Initial Decision of an SEC Administrative Law Judge
In the Matter of
In the Matter of
January 21, 2000
Stephen J. Crimmins for the Division of Enforcement,
Securities and Exchange Commission
Michael P. Carroll for Respondent
Robert G. Mahony, Administrative Law Judge
The Securities and Exchange Commission (Commission) initiated this proceeding by an Order Instituting Proceedings (OIP) on December 4, 1997, pursuant to Section 21C of the Securities Exchange Act of 1934 (Exchange Act) and Rule 102(e) of the Commission's Rules of Practice. 17 C.F.R. § 201.102(e).
The OIP alleges that Respondent, KPMG Peat Marwick L.L.P. (Peat Marwick), failed to comply with established standards of auditor independence in connection with its audit of the 1995 year-end financial statements of Porta Systems Corp. (Porta) and its preparation of the related audit report. It further alleges that, as a result of these activities, Respondent engaged in improper professional conduct under Rule 102(e), directly violated Rule 2-02 of Regulation S-X, and caused violations of Section 13(a) of the Exchange Act and Rule 13a-1 thereunder.
The OIP alleges that Peat Marwick lacked independence because: (i) it loaned $100,000 to the president/chief operating officer of its audit client, Porta; (ii) it capitalized the separate business owned by the president/chief operating officer of Porta; (iii) it fully capitalized the "affiliate" of Porta; (iv) it was entitled to a percentage of the earnings, disposed inventory, and restructured debt of Porta; and (v) by reason of the contractual ties and interdependence between them, Peat Marwick and KPMG BayMark L.L.C. (BayMark) should be considered a single entity for independence purposes.
A hearing was held in Washington, D. C., during the period June 15-25, 1998, at which time the parties submitted testimonial and documentary evidence and presented oral argument.1 The Division of Enforcement (Division) and the Office of Chief Accountant (OCA) filed their Post-Trial Brief on or about October 1, 1998. Respondent filed both its Proposed Findings of Fact and Conclusions of Law and its Counterfindings to Division/OCA's Implied Proposed Findings of Fact on or about November 19, 1998 and filed its Post-Trial Brief of Legal Issues on or about November 25, 1998. In addition, a Reply Brief was filed by the Division/OCA on or about December 31, 1998.
The Division requests that a cease and desist order with additional reporting obligations to effect compliance be entered against Respondent and, in addition, that censure be imposed against Respondent. (Division/OCA's Post-Trial Brief at 51-53, 55-56.)
My findings and conclusions are based on the testimonial and documentary evidence in the record. I applied preponderance of the evidence as the applicable standard of proof. See Steadman v. SEC, 450 U.S. 91, 102 (1981). I have considered all proposed findings and conclusions. I accept those that are consistent with this decision, and I reject those that are not.
Respondent's Answer was filed on January 15, 1998, and admits the following.
Peat Marwick is a limited liability partnership organized under the laws of Delaware with executive offices in New York, New York and is the U. S. member of KPMG International. (Ans. para. 2.)
BayMark was formed as a Delaware limited liability company on January 5, 1995, and later dissolved, pursuant to a Dissolution Agreement dated as of January 2, 1997. BayMark had its executive offices in New York City, and was owned equally by four principals, one of whom was Edward R. Olson (Olson). BayMark was the parent holding company of both KPMG Baymark Capital L.L.C. (Capital), and KPMG Baymark Strategies L.L.C. (Strategies). Further, there was a license agreement between BayMark and Peat Marwick dated as of January 1, 1995. (Ans. paras. 3, 27.)
Strategies was a Delaware limited liability company with offices in Vienna, Virginia and Los Angeles, California which was formed in early 1995. Voting power was held 51% by BayMark and 49% by two of the individual principals of BayMark, one of whom was Olson, until its assets were spun off into two separate limited liability companies, one controlled by Olson and the other controlled by the other individual principal. Strategies was dissolved in November 1996. (Ans. para. 4.)
Capital is a Delaware limited liability company with offices in New York, New York which was formed on January 5, 1995. Voting power was held 51% by BayMark and 49% by two of the individual principals of BayMark. Pursuant to a Dissolution Agreement dated as of January 2, 1997, the ownership of Capital was transferred to the individual principals. Capital was a registered broker-dealer until it withdrew its license. (Ans. para. 5.)
Porta is a Delaware corporation with its principal place of business in Syosset, New York. Its stock is registered with the Commission pursuant to section 12(b) of the Exchange Act and traded on the American Stock Exchange. Porta develops, manufactures, and markets telecommunications equipment and systems. (Ans. para. 7.)
In early 1995, Peat Marwick and BayMark entered into a strategic alliance. Subsequent to the formation of the alliance, Porta engaged Strategies and Olson, to perform turnaround management services for a specified period of fifteen months pursuant to an engagement letter between Strategies and Porta dated October 2, 1995. Thereafter, Olson was made and exercised the responsibilities of the president/chief operating officer of Porta, an audit client of Peat Marwick's Long Island office. (Div. Ex. 30.)
