commence in the near future. Despite an inconsistency between the text of Sky's Form 10-K, on the one hand, and footnote 3 to the financial statements, on the other hand, Scutillo did not determine whether the financial statements or his report required revision. While this conduct arguably violated AU § 550.04, the fourth standard of reporting was not identified in the OIP, and no adverse findings or conclusions will be made as a result. See supra note 33.
Scutillo turned to attorney Greene to advise him about Sky's right to commence mining operations on its properties. In response, he received DX 96. In its posthearing pleadings, the Division argues that Scutillo violated AU § 336, which recognizes that an attorney is one type of specialist upon whom an auditor may rely. Scutillo knew that Greene's practice was limited to securities matters (Tr. 671), yet he relied upon Greene as a specialist in land use, water rights, and environmental law without purportedly obtaining Greene's agreement to function in those roles. However, AU § 336 must be harmonized with AU § 110.03, which permits an auditor to rely on the advice of attorneys in all matters of law. Greene did not balk when Scutillo requested an opinion on topics arguably beyond his areas of specialization. Because Greene's letter was not implausible on its face, and because neither of the Division's experts opined that Scutillo's use of Greene's letter violated AU § 336, I conclude that Scutillo was justified in relying on the letter. See supra note 19.
Finally, Scutillo failed to follow his own audit program in evaluating Sky's issuance of stock for services. In doing so, he violated his duty to exercise due care. He also failed to identify an audit area that required special attention, thereby demonstrating a lack of knowledge of the client's business. AU § 311.06(a).
5. Scutillo did not comply with one of the professional standards applicable to concurring reviews, but these standards were not identified in the OIP.
Neither GAAP nor GAAS require a concurring review. See Potts, 151 F.3d at 813. However, firms like Scutillo & Blake that are members of the AICPA's SEC Practice Section (SECPS) are required as a condition of membership to use concurring reviewers on SEC engagements, which includes audits of companies like Sky that file specified reports with the Commission.
There is no reason why a second reviewer must be a member of the same firm as the auditor who undertakes the engagement. See Robert K. Mautz & Louis W. Matusiak, Concurring Partner Review Revisited, J. Acct., March 1988, at 56, 63.
The Applicable Professional Standards
The SECPS directs member firms to establish policies covering the qualifications of concurring reviewers; the nature, extent, and timing of the concurring review; and the documentation required to evidence compliance with the firm's policies. See SECPS Reference Manual § 1000.39, Appendix E-Scope of the Concurring Review Requirement (1994). The purpose of the concurring review requirement is to provide additional assurance that the financial statements of SEC engagements are in conformity with GAAP and that a member firm's report on such statements is in accordance with GAAS. Performance of a concurring review serves as an objective review of material accounting, auditing, or reporting issues. It does not relieve the partner in charge of the engagement from final responsibility for the firm's audit report. Id. § 1000.39(1).
As to qualifications, the SECPS Reference Manual states that the concurring reviewer should have sufficient technical expertise and experience to achieve the purposes described above. An effective concurring review contemplates a familiarity with the relevant specialized industry practices. The SECPS Reference Manual recognizes that there are various ways to obtain such familiarity, in addition to personal audit experience in the client's industry. Id. § 1000.39(1)(a).
For the concurring review to be an objective review of material accounting, auditing, or reporting issues, the concurring reviewer ordinarily should not assume any of the responsibilities of the partner in charge of the engagement. Similarly, the concurring reviewer should not have responsibility for any segment of the engagement. When consultation occurs with the concurring reviewer during the engagement, the engagement partner should ordinarily develop an initial resolution to the issue before consulting the concurring reviewer. Id.
The concurring reviewer's responsibilities should include reading the financial statements and the member firm's report thereon and making an objective review of significant accounting, auditing, or reporting considerations. Such review should be performed prior to the release of the report. It should include discussions with the partner in charge of the engagement and review of selected work papers. The extent of work paper review is a professional judgment which has to be made by the reviewer and will vary with the particular circumstances of each engagement. Id. § 1000.39(1)(b).
As to documentation, the engagement files should contain evidence that the member firm's policies and procedures with respect to the concurring review requirement were complied with prior to the issuance of the firm's report. Id. § 1000.39(1)(c).
A concurring reviewer is not expected to do the audit all over again. See Potts, 151 F.3d at 813. The Division has cited no accounting literature to suggest that either: (1) a concurring reviewer's responsibility is the equivalent of the audit engagement partner's responsibility, or (2) a concurring reviewer is responsible for searching out additional matters to be considered by the engagement team. In most cases, the concurring reviewer lacks an opportunity to review all of the client's records, engage in discussions with the client's management, or observe the client's actions and attitudes.
Discussion
Scutillo did not violate the applicable professional standards when he asked Jensen to serve as concurring reviewer on the Sky audit. Although Scutillo did not ask Jensen specific questions about Jensen's personal experience auditing mining companies, Jensen had prior audit experience with audits of Commission registrants and basic familiarity with the client's industry. Jensen lacked extensive personal audit experience with mining companies, but he was able to seek assistance on mining-related audit issues from his partner, Jones. No more was required. The Division has presented no evidence that the professional relationship between Scutillo and Jensen was corrupt, that Sky management influenced Scutillo's selection of Jensen as concurring reviewer, or that Scutillo had any forewarning of the allegations that the Commission would later raise against Jensen and Jones.
Here, of course, Jensen did more than the typical concurring reviewer. He visited Sky's mining properties and he spoke with Dorow about the Russian bank transaction. The Division has not argued that in doing so Jensen impermissibly assumed any of the responsibilities of Scutillo.
