==========================================START OF PAGE 1====== UNITED STATES OF AMERICA Before the SECURITIES AND EXCHANGE COMMISSION SECURITIES ACT OF 1933 Release No. 7333 / September 19, 1996 SECURITIES EXCHANGE ACT OF 1934 Release No. 37701 / September 19, 1996 ACCOUNTING AND AUDITING ENFORCEMENT Release No. 817 / September 19, 1996 ADMINISTRATIVE PROCEEDING File No. 3-9085 ---------------------------------- : ORDER INSTITUTING PROCEEDINGS In the Matter of : PURSUANT TO SECTION 8A OF THE : SECURITIES ACT OF : 1933, SECTION : 21C OF THE SECURITIES CYPRESS BIOSCIENCE INC. and : EXCHANGE ACT OF 1934, AND : RULE 102(e) ALEX P. DE SOTO, CPA : OF THE COMMISSION'S RULES OF : PRACTICE, MAKING FINDINGS, Respondents. : IMPOSING SANCTIONS, AND CEASE : -AND-DESIST ORDER ----------------------------------- I. The Securities and Exchange Commission ("Commission") deems it appropriate and in the public interest that public administrative proceedings be, and they hereby are, instituted pursuant to Section 8A of the Securities Act of 1933 ("Securities Act"), Section 21C of the Securities Exchange Act of 1934 ("Exchange Act"), and Rule 102(e)(1)(iii)-[1]- of the ---------FOOTNOTES---------- -[1]- Rule 102(e)(1)(iii) of the Commission's Rules of Practice, 17 C.F.R.  201.102(e), provides in pertinent part: "The Commission may censure a person or deny, temporarily or permanently, the privilege of appearing or practicing before it in any way to any person who is found by the Commission after notice and opportunity for hearing in the matter ... (iii) to have willfully (continued...) Commission's Rules of Practice against: A. Cypress Bioscience Inc., formerly known as IMR Corporation ("Cypress" or the "Company"), to determine whether Cypress violated Section 17(a) of the Securities Act and Sections 10(b), 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act and Rules 10b-5, 12b-20, and 13a-13 thereunder; and B. Alex P. de Soto ("de Soto") to determine whether de Soto willfully violated Section 17(a) of the Securities Act and Sections 10(b) and 13(b)(5) of the Exchange Act and Rules 10b-5 and 13b2-1 thereunder, and willfully aided and abetted and caused Cypress' violations of Sections 13(a), 13 (b)(2)(A) and (B) of the Exchange Act and Rules 12b-20 and 13a-13 thereunder. II. In anticipation of the institution of these administrative proceedings, each respondent has submitted an Offer of Settlement for the purpose of disposing of the issues raised in these proceedings. Solely for the purpose of these proceedings and any other proceedings brought by or on behalf of the Commission or to which the Commission is a party, and prior to a hearing pursuant to the Commission's Rules of Practice, 17 C.F.R. Section 201.1 et seq., the respondents, without admitting or denying the findings set forth herein, except that they admit to the jurisdiction of the Commission over them and over the subject matter of these proceedings, consent to the entry of the findings and to the issuance of this Order Instituting Proceedings ("Order"). III. On the basis of this Order and the Respondents' Offers of Settlement, the Commission finds the following: A. RESPONDENTS Cypress Bioscience Inc. ("Cypress" or the "company"), is a Delaware corporation with principal offices in San Diego, California. At the time of the events recounted here, Cypress was known as IMR Corporation. It changed its name to Cypress Bioscience Inc. on April 15, 1996. Cypress develops, manufactures, markets and distributes a product for the treatment ---------FOOTNOTES---------- -[1]-(...continued) violated, or willfully aided and abetted the violation of any provision of the Federal securities laws or the rules and regulations thereunder." ==========================================START OF PAGE 2====== of human immune system disorders. Alex P. de Soto ("de Soto"), 33, a certified public accountant in the State of Washington, joined Cypress as Vice President and Chief Financial Officer on September 1, 1993. At all relevant times, de Soto was responsible for all accounting functions performed at the company and for preparing all reports and financial statements filed with the Commission on behalf of the company. Prior to joining Cypress, de Soto was an audit manager with the Seattle, Washington office of Coopers & Lybrand L.L.P. ("Coopers"), where he worked on the audit of Cypress for the fiscal year ended December 31, 1992. De Soto resigned from all positions at Cypress on May 6, 1996 and retired from Cypress on June 30, 1996. B. FACTS 1. Summary On November 3, 1993, Cypress filed a report on Form 10-Q for the third quarter ended September 30, 1993 that (1) contained financial statements that materially overstated revenue and materially understated losses by improperly recognizing revenue from purported "bill and hold" transactions; (2) failed to disclose adequately that Cypress had changed its accounting policies to recognize revenue on goods that had not been shipped; (3) failed to disclose that the increase in revenues between third quarter 1992 and third quarter 1993 was primarily attributable to the purported bill and hold transactions, which represented 49% of the current quarter's revenue; and (4) failed to discuss the impact the purported bill and hold transactions were likely to have on future revenue. De Soto approved the inclusion of the improper revenue in the third quarter financial statements, and signed the false Form 10-Q. Cypress' third quarter financial statements were thereafter included in a registration statement on Form S-3. Cypress restated its third quarter 10-Q on March 15, 1994 to reverse $791,781 of the revenue previously recognized. 