In connection with the formation of BayMark and the negotiation of the strategic alliance, Peat Marwick extended non-recourse loans, each in the amount of $100,000 and made as of January 1, 1995, to each of BayMark's owners, including Olson, in March, 1995. Olson agreed to make capital contributions to BayMark and Strategies, and the other three principals were required to make capital contributions to BayMark and their respective businesses, either Capital or Strategies. (Ans. paras. 9, 13, 21.)
Peat Marwick completed its audit of Porta's 1995 year-end financial statements and issued its "Independent Auditors' Report" dated March 22, 1996, in which Peat Marwick opined that there was "substantial doubt about Porta's ability to continue as a going concern." Porta incorporated Peat Marwick's report into its 1995 annual report on Form 10-K, and along with other officers and directors of Porta, Olson signed Porta's annual report on Form 10-K and signed Porta's management representation letter. (Ans. paras. 10, 14.)
In connection with the formation of BayMark and the establishment of the strategic alliance, Peat Marwick extended loans to the BayMark entities in the amount of $4.6 million, and over time the balance grew to over $8 million. In connection with this extension of credit, Peat Marwick took a security interest in certain assets of Strategies as described in the Security Agreement dated January 1, 1995, between Strategies and Peat Marwick. (Ans. paras. 19, 20.)
a. KPMG Corporate Finance
On September 29, 1994, L. Glenn Perry (Perry), the senior partner responsible for resolving auditor independence issues and a member of Peat Marwick's Department of Professional Practice2 (DPP), met with members of OCA, including then Deputy Chief Accountant John Riley (Riley), then Assistant Chief Accountant Roy Van Brunt (Van Brunt), and OCA Chief Counsel Robert Burns (Burns) to discuss a proposed business transaction involving the creation of a strategic alliance with a new entity which was then referred to as KPMG Corporate Finance (KPMGCF). (Tr. 85-86, 89, 114, 758-62, 777; Div. Ex. 6.)
The day before this meeting, Perry faxed a letter addressed to Riley and Van Brunt confirming the meeting. (Tr. 759; Div. Ex. 5.) Included with the letter was a draft outline of the proposed new entity and its relationship with Peat Marwick. The draft stated that the objective of the meeting was to confirm that the staff did not object to Peat Marwick's conclusion that the independence rules did not apply to KPMGCF. (Div. Ex. 5 at 4.)
The draft included the following information: (i) Peat Marwick would license the use of the "KPMG" name to KPMGCF; (ii) Peat Marwick would lend KPMGCF $5 million in the form of a working capital loan; (iii) under the licensing agreement, Peat Marwick would receive a 4-7% royalty based on KPMGCF's gross revenues; and (iv) KPMGCF would provide services to troubled companies in the context of turnaround or bankruptcy.3 (Div. Ex. 5.) All of these proposals were reviewed at the meeting. (Tr. 787-88; Div. Ex. 5.)
At the conclusion of the meeting, Perry was told that the staff had not heard anything that would cause it to raise questions regarding Peat Marwick's independence.4 (Tr. 101-02, 109.) Furthermore, Riley, on cross examination, stated that the following inquiry was "essentially correct":
[That it] [w]ould [ ] be fair to say that at the end of the discussion based on what you had discussed, and in particular about the licensing of the name, the royalty payment and the capitalization, whatever the amount was, that you were comfortable telling Mr. Perry at the end that based on what you'd heard about those things, to use your language, . . . you had not heard anything that would cause you to object on independence grounds?
b. Formation of KPMG BayMark L.L.C.
Tom Vasquez (Vasquez), a Peat Marwick partner, and Jim D'Agostino, an attorney from the law firm Brook, Reed, Smith, Shaw & McClay, initially contacted Olson sometime in 1995 to see if Olson would be interested in starting up a national crisis management organization that would be separate from Peat Marwick. (Tr. 525-27; Resp. Ex. 4.) During 1994 and 1995, Olson owned a crisis management firm called Ed Olson Consulting Group Ltd. which provided assistance to financially troubled companies in need of reorganization or new management. (Tr. 525-26.)
Vasquez wanted Olson to team up with Dan Armel (Armel), a former partner with Coopers & Lybrand, to handle the crisis side of the business, which eventually became Strategies. (Tr. 527, 532.) Ultimately, it was agreed that Olson and Armel, along with Mark Taffet (Taffet) and David Maughan (Maughan) would be the four principals of BayMark,6 the holding company.7 Discussions were held to determine where the financing needed to set up BayMark would come from, and the idea of a revolving credit agreement was mentioned. Olson was told that there would be a non-recourse personal loan extended to him from Peat Marwick because he lacked the money necessary to cover his equity interest in BayMark. Olson believed that identical loans were also extended to the other three principals but did not know of any other sources of funding to help cover operating costs. Following this meeting, it was decided that Merlin Dewing (Dewing), a recently retired partner from Peat Marwick, would be installed as Chairman because of his knowledge of Peat Marwick and its functions. (Tr. 531.) For Olson, Dewing's particular knowledge was notable because he hoped "there would be leads, or marketing leads from [Peat Marwick] to [ ] Strategies for crisis management."8 (Tr. 528-32.)