Jensen had a duty to understand GAAP and GAAS and to recognize when significant departures were made from them. Also, as a member of the AICPA and a partner in a firm that was a member of the SECPS, Jensen was expected to comply with AICPA's auditing standards and to meet the requirements of the SECPS, including the policies and procedures for concurring partner reviews. His role was to determine, based on his own professional judgment, whether the audit evidence, standing alone and viewed objectively with the appropriate level of professional skepticism, supported the significant accounting, auditing, and reporting decisions that Scutillo made. Jensen had an independent duty not to concur in the audit report unless he, in the reasonable exercise of his own professional judgment, was satisfied with the audit. In view of Jensen's pending settlement offer, I will make no findings as to whether he complied with his obligations as a concurring reviewer.
Beyond a single check mark (RX 1A at 437, item 706), there is no documentary evidence in Scutillo's work papers to show that Jensen completed his concurring review function before Scutillo released the audit report on June 14, 1994. It was Scutillo's obligation to obtain such documentation. It would not have imposed a significant burden for Scutillo to ask Jensen to send a letter by facsimile, assenting to the release of the audit report. Even a telephone call would have sufficed, provided that Scutillo then memorialized it in the work papers. In the absence of such documentation, I cannot credit Respondents' testimony that Jensen's initialing the original work papers in August 1994 was a mere formality. However, because the OIP did not reference the concurring review standards, no violation will be found as to Scutillo.
6. Scutillo was reckless in auditing the Russian bank transaction and Sky's issuance of stock for services.
Setting aside the evidence that is inadmissible, that involves the impermissible use of hindsight, and that establishes no more than auditing negligence, the weight of the evidence demonstrates that two of the three audit failures involved reckless behavior by Scutillo.
Recklessness
Scutillo had ample warning that this would be a high-risk audit. Scutillo knew that Sky had hired three internal controllers and three outside auditors in the past year alone. He knew that Winner's Circle and Sky had going concern qualifications on their amended financial statements for two straight years. He knew that Sky had no cash, no sales revenue, and was delinquent in paying its debts. He knew that he had only a month to complete the audit. In these circumstances, more persuasive evidence was required. Scutillo should have expanded the audit procedures he applied to significant transactions or modified those procedures to obtain it.
Scutillo attempted to minimize the audit risk Sky presented when he expressed the view that all audits of public companies are high risk, just because they involve public companies (Tr. 63). The implication of this testimony-that there is no difference between an auditor's approach to risk assessment when auditing sound public companies and shaky public companies-cannot withstand scrutiny. It is the equivalent of Burgher's testimony that once an auditor had added a going concern qualification to an audit report, nothing else really matters. Scutillo's explanation was just as unconvincing as Burgher's.
The audit of the Russian bank transaction offers the clearest evidence of recklessness to emerge from the record. Scutillo was faced with the need to examine an extremely significant transaction that took place on the last day of Sky's fiscal year. The transaction itself was economically irrational: a mining company with no cash, no revenues, and substantial doubt about its ability to operate for the next year purportedly obtained a $40 million asset, but could not use that asset to commence mining operations, because the asset (and the interest it generated) would be tied up for the next four years.36 Scutillo ignored or missed discrepancies appearing on the face of the documents he purportedly inspected. Scutillo did not heed an early warning from Jensen that the transaction did not "pass the smell test." There was intense time pressure. There was additional pressure from Dorow to approve the transaction for the entire $40 million. Scutillo never sent out a confirmation request of any sort, much less a request tailored to the need for competent evidential matter on the $40 million transaction in question. Scutillo relied on an unaudited financial statement to determine that the Russian bank was solvent. He failed to document contacts with Sher and an international banking consultant in his work papers. Although Sher promised to provide an original confirmation from the bank's home office in Moscow, it never appeared. Sher himself became unavailable to Scutillo by telephone.
Scutillo's failure to keep thorough work papers during the Sky audit repeated the very errors that had been brought to his attention during Scutillo & Blake's 1993 peer review. In a December 23, 1993, letter, the peer reviewer had cited an instance where Scutillo & Blake had opted out of the confirmation process, but had not adequately documented its decision not to confirm in accordance with professional standards (DX 132). The peer reviewer also noted that Scutillo & Blake had not adequately documented the overall results of the procedures it employed as an alternative to confirmation. Scutillo & Blake's reply letter of February 1, 1994, gave assurances that it had modified its policies and procedures to require documentation of decisions not to utilize confirmations as an audit test and to summarize the results when it employed alternative procedures. That assurance meant little.37 During the Sky audit, Scutillo failed to send out a confirmation request to Bank Sinektika, failed to document the inspection procedures he took as an alternative to confirmation, failed to document in the work papers his telephone contact with Sher and an international banking consultant, and failed to follow up with a direct inquiry to Moscow when the promised original confirmation did not materialize.
I do not believe that Scutillo was testifying fully and accurately about the audit of the Russian bank transaction. I do not credit his testimony that he knew nothing about the origin of the confirmation form that Sher sent him by facsimile. Nor do I believe his testimony that he would never compromise important auditing procedures, even if it meant that an audit client missed a deadline (Tr. 592). When the June 15 filing deadline approached, Scutillo surrendered his professional judgment to the demands of his client. He held his nose, closed his eyes, and signed off on the audit report, even though the circumstances surrounding the Russian bank transaction plainly required a qualified opinion or a disclaimer of opinion. This was "an egregious refusal to see the obvious, or investigate the doubtful," by any measure. Price Waterhouse, 797 F. Supp. at 1240.
The weight of the evidence also demonstrates recklessness in Scutillo's failure to audit Sky's unrecorded expenses. Scutillo knew that Sky had been issuing enormous quantities of common stock (over 14.7 million shares) to employees and consultants for substantially less than the market price. The audit checklist forms alerted him to test for expenses involved with such stock issuances. He had done so in prior audits. Scutillo's failure to perform the necessary audit procedures here puts to rest his claim that he did not compromise his audit judgments because of the time pressure associated with the June 15, 1994, filing deadline.