2. Background Cypress is a biotechnology firm with a single product that is approved for sale by the FDA. That product, called the Prosorba(R) column, is used to treat human immune system disorders.-[2]- It is a sterile canister containing a protein matrix through which a patient's plasma is infused and then returned to the patient's body. FDA regulations require that ---------FOOTNOTES---------- -[2]- The product is sold in cases of six columns, and a typical treatment requires six columns (one case) over a three-week period. ==========================================START OF PAGE 3====== after manufacturing, the columns be sterilized and then quarantined for 14 days before they can be shipped. Cypress used a subcontractor in Portland, Oregon to perform the sterilization and quarantining, after which the goods were returned to Cypress' Seattle facility for distribution. Once the sterilization and quarantine process was complete, the Prosorba(R) columns had an FDA-approved shelf life of one year, after which time they could not be used. In November 1992, Cypress moved to a new manufacturing facility which had not yet received its Good Manufacturing Practice approval from the FDA, which was required for the company to make unlimited shipments of product.-[3]- The facility was not cleared until March 1993, and as a result Cypress was substantially prevented from filling customer orders for four months. During that period Cypress recognized revenue on product that had been ordered by its customers and that would have been shipped but for the FDA prohibition.-[4]- In the course of the 1992 year-end audit, de Soto, who was then audit manager for Coopers, reviewed those transactions against the criteria for revenue recognition under SEC Accounting and Auditing Enforcement Release ("AAER") No. 108. A memorandum to the engagement partner that de Soto reviewed and approved concluded that the transactions in question failed to meet four out of the seven criteria for bill and hold accounting set forth in AAER 108. In particular, it noted that performance obligations remained, since Cypress had yet to obtain FDA approval for the goods. In addition, the memorandum concluded that, although customers had ordered the columns, there was inadequate evidence to conclude that the risk of ownership had passed to the buyer as to the unshipped columns, that there was a fixed commitment to purchase the goods, and that there was a fixed schedule of delivery for the goods. The memorandum also noted that in response to confirmation requests, several of Cypress' customers had denied any obligation to pay for the product until it was delivered. Because the amount of revenue was not material, however, it was posted on the schedule of unadjusted differences ("SUD"), and was recognized as revenue in Cypress' December 31, 1992 year-end financial statements which were filed with the ---------FOOTNOTES---------- -[3]- During the period of the restriction Cypress was only permitted to ship columns that were scheduled for immediate use on patients. -[4]- The columns in question had been boxed and labeled for shipment and physically segregated from the rest of Cypress' unsold inventory. The only performance obligations remaining were for Cypress to present the packages to Federal Express after the FDA approved the manufacturing facility. ==========================================START OF PAGE 4====== Commission with Cypress' 1992 Form 10-K.-[5]- 3. Cypress' Volume Discount Program In the spring of 1993, Cypress' marketing department launched a volume discount program in an effort to increase sales. Pursuant to this program, Cypress offered customers volume discounts for large orders and encouraged customers to order an amount representing their historic 12 month usage of the Prosorba(R) columns.-[6]- Under Cypress' proposal, customers were not required to accept immediate delivery of the goods, but could take delivery at any time within 11 months. They were invoiced for the full amount of the order, but payment was not due until 30 days after delivery. Moreover, the customer could return unopened product within 14 days of delivery for full credit and could return expired product for replacement. As part of the program, Cypress also offered free temperature-controlled storage of the columns until customers requested that they be delivered. During its third quarter, Cypress' sales began to lag far behind both its internal forecasts and analysts expectations. The company's marketing plan as of the third quarter of 1993 projected quarterly domestic sales of $2,077,200 and annual domestic sales of $7.7 million. By late August 1993, the actual sales for the first two months of the quarter were only $588,000, leaving approximately seventy-five percent (almost $1.5 million) of the sales to be achieved in the last month of the quarter.