(i) Meeting on October 19, 1995
BayMark and its subsidiaries were formed in January of 1995. (Ans. paras. 3-5; Div. Ex. 16.) Beginning in March or April 1995, a series of "rollouts," presentations outlining the Peat Marwick-BayMark alliance, were given to Peat Marwick partners in several Peat Marwick offices throughout the country. At the end of August 1995, Peat Marwick distributed a press release announcing that BayMark was ready to commence business. (Tr. 551-53.)
Perry then received a telephone call from Burns who expressed concern about some of the publicity associated with the alliance and wanted more information. (Tr. 787-88.) Subsequently, a meeting was held on October 19, 1995, to discuss OCA's concerns. (Tr. 127-28, 130.) In attendance were Chief Accountant Michael Sutton9 (Sutton); Burns; Van Brunt; another Assistant Chief Accountant, Scott Bayless (Bayless); Perry; Chris Trattou (Trattou), a senior manager who also worked in DPP; Jack Drogin of the Division of Market Regulation (Market Regulation); and Jerry Sullivan (Sullivan) from the Public Oversight Board10 (POB). (Tr. 128, 635-36, 777.) The thrust of OCA's concerns was whether the two entities could be viewed as independent of one another. Sutton testified that OCA was specifically concerned about BayMark's use of the "KPMG" initials, the royalty arrangement, and the financing of BayMark. (Tr. 130-31.) It was Sutton's understanding, without knowing exactly what was discussed at the September 1994 meeting, that the BayMark structure "was very similar or essentially the same" as KPMGCF's structure as presented in 1994. 11 (Tr. 184.)
Following the meeting, Perry drafted a Memorandum to the File dated October 19, 1995. (Div. Ex. 31.) In the memorandum, Perry summarized his recollection of the October meeting. According to Perry, Burns initially stated that there had been numerous press inquiries about the strategic alliance that the staff could not answer. Burns then "reminded everyone at the meeting, specifically Mr. Sutton," of the fact that he had told Perry the SEC staff did "'not object' to the strategic alliance as described" at the 1994 meeting.12 Burns next indicated that because of the notoriety given the strategic alliance, and indications that another accounting firm might be planning a similar venture, the SEC staff would "not say" that they had no objection to the strategic alliance. Perry noted that the OCA staff was "unsettled" about the situation, and now believed that the "alliance issue" was much "broader than anticipated." Therefore, the OCA staff requested additional information about the 5% royalty fee, the $5 million loan, the licensing agreement, and the staffing for services. Perry further noted that both the POB and SEC staff had concerns about the appearance of this arrangement due to broker-dealer related issues. (Div. Ex. 31 at 1-2.)
The memorandum concludes:
Mr. Sutton ended the meeting with the following statement addressing Mr. Perry, "If you have a significant SEC client, we suggest that you consult with us before you use BayMark." Mr. Perry responded by asking Mr. Sutton "What do you mean by a 'significant?'" SEC client. Mr. Sutton responded, "A client you do not want to embarrass."
A copy of the memorandum was provided to Michael Conway13 (Conway), Trattou, and others at Peat Marwick. (Div. Ex. 31 at 1-2.)
(ii) The Porta Audit - Sturm's October Inquiry
Leonard Sturm (Sturm) is an audit partner in the Long Island Office of Peat Marwick and was the engagement partner for the Porta audit in 1994 and 1995. Sturm first learned that Peat Marwick had a strategic alliance with BayMark at a partners meeting in the early summer of 1995. As a result of that meeting, Sturm knew only that BayMark provided turnaround services and secured financing for companies. (Tr. 676-79.)
Prior to the 1995 audit, the president of Porta, Vince Santulli (Santulli), told Sturm that he was looking for outside help to turn the company around due to losses sustained over several years. Thereafter, Sturm contacted the Peat Marwick Corporate Transactions Group and was advised that someone from BayMark might be able to provide assistance. Sturm then reported this back to Santulli. (Tr. 679-82.)
At some point during October 1995, Sturm contacted DPP and raised the issue of Peat Marwick's independence with regard to auditing Porta. He did so because Porta was going to engage BayMark, but he was unfamiliar with BayMark's structure, capitalization, principals, or its relationship with Peat Marwick. He was referred to Trattou who, at that time, handled all questions related to BayMark for DPP. (Tr. 683-86.) From his initial conversation with Trattou, Sturm understood that BayMark could provide services to an audit client because of the way the alliance was set up. Trattou also informed Sturm that the alliance had been discussed with SEC staff members, and that the staff did not pose any objection to the alliance. (Tr. 696-99.)