I do not accept Scutillo's defense, which consists of little more than saying "oops!" or "anyone can make a mistake!" The audit failure in question did not represent a momentary lapse or an insignificant error.
As to the unrecorded expenses, I conclude that Scutillo was reckless based on the size of the reporting error and the fact that he had placed himself into a predicament whereby time pressure virtually guaranteed a lack of due professional care. On the unrecorded expense issue, the Division has proven that Scutillo's accounting practices were so deficient that the audit amounted to "no audit at all." Price Waterhouse, 797 F. Supp. at 1240.
Negligence, Or Less Than Negligence
I reject the Division's argument that an inference of recklessness may be gleaned from Scutillo's knowledge that Sky's financial records were a "chaotic mess" (Div. Br. at 3; Posthearing Conference of Jan. 9, 2001, at Tr. 18). The Division has established that there were significant deficiencies in Sky's financial records, and that Scutillo knew of them before he accepted the engagement. However, in letters to Sky dated June 24, 1994, and September 1, 1994, Scutillo analyzed the problem, reported his findings to Sky's management, and made recommendations for improvement (RX 1A at 111-13, 121-25, 460-62). No more was required by the applicable professional standards. Cf. In re Ikon Office Solutions, Inc., Sec. Litig., 131 F. Supp. 2d. 680, 697-98 (E.D. Pa. 2001).
AU § 315 required Scutillo to attempt to communicate with Baum and Cutler before accepting the Sky engagement. I conclude that his failure to do so was negligent, but not reckless.
While the issue is a close one, I conclude that Scutillo's audit of Sky's mining properties was not shown to be reckless. I agree with Scutillo that he could justifiably rely on the milling operations he observed at Tallulah and at Springer. It was negligent, but not reckless, to conclude that the Springer transaction was likely to be consummated in the near future and that Sky's capacity to operate would be enhanced as a result. It was negligent, but not reckless, to rely on the prior valuation of Berry by BDO Seidman and Weinberg without looking at the underlying audit records. It was negligent, but not reckless, to value the three mining properties without appreciating Sky's pattern of entering into and backing out of mining leases. See supra note 16. Scutillo was negligent, but not reckless, in his use of Schultz as a specialist. Despite its flaws, Greene's letter to Scutillo, affirming Sky's apparent right to mine its properties, is also a barrier to a determination of auditing recklessness (DX 96). See AU § 110.03. Finally, I conclude that Scutillo is entitled to credit for removing the $16 million Bowerman Mine transaction from Sky's audited financial statements.
SANCTIONS
Under Rule 102(e)(1)(ii), the Commission may censure a person or deny, temporarily or permanently, the privilege of appearing or practicing before it to any person who is found to have engaged in improper professional conduct. The Division argues that Scutillo should be denied permanently the privilege of appearing or practicing before the Commission as an accountant. It also contends that Jensen should be denied temporarily the privilege of appearing or practicing before the Commission as an accountant for two years. The Division initially proposed that Jensen should be required to go through the reapplication and reinstatement process of Rule 102(e)(5) after serving a temporary suspension. It subsequently abandoned that position and now seeks only the temporary suspension (Div. Prop. Find. at Conclusion # 21; Div. Br. at 52; Posthearing Conference of January 9, 2001, at Tr. 8-9). See Carroll A. Wallace, CPA, Initial Decision, 73 SEC Docket 3969, 4034 (Dec. 18, 2000), petition for review granted. Respondents argue that no more than a censure is warranted (Resp. Prop. Find. at 22).
When imposing sanctions in an administrative enforcement proceeding, the Commission applies the public interest analysis in Steadman v. SEC, 603 F.2d 1126, 1140 (5th Cir. 1979), aff'd on other grounds, 450 U.S. 91 (1981). Neither side addresses the need to consider that test when imposing professional discipline against accountants. The Commission has not specifically invoked the Steadman factors in its prior decisions under Rule 102(e) or its predecessor. However, one other Administrative Law Judge has done so. See Combellick, Reynolds & Russell, Inc., Initial Decision, 49 SEC Docket 244, 260 (June 19, 1991), final, 49 SEC Docket 1682 (Oct. 2, 1991); Ernst & Whinney, Admin. Proc 3-6579, Initial Decision at 101-07 (June 28, 1990), final, 46 SEC Docket 1507 (July 27, 1990).
Steadman requires that several issues be considered, including: (1) the egregiousness of the respondent's actions; (2) the isolated or recurrent nature of the infraction; (3) the degree of scienter involved; (4) the sincerity of the respondent's assurances against future violations; (5) the respondent's recognition of the wrongful nature of his conduct; and (6) the likelihood that his occupation will present opportunities for future violations. No one factor is controlling.
In determining the public interest, the Commission has traditionally balanced the mitigating and aggravating circumstances presented by the record. KPMG Peat Marwick LLP, 74 SEC Docket 384, 429 (Jan. 19, 2001), appeal filed, D.C. Cir., No. 01-1131. It has also considered any evidence relating to a respondent's claim of rehabilitation. See Blinder, Robinson & Co., Inc., 48 S.E.C. 624, 632-35 (1986). Mitigation focuses on the facts and circumstances surrounding the underlying misconduct, and the evidence should show that the wrongdoing at issue arose from some type of exigent circumstances that are unlikely to be repeated in the future. Rehabilitation focuses on a respondent's changed direction in his activities since the time of the underlying misconduct.