-[7]- Cypress began aggressively to market its ---------FOOTNOTES---------- -[5]- The FDA approved Cypress manufacturing facility in March 1993, and before the end of the quarter all of the product on which revenue had been recognized in 1992 had been shipped to customers. -[6]- In Cypress' 1993 Marketing Plan, which was presented to Cypress' sales force in April 1993, one of the expressed strategies of the company's marketing department was to "Develop programs which stimulate customer stocking of Prosorba(R)." During 1993, Cypress' marketing department circulated a form letter for use with the bulk price protection program which called for sales representatives to offer bulk discounts and price protection to customers and encourage customers to order a 12-month supply of columns. -[7]- Failure to meet these internal goals would have disappointed analysts, since published earnings projections for Cypress were very close to the (continued...) ==========================================START OF PAGE 5====== volume discount program in September 1993. During the summer of 1993, Marc Bateman, an accountant who was acting as a consultant to Cypress, informed de Soto that the company intended to increase its volume discount revenue to a material amount. At that time Cypress had no chief financial officer, and Bateman sought de Soto's advice as to whether the unshipped goods invoiced pursuant to the volume discount program could properly be recognized as revenue. De Soto referred him to the requirements of AAER 108 and also told him that the company needed to obtain a legal opinion that the storage sales constituted legal sales in the state of Washington under the Uniform Commercial Code. 4. De Soto Becomes Cypress' CFO And Approves Recognition Of Revenue On Product Ordered Through The Volume Discount Program In mid-1993 de Soto decided to seek a position as Cypress' CFO. In August 1993, he interviewed for the position with Paul Self ("Self"), Cypress' then-president and chief operating officer, and initiated discussions about recognizing revenue from "bill-and-hold" transactions. De Soto was hired and began working as Cypress' chief financial officer on September 1, 1993. During his first four weeks at Cypress, de Soto set out to acquaint himself with the details of Cypress' volume discount program. He reviewed the documentation concerning the transactions, including the customer purchase orders and invoices, as well as Cypress-generated sales proposals which offered customers volume based price discounts and encouraged them to order an amount representing their historic 12 month usage. He also reviewed a list of the Cypress customers that were participating in the volume discount program and their sales history for the previous five years, as well as an open order report. Based on his review, de Soto believed that the customer-generated documentation was not sufficient to support recognition of revenue from the volume discount program transactions. De Soto was concerned that the customer purchase orders failed to specify shipment dates and/or raised questions as to whether the customer had accepted title to the product. In fact, several of the purchase orders explicitly provided that the orders could be cancelled without penalty before the columns were ---------FOOTNOTES---------- -[7]-(...continued) company's internal sales forecasts. For example, in August 1993, Doherty & Co. projected Cypress' 1993 sales in the range of $7-8 million. Also in August 1993, Red Chip Review projected Cypress' revenues for 1993 to be $7,553,000. ==========================================START OF PAGE 6====== shipped.-[8]- On September 30, 1993, de Soto issued a memorandum to Cypress' senior management concerning the volume discount program, which de Soto renamed the "customer storage program" or "storage program," with a bold heading in large type stating "Urgent Action Requested." The memorandum noted that there were a number of issues concerning "the large volume of customer storage sales that took place in September." De Soto wrote that the accounting rules "are quite clear as to what transactions can be considered a sale for financial reporting purposes," and described several categories of information he needed to satisfy himself that Cypress had met the spirit of those rules. In particular, he noted that he needed confirmation that the columns that were the subject of the volume discount/storage program transactions had been completed and released for shipment. He also wrote that he intended personally to call Cypress' three largest volume discount/storage program customers "to confirm that they have requested we store their product for them and they intend to take delivery within the near future." He set October 11, the day Cypress was scheduled to release its third-quarter results, as the deadline for the information called for in his memorandum. Immediately, de Soto began to receive additional information indicating the volume discount/storage program transactions should not be recognized as revenue. On the same day he issued his memorandum, Rick Leary, Cypress' Director of Quality Engineering, informed him that the lots of columns devoted to the volume discount/storage program "will probably not be released [for shipment to customers] by October 11." Leary noted that "too many problems are coming up with" two of the lots, which had been sterilized in late August and early September but that still required post-sterilization inspection and formal release. He also noted that there were potential problems with a third lot designated to the volume discount/storage program that had been sent for sterilization, but that had been neither sterilized nor quarantined as of the end of the quarter.