(iii) Perry's November 6, 1995 Letter
Because of what transpired during the October 19 meeting, Perry believed that the OCA staff had changed its position from that expressed to him in 1994. (Tr. 789-90.) Nonetheless, Perry, by letter dated November 6, 1995, provided Sutton with additional information as requested in the October 19 meeting. (Div. Ex. 37.) In terms of the 5% royalty payment, Perry represented that "it was not a commission or a finders fee." Perry further stated that neither the loans to BayMark and its owners nor the licensing agreement provided Peat Marwick with "the ability to 'control' BayMark." The letter also stated that BayMark might subcontract services from Peat Marwick depending on the particular type of BayMark engagement involved. Perry concluded by stating that "[a]t th[e] September, 1994 meeting, the SEC staff stated that it did not object to the strategic alliance we had described. We have proceeded on that basis." (Div. Ex. 37 at 2-3.) About the time Perry wrote this response letter, he first learned of the personal loans made to BayMark principals, but only to the extent that $5 million would be lent "to BayMark and its owners."14 (Tr. 774-76.)
(iv) Burns's November 16, 1995 Memorandum
A memorandum dated November 16, 1995, addressed to Sutton from Burns highlighted portions of the licensing agreement.15 (Resp. Ex. 75.) Sutton was also provided with a copy of the agreement. Among the highlighted portions of the licensing agreement were paragraphs 2.7 and 16. Paragraph 2.7 of the licensing agreement explains that the $5 million loan is actually comprised of four loans of $100,000 each to the four BayMark principals, and two revolving credit agreements totaling $4.6 million. Paragraph 16 states that Peat Marwick and BayMark are independent contractors without the right to bind the other. (Resp. Ex. 75 at 1-2.)
(v) The Porta Audit - Sturm's December 1995 Inquiry
By November of 1995, Olson had become president and chief operating officer (COO) at Porta and remained in these positions until November 1996. (Tr. 554.) Olson took the position as president of Porta because it had sustained $45,000,000 in losses over three years and appeared to be on the brink of failing.16 (Tr. 586.) Consequently, at some point in the beginning of December 1995, Sturm again spoke with Trattou to determine whether it was proper that Olson who, in addition to performing consulting services for Porta, now had the title of president and COO and was performing "COO-type functions." Trattou responded by saying that he needed to confer with other members of DPP and would get back to him. (Tr. 700-05.)
(vi) The Porta Audit - Trattou's December 5, 1995 E-mail
Note: See Erratum with reference to the paragraph immediately below.
During his testimony, Conway was shown a Peat Marwick internal e-mail dated December 5, 1995. (Tr. 922; Div. Ex. 39.) The e-mail was written by Trattou and sent to the following Peat Marwick members: (i) Vasquez, (ii) Robert Lambert (Lambert), and (iii) Donald Rose; it was not sent to Conway or Perry. (Tr. 922-23; Div. Ex. 39.) The e-mail referred to the fact that a Peat Marwick office had presented the following inquiry:
[W]hether [ ] Strategies (Ed Olsen) [sic] may act as interim president, for 15 months ($10,000 a month), for a public audit client. The purpose is to turn around the companies [sic] financial condition and develop a new strategy. [Peat Marwick] will continue to be the auditors during the turn around period and the original Chairman/CEO and a new CFO from industry will continue their roles.
(Div. Ex. 39.)
The e-mail went on to point out that Perry and Conway believed that it was not appropriate to have Olson act as interim president of an audit client unless "Strategies is truly independent and not controlled by [Peat Marwick], but the form [wa]s such that it [did] not work." (Div. Ex. 39.) In contrast, Trattou expressed both his belief that the situation could work if appropriate safeguards were taken and his concern that "[i]f we start identifying transactions that 'look' like problems then we weaken our position that BayMark is truly an independent company." (Div. Ex. 39.) Furthermore, Trattou wanted to "work [it] out with Lambert, Perry and Conway" before Vasquez got involved.17 (Div. Ex. 39.)
Although Conway never received this e-mail, he testified that at the time, he had two primary concerns with respect to the Peat Marwick-BayMark relationship. (Tr. 923.) The first was about the issues raised by the OCA staff regarding the relationship because he did not "understand where those issues were going to go." (Tr. 923.) The second was that Strategies was going to place someone into a key management position at a troubled company, and because Strategies was using the "KPMG" initials, there was a reputational risk if something went wrong.18 (Tr. 924.) However, Conway, at that time, was not aware of any conclusion by the OCA staff that Peat Marwick controlled BayMark; moreover, it has always been Conway's belief that Peat Marwick never controlled BayMark. (Tr. 924.)
(vii) Meeting on December 6, 1995
Perry's role as the lead representative for Peat Marwick in the meetings with OCA to discuss BayMark concluded with his letter of November 6, after which Conway became the primary spokesperson. (Tr. 795-96.) Conway testified that his first contact with Sutton regarding BayMark was sometime in November 1995 when Sutton called him to arrange a meeting to discuss OCA's concerns. (Tr. 862-64.)