In auditing the Russian bank transaction and the stock-for-services transactions, Scutillo's deviations from the applicable professional standards were egregious. His breaches of his professional obligations as to the audit of the Russian bank transaction involved a high degree of scienter, while his breaches of his professional obligations as to the audit of the stock-for-services issue involved a moderate degree of scienter. He offered no assurances against future breaches of the applicable professional standards. He insisted the audit of the Russian bank transaction did not deviate from the applicable professional standards. He acknowledged an omission with respect to the audit of the stock-for-services issue, but he was quick to minimize the omission. He made no credible promises of altering his professional behavior in the future.
Scutillo stated that Greene, Jacobs, and Weinberg did not convey to him any concerns about the integrity of Sky management. I find that unrebutted testimony to be a mitigating factor.
Scutillo has no prior or subsequent disciplinary history. According to Greene, Scutillo's professional reputation in his community is "very positive" (Tr. 993). While I have expressed doubts about Greene's credibility on other matters, the Division has not challenged this particular testimony. Scutillo has not audited any public companies since completing the Sky audit.
The Division argues that Scutillo's breaches of the applicable professional standards were aggravated by his "mendacity" at the hearing and his unwillingness to admit any error or misjudgment during the Sky audit (Div. Br. at 52). Scutillo's testimony about the Russian bank transaction lacked credibility, and I have given it reduced weight for that reason. However, the record does not permit me to find that his testimony was perjurious.38 The Division has also raised non-frivolous concerns about the legitimacy of work papers documenting Scutillo's conversations with Jensen and Greene (DX 90, DX 121). The weight of the evidence does not warrant a finding that Scutillo manufactured these documents after the audit to minimize his culpability in this proceeding.
Scutillo complains about the length of time it took the Commission to bring this case (four years and ten months from the audit report in June 1994 to the OIP in April 1999). He maintains that the delay seriously undermines any argument that he represents a future threat to the integrity of the Commission's processes (Resp. Prop. Find. at 21-22; Resp. Br. at 1).39 Cf. Johnson v. SEC, 87 F.3d 484, 490 n.9 (D.C. Cir. 1996); George Craig Stayner, CPA, 67 SEC Docket 425 (May 14, 1998) (dismissing an administrative disciplinary proceeding that had not been instituted until eight years after the alleged misconduct occurred, without determining whether the rationale of Johnson applied).
Some of the delay in initiating the proceeding can be attributed to the Commission's decision to prosecute the respondents in Sky Scientific first and the outside auditors second. Scutillo does not argue that the Commission lacks the discretion to make such a policy choice, but he does suggest that the choice has collateral consequences.
Scutillo presents neither a statute of limitations defense nor a laches defense. The time lag is relevant only insofar as it afforded Scutillo an extended opportunity to demonstrate his rehabilitation. Scutillo has made good use of the opportunity. First, he cooperated in the Division's investigation of Sky's principals, testifying three times and willingly providing documents (Tr. 540-41). Second, Scutillo resigned from the Sky engagement and refused to consent to the continued use of his 1994 audit report (DX 5, RX 13, RX 14). While the Commission has not always given much weight to actions taken after the start of an investigation, see Gary L. Jackson, 48 S.E.C. 435, 444 (1986), the Commission's settlement order in the disciplinary proceeding against the successor auditor puts Scutillo's actions on a stronger footing. See Frederick R. Grant, 69 SEC Docket at 1505-06 nn.7 & 9. Third, Scutillo & Blake received fully favorable peer review reports in 1996 and 1999 (RX 2-RX 4).
While both the engagement partner and the concurring reviewer have the obligation to comply with GAAS and to determine that the client's financial statements comply with GAAP, the nature and extent of their respective obligations are not the same, and sanctions should only be imposed when an accountant fails to meet the professional standards applicable to his role. I have considered that distinction in assessing Scutillo's sanction here.
In my judgment, professional discipline of perpetual duration is not required against Scutillo. The Division has not proven all of its allegations of recklessness. Scutillo has enjoyed a successful accounting career, otherwise free from professional discipline. He has demonstrated partial rehabilitation since June 1994. After considering all the facts and circumstances in the light of Steadman, I conclude that Scutillo should be denied temporarily the privilege of appearing and practicing before the Commission as an accountant for three years. Since this is not a permanent denial, the reinstatement application provisions of Rule 102(e)(5) are inapplicable.
RECORD CERTIFICATION
Pursuant to Rule 351(b) of the Commission's Rules of Practice, 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 January 23, 2001, as amended on April 30, 2001.
ORDER
Based on the findings and conclusions set forth above, and pursuant to Rule 102(e)(1) of the Commission's Rules of Practice, Barry C. Scutillo is denied temporarily the privilege of appearing and practicing before the Commission as an accountant for three years.
The case against Jensen is before the Commission. It shall be statistically deactivated for purposes of periodic status reports to the Commission under 17 C.F.R. § 201.900(b). The pendency of Jensen's settlement offer also constitutes good cause for enlarging the time within which the parties may petition the Commission for review of this initial decision.
This order 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 initial decision may be filed within twenty-one days after service of the initial decision, or within twenty-one days after the Commission accepts Jensen's settlement offer, whichever is later. It shall become the final decision of the Commission as to each party who has not filed a petition for review pursuant to Rule 360(d)(1) within twenty-one days after service of the initial decision on that party, or within twenty-one days after the Commission accepts Jensen's settlement offer, whichever is later, unless the Commission, pursuant to Rule 360(b)(1), determines on its own initiative to review this initial decision as to that party. If a party timely files a petition for review, or the Commission acts to review on its own motion, the initial decision shall not become final as to that party.