-[9]- These four lots, which Leary informed de Soto would probably not be available for distribution on or before October 11, 1993, constituted all of the product designated for the volume discount/storage program for the third quarter of 1993. In fact, the lots were not released for shipment until varying dates between November 3 and December 13. Consequently, as of ---------FOOTNOTES---------- -[8]- At least nine purchase orders, including the purchase orders from one of Cypress' three largest storage customers, contained cancellation clauses. -[9]- The fourth lot referred to in de Soto's memo was also not sterilized as of October 11, 1993. ==========================================START OF PAGE 7====== September 30, 1993, these lots were not available to fill orders. De Soto decided to abandon his plan to confirm orally with Cypress' three largest volume discount/storage program customers the circumstances and terms of the storage agreement. De Soto claimed to have relied on oral assurances he had received from Cypress' sales representatives that their customers had made a commitment to purchase the goods and agreed to accept title to them. In fact, some of Cypress' sales representatives understood that their customers were not obligated to purchase the goods they ordered pursuant to the volume discount/storage program, or could defer purchases into future periods. 5. False and Misleading Statements Concerning Cypress' Third Quarter Results On October 11, with de Soto's approval, Cypress announced its results for the third quarter of 1993, reporting revenue of $2,009,122 for the quarter, $982,650, or 49 percent, of which was recognized from the volume discount/storage program. Thereafter, de Soto drafted Cypress' report on Form 10-Q including the Management's Discussion and Analysis ("MD&A") narrative and the financial statements for Cypress' 1993 third quarter. In the MD&A narrative, de Soto failed to disclose Cypress' reliance upon volume discount/storage program revenue to make up for substantial shortfalls from the company's revenue goals for the third quarter of 1993. Instead, the MD&A stated that the quarterly and nine month cumulative revenue from product sales were up more than 60 percent from the year before because of "increasing acceptance of the Prosorba column among medical practitioners, increased productivity of the Company's sales force, and new sales and marketing programs introduced during 1993." The reference to "new sales and marketing programs" was the only reference to the volume discount/storage program. In his initial draft of the MD&A, de Soto included no disclosure of the volume discount/storage program. He included the language quoted above only after a partner at Cypress' independent auditor reviewed the Form 10-Q and suggested that the storage program be disclosed. That partner was not satisfied that the disclosure de Soto drafted was adequate, and recommended that de Soto provide a more detailed description of the program and explain its impact on third quarter revenue. Having reviewed all relevant documentation concerning Cypress' volume discount program and sales history for each customer participating in the program, de Soto knew that by recognizing revenue from the volume discount/storage program, Cypress had accelerated into the third quarter a quantifiable amount of revenue that would otherwise have been recognized from participating customers over the next three quarters, and that the effect of that acceleration would be to depress future revenues dollar for dollar. Nevertheless, Cypress declined to make additional disclosures. Thus, the Form ==========================================START OF PAGE 8====== 10-Q did not disclose the existence of the volume discount/storage program, or that revenues from it, which constituted 49 percent of total revenue for the quarter, accounted for virtually the entire increase in revenue from third quarter 1992. Furthermore, the Form 10-Q failed to disclose that recognition of the revenues in the current quarter was likely to depress future revenue. Finally, Cypress' Form 10-Q for the third quarter 1993 failed to make adequate disclosure concerning the change in revenue recognition policy.-[10]- Cypress' financial statements previously had contained a note disclosing that the company recognized revenue when its product was shipped. In its third quarter 10-Q, de Soto changed this note disclosure to state that the company recognized revenue "when earned." De Soto made this change to facilitate recognition of revenue from the volume discount/storage program transactions, but the third quarter 10-Q does not provide any justification for the change in accounting policy or explain why the newly adopted principle is preferable.