The meeting was held on December 6, 1995. (Tr. 863-64.) At the meeting, Conway and Perry represented Peat Marwick while Sutton and Burns represented OCA. (Tr. 136, 864.) Also present were POB Chairman Al Sommer, and POB members Sullivan and Don Kirk. (Tr. 136.) Conway described the meeting as OCA and POB trying to learn more about BayMark and Conway trying to listen to their respective concerns. (Tr. 865.) Conway and Sutton both testified that the following specific items were raised by either OCA or POB and were discussed at the meeting: (i) the prohibition against conducting broker-dealer activities for audit clients, (ii) the "[e]quity and revolver loans" from Peat Marwick, (iii) the use of the "KPMG" name, and (iv) the royalty.19 (Tr. 136-38, 867-69, 929; Div. Ex. 40.)
Sutton agreed that neither he "[n]or anyone on the OCA staff [said] that Peat Marwick could not audit SEC registrants of [a] public company who would use BayMark or BayMark services," only that "[i]n substance, [it] was discussed." (Tr. 140.) Sutton did advise Conway, however, that the "working assumption" of the staff was that Peat Marwick effectively controlled BayMark. (Tr. 140.) Furthermore, in regard to the phrase, "Problem if [BayMark] doing anything [Peat Marwick] can't do," found in Burns's notes of the December 6 meeting, Sutton explained that this was a reference to his "concern" that he had "expressed" about viewing BayMark "as being an independent entity, separate and apart from Peat Marwick." (Tr. 142-43; Div. Ex. 41 at 3.) Otherwise, as Sutton stated "any services provided to an audit client by BayMark" would impair Peat Marwick's independence with respect to that client because those services would be viewed as being provided by that single entity. (Tr. 143.) According to Conway, Sutton did not at any time during this meeting insist that Peat Marwick stop auditing any BayMark clients.20 (Tr. 870.)
(viii) The Porta Audit - Trattou's December 8, 1995 Telephone Call
Trattou called Sturm on December 8, 1995, to get additional information about Porta but did not provide an answer to Sturm's early December inquiry. Trattou asked about Porta's fee for its 1995 audit, whether any audit procedures had started, and whether any subcontracting services had been or would be provided to BayMark. Sturm replied that the proposed fee for Porta's audit was $150,000, but had not been finalized. He also advised that no audit procedures had begun, and no subcontracting services had been planned or performed. Trattou explained that he needed the information to prepare for an upcoming meeting with the SEC and would get back to Sturm. (Tr. 705-08.)
(ix) Meeting on December 18, 1995
The next meeting was held on December 18, 1995. (Tr. 143-44.) Conway, Sutton, Burns, and staff from Market Regulation attended the meeting. (Tr. 144, 872-73.) Harvey Pitt (Pitt), a partner in the law firm of Fried, Frank, Harris, Shriver & Jacobson, also attended as counsel for Peat Marwick. (Tr. 873-74, 1065, 1067.) According to Sutton, the meeting was another opportunity for Peat Marwick and its attorney to "make their arguments why the [OCA] staff should view BayMark as not being a controlled entity at [ ] Peat Marwick, and why [OCA] should not object to the relationship" as impairing Peat Marwick's independence. (Tr. 144.)
Pitt was retained in early December by Peat Marwick to advise it as to whether the operating arrangement with BayMark complied with the SEC independence rules. (Tr. 1067.) In preparation for the meeting, Pitt and other attorneys from his firm reviewed the operating agreements between Peat Marwick and BayMark including the licensing agreement as well as other documentation. (Tr. 1067-68.) In order to prepare for the meeting, Pitt spoke with Burns prior to the meeting to determine the concerns of the staff. Burns advised "that Sutton was concerned about the way things looked [and] about some of the press reports that he had read." Sutton, according to Burns, also suggested "that it would be helpful if Peat Marwick could advise the staff of the types of arrangements it had with respect to BayMark and indicated that [Peat Marwick] should not overly dwell on legal issues as such." During this conversation, Burns also commented to Pitt that Sutton "was relatively new to the staff . . . [and] more concerned with appearances and the way things would look and embarrassment[,] than he was with legalities." Pitt replied that this was a different approach from his past practice in dealing with OCA and, from Pitt's perspective, it was the legalities that would control. (Tr. 1069-73.)
Pitt began his presentation by explaining to Sutton that he had been retained to provide a fresh perspective on the independence issue, and that he would illustrate how he arrived at the conclusion that there was no independence problem. However, Pitt's analysis of the independence issue was never completed because, according to Pitt, at some point during his presentation, Sutton made it very clear that he was not interested in whether "a lawyer could justify the proposed arrangements."21 Sutton "was concerned about the appearances and . . . wanted to focus on what he saw as the optics of the situation, not on the legalities."22 The discussion then proceeded to the "question of whether there could be some accommodation that would satisfy [ ] Sutton's concerns, as opposed to an explanation of why the relationships were appropriate under the Commission's rules." (Tr. 1075.)