______________________________
James T. Kelly
Administrative Law Judge
| 1 | "Generally accepted accounting principles" are the basic postulates and broad principles of accounting pertaining to business enterprises. These principles establish guidelines for measuring, recording, and classifying the transactions of a business entity. "Generally accepted auditing standards" are the standards prescribed for the conduct of auditors in the performance of an examination of management's financial statements. See SEC v. Arthur Young & Co., 590 F.2d 785, 788 nn. 2 & 4 (9th Cir. 1979). |
| 2 | The exhibits offered by the Division and by Respondents will be cited as "DX ___" and "RX ___," respectively. The hearing transcript, as amended by my Order of August 16, 2000, will be cited as "Tr. ___." Citations to the posthearing pleadings will be noted as follows: Division's Proposed Findings of Fact and Conclusions of Law and Division's Brief, both dated September 21, 2000, will be cited as "Div. Prop. Find. ___" and "Div. Br. ___," respectively. Respondents' Proposed Findings of Fact and Conclusions of Law and Respondents' Brief, both dated December 1, 2000, will be cited as "Resp. Prop. Find. ___" and "Resp. Br. ___," respectively. The Division's Reply Brief, dated December 6, 2000, will be cited as "Div. Reply Br. ___." |
| 3 | A concurring reviewer provides a second-level review and thus affords further assurance that the audited company's financial statements conform to GAAP and that the audit measures up to GAAS. See Potts v. SEC, 151 F.3d 810, 811 (8th Cir. 1998), cert. denied, 526 U.S. 1097 (1999). |
| 4 | On December 16, 1996, the Commission instituted an administrative enforcement proceeding against Sky and seventeen other firms and individuals. That OIP alleged that between April 1993 and June 1995, various respondents violated the registration provisions of the Securities Act of 1933 (Securities Act) by participating in the offer and sale of common stock in regard to which Sky had filed Forms S-8. It also contended that certain respondents violated the antifraud provisions of the securities laws by making materially false and misleading statements and omitting to state material facts to prospective investors. Additional antifraud and antitouting violations, excessive undisclosed markups, and the creation of false accounting records were also charged.
Three respondents defaulted and one settled prior to hearing. On March 5, 1999, Administrative Law Judge Robert G. Mahony issued an initial decision sustaining the charges and imposing sanctions against the fourteen remaining respondents. Sky Scientific, Inc., Initial Decision, 69 SEC Docket 945. Familiarity with that decision is assumed. Six respondents have perfected appeals to the Commission. Four more respondents settled after the hearing. The Commission summarily affirmed the initial decision as to one respondent and it declared the initial decision final as to three others. |
| 5 | Continuation of an entity as a going concern is assumed in financial reporting in the absence of significant information to the contrary. Information that significantly contradicts the going concern assumption relates to the entity's inability to continue to meet its obligations as they become due without substantial disposition of assets outside the ordinary course of business, restructuring of debt, externally forced revisions of its operations, or similar actions. See Codification of Statements on Auditing Standards § 341.01 (1994) (hereafter cited as "AU § ___"). |
| 6 | The 1994 Form 10-K reported that Sky would pay dividends on this preferred stock at the rate of 4.25% (DX 1 at 43, note 10). The purchase agreement stated that the dividend rate would be 2.5% (DX 127 at ¶ 5). The preferred stock certificate in the record shows only a front page (DX 115). That exhibit is silent about the rate that Sky would pay (Tr. 150). |
| 7 | Scutillo disavowed his audit work papers, insofar as they stated that Sky had no unusual or major year-end transactions (Tr. 79-80; DX 54). |
| 8 | Scutillo's work papers stated that Baum had caused Sky to send out confirmation requests only for notes payable balances (RX 1A at 633). Scutillo testified that he did not rely on any work done by Baum (Tr. 32). As a result, Scutillo requested Sky to send out confirmation requests to several domestic banks on and after May 16, 1994 (RX 1B at 639, 647, 653, 660, 662-64). Each such confirmation request advised the recipient to return the completed form to Scutillo & Blake, whose address was provided in the lower right-hand corner of the document.
As to Sky's single most significant banking transaction, however, Scutillo elected not to send out a confirmation request. The facsimile confirmation Scutillo received from Sher had been signed by Henry Corona, an official of the Sky subsidiary involved in the transaction, and was dated May 1, 1994 (Tr. 163; DX 125). The lower right-hand corner of that confirmation form was blank in the space where the auditors' return address was supposed to be provided (DX 125). Baum's notes payable confirmation forms (RX 1C at 1041, 1043, 1046) looked nothing like the bank confirmation form that Sher faxed to Scutillo (DX 125). I find it highly unlikely that Baum caused Sky to send out DX 125. |
| 9 | One footnote to the financial statements claimed that Bank Sinektika had substantial off-the-book assets (Tr. 170; DX 122). Another footnote explained that the bank had entered a long-term financial arrangement with Atlantic Bancorp, Inc., which would enable it always to meet its obligations (DX 122). Sher was the president, chief executive officer, and a director of Atlantic Bancorp (DX 130). |
| 10 | Greene was very quick to minimize his involvement with his former client. For example, Greene could not recall if he ever saw Sky's 1994 Form 10-K before it was filed, and he stressed that he had no role in negotiating the Russian bank transaction or preparing the purchase agreement (Tr. 1014, 1020-21). He explained that Sky had in-house counsel and did a lot of things internally (Tr. 1015, 1021-22).