-[11]- On November 3, 1993, Cypress filed its report on Form 10-Q for the third quarter ended September 30, 1993. De Soto made the ---------FOOTNOTES---------- -[10]- Under generally accepted accounting principles ("GAAP"), a change in accounting principle includes not only accounting principles and practices but also the methods of applying them. Accounting Principles Board Opinion No. 20 provides that the "nature of and justification for a change in accounting principle and its effect on income should be disclosed in the financial statements of the period in which the change is made." Furthermore, the opinion states that "the justification for the change should explain clearly why the newly adopted accounting principle is preferable." In addition, Accounting Principles Board Opinion No. 22 states that "disclosure of accounting policies should identify and describe the accounting principles followed by the reporting entity and the methods of applying those principles." See also Regulation S-X, Article 10, Reg. 210.10-01(a)(5) (disclosure required where events subsequent to the end of the most recent fiscal year have occurred which have a material impact on the registrant). -[11]- In its amended and restated third quarter 10-Q, Cypress changed this accounting policy note back to state that revenue was recognized when the product is shipped. ==========================================START OF PAGE 9====== decision to include the improper revenue in the third quarter financial statements and signed the materially misleading Form 10-Q. Cypress' third quarter financial statements were thereafter included in a registration statement on Form S-3, which de Soto drafted and signed. This Form S-3 was filed with the Commission on November 8, 1993, to update Cypress' 1991 registration statement for stock to be issued pursuant to outstanding warrants, and went effective on November 24, 1993.-[12]- 6. Cypress Restates Its Third Quarter 10-Q After completing its year-end audit field work and its review of all customer storage program documentation Cypress' independent auditors concluded that revenue recognition for storage program transactions was not appropriate. Cypress restated it third quarter 10-Q on March 15, 1994 to reverse $791,781 of the $982,650 customer storage program revenue previously recognized.-[13]- On June 23, 1994, Cypress filed a current report on Form 8-K with the Commission reporting that it had changed its certifying accountant for the fiscal year ending December 31, 1994. C. LEGAL ANALYSIS 1. Applicable Law Section 10(b) of the Exchange Act and Rule 10b-5 thereunder prohibit the use of manipulative and deceptive practices in connection with the purchase or sale of a security. Section 17(a) of the Securities Act prohibits similar conduct in the offer or sale of securities. Section 13(a) of the Exchange Act requires all issuers with securities registered under Section 12 ---------FOOTNOTES---------- -[12]- No warrants were exercised pursuant to that updated registration statement before the company restated its false and misleading third quarter 1993 Form 10-Q. -[13]- The company left $190,869 of storage program revenue in the restated third quarter 10-Q, and the auditors posted this amount to the SUD, which was deemed not material. The auditors did not concur with the company's decision to retain this amount in revenue, but did not object due to its immateriality. No disclosures or explanations were given by Cypress in its amended and restated third quarter 10-Q as to why the $190,869 in storage program revenue was not excluded from the restated financial statements. ==========================================START OF PAGE 10====== of the Exchange Act to file such periodic reports as the Commission shall prescribe by its rules and regulations. Rule 13a-13 requires issuers to file quarterly reports. Rule 12b-20 requires that periodic reports contain such further information as is necessary to make the required statements, in light of the circumstances under which they are made, not misleading. Item 4.01 of Regulation S-X provides that financial statements which are not prepared in accordance with generally accepted accounting principles ("GAAP") are presumed to be misleading. In addition, Item 303 of Regulation S-K requires MD&A as part of periodic reports filed pursuant to Section 13(a). Item 303 specifies that, for interim periods, the MD&A include, among other things, a discussion of any material changes in the registrant's results of operations with respect to the most recent fiscal year-to-date period for which an income statement is provided and corresponding year-to-date period of the preceding fiscal year. Instructions to Item 303 require that this discussion identify any significant elements of the registrant's income or loss from continuing operations which do not arise from or are not necessarily representative of the registrant's ongoing business. Section 13(b)(2)(A) of the Exchange Act requires an issuer to make and keep books, records, and accounts which, in reasonable detail, accurately and fairly reflect the transactions and dispositions of its assets. Rule 13b2-1 provides that no person shall, directly or indirectly, falsify or cause to be falsified, any book, record or account subject to Section 13(b)(2)(A). Section 13(b)(2)(B) of the Exchange Act requires issuers to devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances that transactions are recorded as necessary to permit preparation of financial statements in conformity with generally accepted accounting principles. Section 13(b)(5) of the Exchange Act provides that no person shall knowingly circumvent or knowingly fail to implement a system of internal accounting controls or knowingly falsify any book, record, or account required by Section 13(b)(2). 