Pitt also testified that prior to the meeting, Burns never informed him that the OCA staff had ordered or expected Peat Marwick to stop any BayMark-related activities; rather, Burns presented the situation to Pitt as one in which OCA knew that Peat Marwick was continuing its BayMark activities while both sides sought a "methodology that might give [ ] Sutton comfort that the situation would not be embarrassing." (Tr. 1076.) Pitt also stated that during the meeting, Sutton "made it quite plain that he wanted to find a workable solution, but at no time were there any directives given." (Tr. 1077.) Furthermore "there were generic discussions [at the meeting] about the fact that certain matters were ongoing," and after an overview of these ongoing matters by Conway, OCA's reaction was to have both sides "talk over the next few days and try to come up with something that would satisfy both the Commission staff and Peat Marwick."23 (Tr. 1077-78.)
At the hearing, Sutton reviewed Burns's notes of the December 18 meeting. Based on his review, Sutton testified that he had expressed the idea that if BayMark performed services that Peat Marwick could not, then Peat Marwick's independence would be impaired. Sutton further testified that he informed Peat Marwick at the meeting, that short of accepting an arrangement whereby BayMark could be viewed as independent, the only alternative would be to view independence on a client-by-client basis. (Tr. 145-46; Div. Ex. 43.) He also recalled "continuing to express concerns about the ability to view BayMark as [ ] an independent entity" and the impact the relationship would have on Peat Marwick's independence as an auditor. (Tr. 145.)
It was of some concern to Sutton that business was continuing during the discussion period (October 1995 through December 1995), but Sutton believed it to be more of a worry to Peat Marwick because Conway expressed uneasiness on a number of occasions "about having work in progress and needing . . . to have a resolution of the issues." Based upon what Conway was telling him, Sutton stated: "I was aware that work was going on. I was aware that he recognized that . . . with this cloud of independence hanging over the scene [ ] there was an issue for Peat Marwick." Thus, through January 1996, Sutton understood that Conway wanted to get the issues resolved as quickly as possible. (Tr. 189-92.)
(x) Burns's December 21, 1995 Memorandum
Sutton identified a document dated December 21, 1995, as a memorandum he asked Burns to write which analyzed OCA's position on the issues discussed in the meetings with Peat Marwick with the objective of coming to some agreement as to the "necessary changes to the [Peat Marwick-BayMark] structure to eliminate the staff's objections." (Tr. 147; Div. Ex. 46A.) As he reviewed Burns's memorandum, Sutton agreed that among the "minimum conditions" OCA insisted upon for the staff not to object to the alliance on independence grounds were: (i) removal of the "KPMG" name; (ii) cancellation of the 5% royalty; and (iii) repayment of loans made to individuals with the possibility that the working line of credit would have to be repaid. (Tr. 148.) These conditions never changed as discussions continued with Peat Marwick from December 1995 through February 1996. (Tr. 149.)
(xi) The Porta Audit - Sturm's Follow-up to Trattou's December 8, 1995 Telephone Call
Following Trattou's December 8 telephone call, Sturm had several conversations with Trattou. (Tr. 708.) In late December, Sturm learned that there were going to be some modifications made to the strategic alliance so that it would be acceptable to the SEC. (Tr. 709.) Sturm stated: "I was specifically told [the SEC was] aware of the Porta situation and that I should proceed with the audit unless I heard otherwise and that even if there was an issue [with] the Porta situation, because everybody knew about it, it would be grandfathered." (Tr. 709.) The only specific modification that Trattou mentioned to Sturm concerned the removal of the "KPMG" initials from BayMark's name. (Tr. 712.) Sturm testified that this conversation with Trattou occurred during the period December 9-26, 1995.24 (Tr. 711-13, 740-41.) Trattou told him that the Porta situation, by name, was specifically discussed with the SEC. (Tr. 716-18, 740-41.) Sturm knew that Trattou had been conferring with a Peat Marwick partner and believed that partner was Conway. (Tr. 741.) Had he received any negative information from DPP in October over the BayMark arrangement, Sturm would have advised Porta that if it hired BayMark, Peat Marwick would no longer be independent and could not do the audit. (Tr. 832.)
(xii) Meeting on December 26, 1995
The next meeting between Conway and Sutton occurred on December 26, 1995, when they met alone at Sutton's office. (Tr. 149, 876.) The overall purpose was to discuss the changes that "needed to be made and to have [Conway] consider the [OCA] staff's views on those issues." (Tr. 149.)