Greene's testimony is difficult to square with his admission that Sher signed the purchase agreement in Greene's office (Tr. 1011). Moreover, if Greene's testimony minimizing his involvement with Sky were true, one must wonder why Sky issued him 105,000 shares of stock during fiscal year 1994 (DX 81). Either Greene earned those shares by performing services for Sky or he was one of the "purported" consultants who obtained Sky stock without performing services. Neither alternative enhances his credibility. |
| 11 | The Division does not allege that the treatment of the Tallulah Mine on Sky's 1994 balance sheet was improper (Div. Br. at 18 n.68). Nor is the Bowerman Mine a part of the Division's case. Sky had valued the Bowerman Mine at $16 million in its most recent unaudited quarterly report (DX 27 at 12, note 8). Scutillo asked Sky to take the Bowerman Mine off its 1994 balance sheet because of uncertainties about Sky's right to mine that property (Tr. 80-81, 387, 620, 693-94, 747-48; DX 1 at 22, 46, RX 1A at 235, item 38). |
| 12 | Both BDO Seidman's 1992 audit report and Weinberg's restatement of that report identified sixteen claims of ore reserves in Pershing County, Nevada, acquired by Sky for convertible preferred stock, and valued at $8 million (RX 6 at 4, 7, 10, note 1, RX 18 at 2, 4, 6, note 2). I find as a fact that the property so described is the Berry Mine, and I reject the Division's claim that there is ambiguity on that point (Div. Prop. Find. ## 316-17). I agree with the Division that Scutillo had no evidence as to what audit procedures BDO Seidman and Weinberg may have used in reviewing management's claim of an $8 million valuation.
Scutillo testified that he obtained BDO Seidman's 1992 audit report during the 1994 audit (Tr. 599-607; RX 6). However, BDO Seidman's report was not part of Scutillo's work papers and Scutillo never communicated with BDO Seidman (Tr. 209-11). By the time of the hearing, BDO Seidman had destroyed its underlying audit records pursuant to a six-year document retention policy (Tr. 754-58; RX 16). Weinberg's restatement of Sky's 1992 financials, dated April 26, 1993, is to the same effect as BDO Seidman's report (RX 18 at 6, note 2). After reviewing Weinberg's files, Scutillo's associate wrote: "Ore reserves recorded at face value of preferred stock issued to acquire properties" (RX 1A at 336). However, the $8 million valuation did not appear in Winner's Circle's 1993 financial statements, audited by Weinberg and reproduced in Sky's 1994 Form 10-K (Tr. 897, 961-63; DX 1 at 31). |
| 13 | Net present value is the difference between the present value of the future net cash receipts of an investment project when discounted at the firm's cost of capital and the initial cash investment in the project. See Kohler's Dictionary for Accountants 343 (W.W. Cooper & Yuji Ijiri eds., 6th ed. 1983). |
| 14 | Sky's 1994 Form 10-K stated that the three employees had extensive backgrounds in mining and geology (DX 1 at 53; see also RX 12). Bowkus's experience was in mining coal, not precious metals (Tr. 257). Moreover, Greene's law partner depicted Sky as a novice in the mining business in pleadings drafted for separate litigation regarding the Bowerman Mine (DX 104 at ¶ 22). Those pleadings were part of Scutillo's work papers. |
| 15 | The initial decision in the companion administrative enforcement proceeding found that the processing activities at Tallulah were a sham, designed by Sky "to dupe [its] independent auditors" and "to trick Scutillo into believing the mill was operating." Sky Scientific, 69 SEC Docket at 953, 957. The present record lacks evidence about a sham demonstration. Scutillo believed he was observing legitimate processing activities (Tr. 686-87, 690; RX 1B at 740-41).
The fact that management deliberately deceived the outside auditors may be viewed as a mitigating factor in some circumstances. See Ernst & Ernst, 46 S.E.C. 1234, 1272 (1978). However, fraud, like collateral estoppel and res judicata, is an affirmative defense. See Rule 220(c) of the Commission's Rules of Practice, 17 C.F.R. § 201.220(c); cf. Fed. R. Civ. Pro. 8(c). Affirmative defenses are waived if not pleaded in an answer to the OIP. See Russell Ponce, 73 SEC Docket 442, 466 n.54 (Aug. 31, 2000), appeal filed, 9th Cir., No. 00-71398. In this case, Respondents did not plead or prove that Sky management defrauded them. Nor did they claim in their answer that the findings in the Sky Scientific initial decision should be binding here. As a result, any such defenses have been waived. |
| 16 | In Sky Scientific, 69 SEC Docket at 950, the initial decision found that "[d]uring the relevant period, [Sky] repeatedly entered into and then backed out of agreements to acquire or lease mining properties." Sky's 1994 Form 10-K showed several such cancelled transactions predating the Springer transaction (DX 1 at 22, 25, 27). These included the Bowerman, Starr King, Andy, and McCann Canyon mines, and the acquisition of Financial Control Associates International, Inc. |
| 17 | Scutillo had already spoken with the Nevada attorney (RX 1A at 186). Scutillo has not explained how Greene's letter provided him with competent evidential matter on Sky's right to mine that was as reliable as the information he could have obtained directly from the Nevada attorney. |
| 18 | Berry and Danner were identified as mineral properties worth $8 million and $16 million, respectively. Capitalized expenses of $18,250 increased that figure to $24,018,250 on the balance sheet (Tr. 53-54, 321; DX 1 at 31). Evergreen was listed on the audited financial statements as an asset worth $5.5 million ($550,000 under current assets as a prepaid lease and $4,950,000 as the long term portion of a prepaid lease) (Tr. 51-52; DX 1 at 31, 38). |
| 19 | Achuff also contacted the Bureau of Land Management and the Forest Service. She learned that Sky lacked the necessary permits to engage in full-scale mining at the three relevant properties as of February 28, 1994 (Tr. 282-85). Her testimony on this subject conflicts with Greene's letter to Scutillo (DX 96). The issue for decision is not whether Achuff's hearsay is more credible than Greene's hearsay, but whether Scutillo was entitled to rely on Greene's letter as competent evidential matter under AU § 110.03 (an auditor may appropriately rely on the advice of an attorney in all matters of law). |