2. Cypress' Violations Cypress violated Sections 13(a) and 10(b) of the Exchange Act and Rules 13a-13 and 12b-20 thereunder by filing its third quarter Form 10-Q which included false financial statements and failed to disclose in the MD&A section the material impact the purported bill and hold sales had on current revenue and earnings and were likely to have on future revenue and earnings. By incorporating the false Form 10-Q into its Registration Statement on Form S-3, Cypress also violated Section 17(a) of the Securities Act. De Soto's knowledge that the financial statements were false and the MD&A disclosures misleading, is discussed below. That knowledge is imputed to Cypress and satisfies the scienter requirements for Section 17(a) of the ==========================================START OF PAGE 11====== Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder.-[14]- a. False Financial Statements The recognition of $982,650 in revenue from columns ordered pursuant to Cypress' customer storage program was improper because the goods purportedly sold had not been completed-[15]- and, even if completed, the transactions were not sales under generally accepted accounting principles and AAER 108. As explained below, the purported "bill and hold" revenue recognized by Cypress failed to meet the revenue recognition criteria under GAAP, and also failed to meet the guidance set forth for SEC registrants under AAER 108. Under APB Statement No. 4, which was rescinded in March 1993, revenue was generally recognized when (1) the earnings process was complete or virtually complete, and (2) an exchange had taken place. This revenue recognition concept has been carried forward in FASB Statement of Financial Accounting Concepts No. 5, para. 83-84, and in other authoritative literature and continues to provide the foundation for revenue recognition in accordance with GAAP. The inclusion by Cypress of $982,650 in revenue from the customer storage program was improper because, as set forth above, the goods purportedly sold had not been completed. Accordingly, the revenue was not recognizable because no products were available to be exchanged for cash or claims to cash. The ---------FOOTNOTES---------- -[14]- Since a corporation acts through its representatives, their knowledge renders the corporation liable for violating Section 10(b) and Rule 10b-5. See SEC v. Manor Nursing Center Inc., 458 F.2d 1082, 1096-7 (2d Cir. 1972); Kirkland v. E.F. Hutton and Company, Inc., 564 F.Supp. 427, 447 (E.D.Mich. 1983); SEC v. Blinder, Robinson & Co., Inc., 542 F.Supp. 468, 476, n.3 (D.Colo. 1982), aff'd., Fed.Sec.L.Rep. (CCH) 99,491, at 96,856 (10th Cir. 1983), cert. denied, 469 U.S. 1108 (1985). -[15]- See FASB Statement of Financial Accounting Concepts No. 5, 83.b ("revenues are considered to have been earned when the entity has substantially accomplished what it must do to be entitled to the benefits represented by the revenues.") ==========================================START OF PAGE 12====== earnings process was, therefore, not complete.-[16]- Even if the goods purportedly sold had been completed, however, the recognition of revenue would have still been improper because no exchange had taken place as contemplated by GAAP. AAER 108 states that recognition of revenue on "bill and hold" transactions (prior to shipment or exchange with the customer) is a departure from the general rule of revenue recognition, and is appropriate only if certain conditions described in AAER 108 are met. As described below, the Cypress transactions failed to meet virtually all of these conditions. - It was at best questionable as to whether the risks of ownership had passed to the buyer or whether the buyer had made a fixed commitment to purchase the goods. No payment obligation arose when the goods were "sold" and stored by Cypress. Instead, it was triggered by delivery of the product, which could occur up to eleven months later. Moreover, many customer purchase orders were cancelable or vague in their terms. Finally, customers could return or exchange product. - The buyers did not request that the transaction be on a "bill and hold" basis. Cypress' volume discount/storage program orders resulted from a sales promotion offered to the customers by Cypress' marketing department, rather than from the requests of the individual customers. - There was no fixed schedule for the delivery of goods. Other than a mandatory "drop dead" date under which delivery was required eleven months after the order if not previously elected, the Cypress transactions called for no fixed delivery schedule consistent with the buyer's business purpose. - Cypress had retained specific performance obligations by agreeing to exchange unused product indefinitely. - The ordered goods had not been segregated from Cypress' inventory as of September 30, 1993. The lack of physical segregation and identification to customers was a further indication that Cypress continued to retain specific performance obligations such that the earning process was ---------FOOTNOTES---------- -[16]- The goods assigned to the customer storage program had not been released from quarantine as of September 30, 1993. During the period between October 1, 1993 and December 31, 1993, nearly all of the storage program orders were filled with product from lots other than the four lots assigned to the Cypress storage program. ==========================================START