Conway believed that the meeting would be an opportunity to "somehow . . . negotiate what [would] be worked out with [Peat Marwick's] relationship with BayMark." (Tr. 876.) Prior to the meeting, Conway prepared notes as a guide for his discussions with Sutton. (Tr. 876-77; Resp. Ex. 26A.) In the top portion of his notes, Conway identified the equity loans and revolving line of credit, the use of the "KPMG" name, and the royalty arrangement as representing OCA's primary concerns with the Peat Marwick-BayMark relationship. (Tr. 877-78; Resp. Ex. 26A.) Going into the meeting, Conway was prepared to lay the groundwork to resolve these issues and to negotiate at least some of them with BayMark. (Tr. 879; Resp. Ex. 26A.) Conway's notes referred to Pitt's prior advice that Peat Marwick had "good legal grounds" to pursue "the existing relationship with BayMark," and Peat Marwick's attempt to properly structure the relationship in order to have a relationship with a firm that could perform activities that Peat Marwick could not. (Tr. 879-80; Resp. Ex. 26A.)
Additionally, Conway wanted to express to Sutton that although Peat Marwick could fight them, he did not want an adversarial relationship to develop because Peat Marwick dealt with the SEC on a regular basis. (Tr. 880; Resp. Ex. 26A.) Conway also wanted to make clear for Sutton that the 1994 KPMGCF documents originally presented to OCA described both the current BayMark structure and Peat Marwick's desire for a "no objection," which it sought from OCA in accordance with past protocol.25 (Tr. 880-81; Resp. Ex. 26A.) Finally, Conway intended to convey to Sutton that Peat Marwick had put everything on hold, including referrals to BayMark, pending settlement of the matter; had acted in good faith when it met with the OCA staff in 1994; and had invested a considerable amount of energy, effort, and money into the BayMark relationship. (Tr. 881-82.)
Conway's notes for the December 26 meeting also included a section which read as follows: "Need to finish engagements contracted for -- both BayMark and Peat Marwick," with "(4 Buy deals, 1 [management] workout, 1 looking for equity) +18 'on hold'" written below it. (Tr. 882; Resp. Ex. 26A.) According to Conway, this notation identified six engagements where the respective companies had, at that point, service contracts with BayMark and were simultaneously Peat Marwick audit clients;26 therefore, Peat Marwick had to know "fairly soon" if they could continue or had to stop those engagements. (Tr. 882-83.) Conway testified that he wanted to make sure that Sutton understood that "we had those engagements in process and wanted, frankly, his yea or nay as to whether or not they could go forward. " (Tr. 883.) Conway also had "Need to resolve ASAP -- This week" in his notes because it was near the end of December, and some of these simultaneous clients of Peat Marwick and BayMark would need a year-end audit. (Tr. 883; Resp. Ex. 26A.) Conway thought the six engagements were discussed at the December 26 meeting because of the notation, "work-out engagements -- concern of [Sutton]'s" found in his notes27 of the meeting, and if not, he was sure that they were at least discussed in a subsequent telephone call.28 (Tr. 888-89, 892; Resp. Ex. 155.)
Similarly, Sutton agreed he was generally aware that Conway was seeking to resolve these matters quickly because of Peat Marwick and BayMark's ongoing business activities. (Tr. 189-90.) Sutton initially testified that he was told about the eighteen other engagements which were "on hold" but then stated he did not have a specific recollection of Conway telling him that "six [engagements] were going on and the eighteen were on hold."29 (Tr. 198.) Sutton later explained that he may have known that Peat Marwick had six ongoing engagements but that during the December 26 meeting, he neither approved of them nor instructed Conway to stop any of them. (Tr. 204-05.)
Sutton's notes of the December 26 meeting describe what Conway told him as: "4 buy deals-looking for acquisitions [nothing today]; 1 strategies-assistance to troubled companies; work-out; top line management [KPMG could not do]; 1-looking for partners; 18 on hold-no agreements signed." (Resp. Ex. 38A.) According to Conway, "KPMG could not do" meant that Peat Marwick could not have an audit client where it had someone running the company. (Tr. 900.) Conway further testified that he communicated the information in essentially the form Sutton wrote in his December 26 meeting notes, and although Porta was not identified by name,30 he remembered "specifically saying that there was someone from Strategies running a company." (Tr. 900.) Sutton understood that the Strategies engagement involved consulting work, and while he agreed that auditors may perform consulting work, Conway told him that the kind of consulting work Strategies was doing was work Peat Marwick could not do.31 (Tr. 208-09.)
Conway testified that he initially did not get far down his list of points because Sutton got upset when Conway brought up the fact that Peat Marwick could fight the SEC on the matter, and he thought the meeting would end right there. (Tr. 887.) Nonetheless, the meeting continued with a clarification of what issues needed to be addressed and what changes Sutton thought would be appropriate; however, they did not agree that those changes would necessarily be made immediately. (Tr. 888.) Overall though, the meeting led to the understanding that the removal of the "KPMG" name, the cancellation of the royalty arrangement, and the repayment of the individual loans would be the primary changes necessary in order for the OCA staff not to object to the Peat Marwick-BayMark relationship. (Tr. 148-50, 888, 897.) When questioned about how he felt at the end of the meeting, Conway stated: "I [thought] that [we were] essentially in agreement" with the understanding that there would be a follow-up telephone call to discuss whatever was still pending such as information regarding the loans. (Tr. 895-96.)