| 20 | Compare Division's Witness List, dated Dec. 29, 1999, item 7 (identifying Holder only as an expert on GAAS) with Div. Prop. Find. # 7 and Div. Br. at 43 (identifying Holder as an expert on both GAAP and GAAS). |
| 21 | Engineering geologists apply geological knowledge to engineering problems, such as reservoir design and location. They also evaluate the danger of earthquake or flood damage and assess slope stability for highway and tunnel construction purposes. Economic geologists study the distribution of mineral deposits and the economic considerations involved in their recovery. They also assess the reserves available, guide the exploration for mineral reserves, and help determine which deposits are economically available to mine. See 12 Encyclopedia Americana, International Edition 453 (1997). At the time of the audit, Scutillo did not know what an engineering geologist was (Tr. 346). |
| 22 | In a September 1988 article, Burgher wrote: "[C]ounsel should be careful to select an expert that is court-wise. . . . [T]he broad gauged and experienced expert needs to know when to trip up his cross-examining questioner and when to buy time to think over or delay answering" (Tr. 929; DX 133). I admitted DX 133 into evidence at the Posthearing Conference of Jan. 9, 2001, at Tr. 4-5. |
| 23 | Administrative disciplinary proceedings against accountants originate with a recommendation to the Commission by the Office of the Chief Accountant. See 17 C.F.R. § 200.22. Until December 1993, the Office of General Counsel handled the prosecution. The Commission then transferred prosecution responsibility to the Division. See SEC News Release No. 93-62 (Dec. 9, 1993). The rule was renumbered as Rule 102(e) in 1995 as part of a comprehensive revision of the Rules of Practice, but was not changed in substance. See Rules of Practice, 59 SEC Docket 1546, 1554-55 (June 9, 1995). |
| 24 | Little guidance comes from the OIPs in comparable cases, alleging pre-1998 reckless professional conduct by accountants, but issued after the 1998 rule amendment. The OIPs in Kevin E. Orton, CPA, Admin. Proc. 3-9872 (Apr. 14, 1999), and Carroll A. Wallace, CPA, Admin. Proc. 3-9862 (Apr. 1, 1999), did not invoke Rule 102(e)(1)(iv)(A). In contrast, the OIPs in Michael J. Marrie, CPA, and Brian L. Berry, CPA, Admin. Proc. 3-9966 (Aug. 10, 1999) at ¶ 48, and Scott E. Edwards, CPA, Admin. Proc. 3-10220 (June 8, 2000) at ¶ 28, did invoke Rule 102(e)(1)(iv)(A). |
| 25 | Private plaintiffs alleging securities fraud filed most of the cited cases. Many of the decisions involve rulings on motions to dismiss complaints under Federal Rule of Civil Procedure 9(b) (failure to plead fraud with particularity). Others involve rulings on motions to dismiss complaints under the heightened pleading requirements of the Private Securities Litigation Reform Act of 1995 (PSLRA). None involve adjudications under Rule 102(e).
While the PSLRA creates new pleading standards applicable to private plaintiffs distinct from the pleading standards governing the Division, there has been no change in the substantive law regarding what constitutes scienter under the federal securities laws. The Division might not be precluded from initiating or maintaining an antifraud case as easily as an ordinary civil plaintiff, but it is not sufficient for the Division to rest its case on evidence of scienter that would be inadequate to plead or prove a case in a civil Rule 10b-5 suit. A ruling to the contrary would render meaningless the Commission's representation, with regard to Rule 102(e)(1)(iv)(A), that "for purposes of consistency under the federal securities laws, `recklessness' in subparagraph (A) of the rule amendment should mean the same thing as courts have defined `recklessness' to mean under the antifraud provisions" of the federal securities laws. See Rule Amendment, 68 SEC Docket at 710. |
| 26 | See Rule Amendment, 68 SEC Docket at 721 (Johnson, Comm'r, dissenting) ("I support the intentional or reckless part of the amendment without reservation. As to that part addressing a pattern of negligence, I would generally reach the same result as the majority, but through a different analysis [i.e.,] . . . only if the pattern of negligence supports an inference that the accountant acted recklessly.") (footnote omitted); see also Answer at 2 (arguing that Respondents lacked scienter and that their conduct was, at worst, negligent). |
| 27 | Also at issue is an accompanying declaration by Robert Strahota (Strahota), Assistant Director of the Commission's Office of International Affairs (DX 113). Strahota stated that, in his capacity as an officer of the Commission, he met with Koslov at the Russian Embassy in Washington, D.C., placed Koslov under oath, and witnessed Koslov's signature on the English-language version of Koslov's statement. DX 113 duplicates the last page of DX 114, but there is no reason why it should not be admitted into evidence. It is relevant and it is accepted. As to DX 114, the Division invokes Federal Rule of Evidence 902(3) (self-authentication of foreign public documents). Authentication is not an issue (Resp. Br. at 43). I have no doubt that the Russian-language documents are what they are purported to be, that Koslov is who he is purported to be, that Koslov signed the English-language statement under oath on May 30, 1995, and that Strahota saw him sign it. |
| 28 | The Division did not provide a certificate from the translator identifying the translator's credentials or attesting to the accuracy of the translation. Koslov's ability to read and write English and Strahota's ability to read and write Russian are not established on the record. My reference to Pegasus Translations is based solely on the facsimile trailer appearing at the top of DX 114 at 500236. The Division has offered no explanation for the absence of a translator's certificate, or for the absence of verbatim translations of all the Russian-language documents within DX 114. If time constraints were initially a concern, the five-year interval between the date of the statement and the hearing afforded ample opportunity to complete the task. |