OF PAGE 13====== not complete. - The goods were not complete and ready for shipment. Many of the goods eventually used to fill customer orders had not cleared quality control and quarantine, and were not, in fact, ready to be shipped at the time the revenue was recognized. In addition, it is a well-established tenet of GAAP that transactions must be accounted for in accordance with their substance rather than their form. Prior to initiation of the volume discount/storage program, customers ordered product when needed, Cypress recognized revenue upon shipment and payment was required net 30 days after shipment. Under the volume discount/storage program, the substance of the sales, usage and delivery requirements, and payment terms remained the same. Despite their participation in the program, customers delayed orders for delivery until needed so that cash outlays could be minimized.-[17]- Payment terms continued to be net 30 days after shipment. Nevertheless, Cypress accounted for the sales as if the substance had changed, since under the volume discount/storage program, revenue was improperly accelerated into a single period, rather than continuing to be recognized as shipments were made. Based on the foregoing, the Cypress volume discount/storage program transactions violated revenue recognition criteria both under GAAP and by the terms of AAER 108. b. Misleading Disclosures The $982,650 in revenue from the volume discount/storage program represented approximately 49 percent of third quarter 1993 revenue. Without this revenue Cypress would have reported a 41 percent decline from its second quarter revenue. As the Commission pointed out in a 1987 concept release: The Commission has long recognized the need for a narrative explanation of the financial statements, because a numerical presentation and brief accompanying footnotes alone may be insufficient for an investor to judge the quality of earnings and the likelihood that past performance is indicative of future performance.-[18]- ---------FOOTNOTES---------- -[17]- It should be noted that the liberal Cypress return policy made the "obligation" virtually risk-free, since the customer could exchange product indefinitely if not used. -[18]- Securities Act Release No. 6711 (April 24, 1987). ==========================================START OF PAGE 14====== Under Regulation S-K, Item 303(b), material changes in results of operations in the current fiscal quarter and the corresponding fiscal quarter in the previous year must be disclosed for interim financial statements. Given that the storage program sales materially increased Cypress' reported revenue from the previous fiscal year and reversed a decreasing revenue trend from Cypress' second quarter 1993, some discussion of that program was necessary to a proper understanding of Cypress' third quarter operating results. The 10-Q similarly failed to disclose the material effect the program was likely to have on future earnings. Under the program, Cypress accelerated into the third quarter up to a year's worth of revenue for the thirty-four participating customers. Accordingly, Cypress was likely to have less or no revenue from these customers during the next three quarters. Thus, it had the foreseeable effect of materially reducing revenue for the three quarters to follow.-[19]- Lastly, in its accounting policies note to the third quarter financial statements, Cypress changed its revenue recognition policy in order to recognize revenue from the volume discount/storage program, without providing an adequate explanation or justification for the change in the method of applying the accounting policy. c. Books and Records Cypress violated Section 13(b)(2)(A) by recording the volume discount/storage program transactions as third quarter sales in its books and records. Cypress violated Section 13(b)(2)(B) because it did not have in place internal accounting controls sufficient to provide reasonable assurances that its volume ---------FOOTNOTES---------- -[19]- See Regulation S-K, Item 303 (known trends or uncertainties that will have a material unfavorable impact on net sales or revenues must be disclosed); see also In the Matter of Bank of Boston Corporation, Admin. Proc. File No. 3-8270, Admin. Proc. Release No. ID-81, 60 SEC Docket 2695 (respondent violated Exchange Act reporting and disclosure provisions because it knew or should have known when it filed interim quarterly report that known trends and uncertainties in its real estate portfolio could reasonably be expected to have a material unfavorable impact on respondent's current financial condition and future operating results); Item 303, Interpretive Release, 43 SEC Docket 1577, 1579, 54 Fed.Reg. 22427 (May 24, 1989) (required disclosure of presently known trends includes "the likely non-renewal of a material contract"). ==========================================START OF PAGE 15====== discount/storage program transactions were recorded on its financial statements in accordance with generally accepted accounting principles. 3. De Soto's violations De Soto was Cypress' principal accounting officer and was responsible for preparing the third quarter 1993 financial statements. As such, de Soto was principally responsible for the decision to include the volume discount/storage program revenue in the third quarter financial statements. He also was principally responsible for the decision not to disclose the facts concerning these transactions, the impact they would have on future revenue, or to adequately describe the new revenue recognition policy in Cypress' quarterly report notwithstanding the contrary advice of Cypress' auditors. In doing so, de Soto acted with scienter. As a result of his work during the 1992 audit, he was familiar with the requirements of AAER 108. When he prepared the financial statements, he knew that the volume discount/storage program goods were not completed or ready to ship, and thus that the earnings process was not complete. He also knew that a number of customers had not agreed to accept title to the goods or had not made a fixed commitment to purchase the goods, and that Cypress had not segregated the storage program goods, contrary to AAER 108's requirements. He also authorized the accounting entries to record the transactions as sales, and, as of September 30, 1993, failed to implement internal accounting controls to ensure that Cypress' financial statements were prepared in accordance with GAAP. As a result, he willfully violated Section 17(a) of the Securities Act and Sections 10(b) and 13(b)(5) of the Exchange Act and Rules 10b-5 and 13b2-1 thereunder. He also willfully aided and abetted and caused Cypress' violations of Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act, and Rules 12b-20 and 13a-13 thereunder. IV. FINDINGS On the basis of this Order and the Offers of Settlement submitted by the respondents, the Commission finds that: A. Cypress violated Section 17(a) of the Securities Act and Sections 10(b), 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act and Rules 10b-5, 12b-20, and 13a-13 thereunder; B. Alex P. de Soto willfully violated Section 17(a) of the Securities Act and Sections 10(b) and 13(b)(5) of the Exchange Act and Rules 10b-5 and 13b2-1 thereunder and ==========================================START OF PAGE 16====== willfully aided and abetted and caused Cypress' violations of Sections 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act and Rules 12b-20 and 13a-13 thereunder. V. In view of the foregoing, the Commission has determined it is in the public interest to accept the Respondent's Offers of Settlement. Accordingly, IT IS HEREBY ORDERED, effective immediately, that: A. Cypress, pursuant to Section 8A of the Securities Act and Section 21C of the Exchange Act, cease and desist from committing or causing any violation and any future violation of Section 17(a) of the Securities Act and Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and Rules 10b-5, 12b-20, and 13a-13 thereunder. B. De Soto, pursuant to Section 8A of the Securities Act, and Section 21C of the Exchange Act, cease and desist from committing or causing any violation or any future violation of Section 17(a) of the Securities Act and Sections 10(b) and 13(b)(5) of the Exchange Act and Rules 10b-5 and 13b2-1 thereunder, and from causing any violations of Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and Rules 12b-20 and 13a-13. C. De Soto, pursuant to Rule 102(e)(1)(iii) of the Commission's Rules of Practice, is denied the privilege of appearing or practicing before the Commission as an accountant. D. After three years from the date of this Order, de Soto may apply to the Commission by submitting an application to the Office of the Chief Accountant which requests that he be permitted to resume appearing or practicing before the Commission as: 1. a preparer or reviewer, or a person responsible for the preparation or review, of financial statements of a public company to be filed with the Commission upon submission of an application satisfactory to the Commission in which de Soto undertakes that, in his practice before the Commission, his work will be reviewed by the independent audit committee of the company for which he works or in some other manner acceptable to the Commission; 2. an independent accountant upon submission of an application containing a showing satisfactory to the Commission that: ==========================================START OF PAGE 17====== a. De Soto, or any firm with which he is or becomes associated in any capacity, is and will remain a member of the SEC Practice Section of the American Institute of Certified Public Accountants Division for CPA Firms ("SEC Practice Section") as long as he appears or practices before the Commission as an independent accountant; b. De Soto or the firm has received an unqualified report relating to his or the firm's most recent peer review conducted in accordance with the guidelines adopted by the SEC Practice Section; and c. De Soto will comply with all applicable SEC Practice Section requirements, including all requirements for periodic peer reviews, concurring partner reviews, and continuing professional education, as long as he appears or practices before the Commission as an independent accountant. 3. The Commission's review of any request or application by de Soto to resume appearing or practicing before the Commission may include consideration of, in addition to the matters referenced above, any other matters relating to de Soto's character, integrity, professional conduct, or qualifications to appear or practice before the Commission. By the Commission. Jonathan G. Katz Secretary ==========================================START OF PAGE 18======