| 29 | Scutillo offered testimony that an international banking consultant "made some calls and was advised" in May or June 1994 that Russian bank financial statements were not audited. The Division offered a Russian-language document (without a corresponding English translation) that purportedly constituted Bank Sinektika's auditing record as of December 26, 1994, some six months after Respondents' audit of Sky. One is left to speculate whether Scutillo received erroneous information from the international banking consultant, whether Scutillo lied at the hearing, whether the Russian bank underwent an audit that was not required by Russian law, or whether Russian law regarding bank audits changed between May 1994 and December 26, 1994. |
| 30 | A deposition taken in a foreign country in response to a letter of request or letter rogatory need not be excluded from evidence merely because the deposition does not contain a verbatim transcript. Cf. Fed. R. Civ. Pro. 28(b). The Division has not suggested that such a provision should be applied here by analogy. |
| 31 | The Commission's Chief Accountant recently requested the American Institute of Certified Public Accountants (AICPA) to provide guidance on valuation models and methodologies used in measuring fair value and in auditing those measurements. See Letter from Lynn Turner, Chief Accountant, to Arlene Thomas, Vice President of Professional Standards and Service, AICPA (Nov. 17, 2000), available at http://www.sec.gov/info/accountants/staffletters/valuguid.htm. The letter stated:
|
| 32 | The initial decision in the companion administrative enforcement case found that Sky included a $40 million reserve for doubtful liquidity against the CDs in its 1995 financial statements, "as it should have done in the first instance." Sky Scientific, 69 SEC Docket at 956 n.23. |
| 33 | The ten auditing standards are to a great extent interrelated and interdependent. AU § 150.03. However, only three alleged GAAS violations were identified in the OIP and they are the only ones that will be considered here. It is inappropriate for the Division to allege in its posthearing pleadings that Scutillo lacked adequate technical training and proficiency as an auditor because Sky was his first audit of a mining company (Div. Br. at 40). That charge belatedly invokes the first general standard, which was not identified in the OIP. It is likewise inappropriate for Scutillo to defend on the ground that he maintained an independent mental attitude toward his client (RX 11 at 12). The OIP raised no allegations under the second general standard. |
| 34 | While Audit Risk Alerts are prepared by the AICPA staff and not acted upon by a senior technical committee of the AICPA, they are intended to help auditors plan their audits, and auditors should carefully review and consider the issues discussed in the Audit Risk Alerts throughout the audit process. See MicroStrategy, 115 F. Supp. 2d at 654 (finding that failure to heed an Audit Risk Alert contributed to a strong inference of scienter). Scutillo recognized Audit Risk Alerts as authoritative (Tr. 735). |
| 35 | The case law provides that uninsured foreign CDs ought to be treated as securities, at least in the absence of a comprehensive regulatory scheme that virtually guarantees repayment. See SEC v. Randy, 38 F. Supp. 2d 657, 665-67 (N.D. Ill. 1999) and cases cited therein. The parties have not litigated the dispute on this basis, however, and there is no record as to whether or how securities confirmation procedures might have differed from the confirmation procedures Scutillo actually used. |
| 36 | There is a split of authority as to whether the economic irrationality of transactions constitutes evidence of scienter, or only of negligence. Compare Graham v. SEC, 222 F.3d 994, 1005 (D.C. Cir. 2000) (holding that an economically irrational trading pattern was a large red flag supporting an inference of recklessness and citing Edward J. Mawod & Co. v. SEC, 591 F.2d 588, 595 (10th Cir. 1979)) with In re Livent, 78 F. Supp. 2d at 218 (holding that the purported economic irrationality of transactions was, at worst, an allegation of the auditor's negligence, not recklessness). I have followed the appellate decisions here. |
| 37 | Scutillo's reaction to the 1993 peer review documents was probative on the issue of his credibility. He initially offered into evidence only the AICPA's acceptance of the 1993 peer review report (Tr. 554-55; RX 5). He testified that he could not recall the contents of the underlying documents (the peer reviewer's comment letter and Scutillo & Blake's response thereto), but he was sure that there was nothing of significance in those documents (Tr. 555).
I requested that the missing documents be supplied for the record (Tr. 557). When the Division later provided them (Tr. 739-40; DX 132), Scutillo became very anxious to elaborate on the peer reviewer's comment letter, adding that an explanation was "critical" (Tr. 742). Scutillo's explanation was plausible enough (Tr. 742-46). Moreover, the omissions identified in the peer reviewer's letter did not result in the misstatement of the financial statements in question and did not preclude a favorable 1993 peer review for Scutillo & Blake. However, Scutillo never came to grips with the more troublesome issues: (1) why the same failure to document audit steps in the work papers occurred again, only a few months later; and (2) why it suddenly became "critical" to provide an explanation for a document that supposedly contained nothing of significance. |
| 38 | See Charles F. Kirby, Initial Decision, 73 SEC Docket 3550, 3583-84 (Dec. 7, 2000), petition for review granted (enhancing registration and civil penalty sanctions for lack of candor under oath); see also U.S. Sentencing Guidelines Manual § 3C1.1 (2001). While the federal sentencing guidelines do not control the imposition of sanctions in administrative disciplinary proceedings, they are instructive as to the type of conduct that might warrant stiffer administrative sanctions.
The federal sentencing guidelines in criminal cases call for a two-level enhancement if the defendant obstructed or impeded the administration of justice. See id. Perjury is the type of conduct that warrants an enhancement, as is producing a false, altered, or counterfeit document during an official investigation or a judicial proceeding. See id. at Application Note 4(b) and (c). A defendant's denial of guilt (other than a denial of guilt under oath that constitutes perjury) is not a basis for enhancement. See id. at Application Note 2. |
| 39 | Delays in moving the case from the OIP to a hearing were attributable to Respondents, not the Division. See Order of April 7, 2000, at 2-4 (sealed). |
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