(xiii) Telephone Meeting on December 28, 1995
As a follow-up to the December 26 meeting, Conway and Sutton spoke again by telephone on December 28. At the conclusion of that telephone call, Conway believed that both he and Sutton were in agreement that the six ongoing engagements could continue and that they had completed their discussions with regard to the issues raised by Sutton and his staff. (Tr. 901-02.) Sutton similarly testified that they had discussed the minimum conditions required by OCA, and that Conway had agreed that Peat Marwick could make those changes in order to resolve the Peat Marwick-BayMark structural concerns. Additionally, Sutton invited Conway to write a letter to memorialize the points discussed and resolutions reached in order to avoid any future confusion. (Tr. 151.)
Sutton testified that from the outset of his meetings with Peat Marwick, he had concerns and reservations about the Peat Marwick and BayMark alliance which eventually led to objections. However, Sutton could not remember two drafts of letters written by Burns and dated November 7 and December 7, 1995, which would have expressed these objections based on independence grounds but were never sent to Perry or Conway. (Tr. 186-88; Resp. Exs. 91, 126.) Nor could Sutton offer any reason why these letters were not sent. Instead, Sutton conceded that what was occurring through his series of meetings with Peat Marwick was an attempt to resolve the issues at hand. (Tr. 187-89.)
c. Conclusion of Discussions between Peat Marwick and OCA
(i) Conway's December 29, 1995 E-mail
After the December 28 telephone meeting, Conway sent out an internal e-mail dated December 29, 1995, summarizing where Peat Marwick stood after the most recent discussions with the SEC about the BayMark structure.32 (Div. Ex. 48.) The second page of the e-mail contained the following passage:
Mr. Sutton said that he was going to try to get the matter resolved on the basis that we discussed and that, if resolved quickly, he thought that BayMark would be able to complete the engagements in process without jeopardizing our independence with respect to our SEC audit clients. Mr. Sutton needed to discuss the matter with others before he came to a final conclusion (I assume one of the "others" is [Commission Chairman] Arthur Levitt).
(Div. Ex. 48 at 2.)
In regard to this portion of his e-mail, Conway believed that if Sutton received approval for the agreement he and Sutton had worked out, then all Peat Marwick had to do was start its discussions with Market Regulation. (Tr. 958.) With respect to this part of the e-mail, Sutton similarly testified:
The emphasis on the discussion in my mind was that the solution to this problem was to resolve these structure issues and do so quickly so that these engagements wouldn't be continuing under a cloud . . . about the independence of the firm with respect to the audit clients.
(Tr. 155-56.) By "quickly", Sutton meant to resolve the situation "before audit work had progressed to the point where it would be impossible to conclude . . . that the firm was not independent." (Tr. 156.)
(ii) Sutton E-mail on January 3, 1996
Conway contacted Sutton by telephone on January 3, 1996, to inform him that Peat Marwick was ready to negotiate with BayMark to make the changes that OCA wanted in the Peat Marwick-BayMark alliance including, among other things, removal of the "KPMG" name from BayMark, the cancellation of the royalty arrangement, and repayment of the equity loans made to BayMark principals. (Resp. Ex. 96.) Conway testified: "we essentially had the handshake that we were done. We agreed that we were going to go talk to [M]arket Reg[ulation]. I was frankly quite happy that we were finished." (Tr. 902.)
Later that same day, Sutton sent Burns an e-mail that read, in pertinent part, as follows:
Mike wants to begin formalizing the arrangements, but wants to be sure that we are satisfied before putting the lawyers to work. I told him that we would get back to him in the next day or so.
You should have whatever discussions you think we should have with Market Reg[ulation] to let them know what we are doing so that we can give appropriate direction to Mike.
(Resp. Ex. 96.)
Conway affirmed that this part of Sutton's e-mail accurately described what he was thinking in that he wanted to put Peat Marwick's lawyers to work on the negotiations as soon as possible. (Tr. 904.) Peat Marwick was no longer doing business with BayMark and could not resume doing business with BayMark unless the outstanding issues with the SEC were resolved.33 (Tr. 903-04.) Conway understood that Peat Marwick's counsel was to begin discussions with Market Regulation and that the changes OCA wanted could not be made until matters were clarified with Market Regulation.34 (Tr. 907.)
From Sutton's viewpoint, he knew that Peat Marwick was essentially "on hold" in regard to negotiating any structural changes with BayMark until OCA got back to them. (Tr. 245-46.) Because OCA and Peat Marwick had an agreement in principle that Sutton was comfortable with, he viewed the matter, at that point, to be procedural. His e-mail was a direction to the staff to follow up.35 (Tr. 246-48.)
(iii) Burns's Memorandum to Sutton on January 5, 1996
As instructed by Sutton's January 3 e-mail, Burns met with Catherine McGuire (McGuire), Chief Counsel for Market Regulation, to discuss BayMark.36 (Tr. 372; Div. Ex. 49.) He sent a memorandum regarding this meeting to Sutton that same day. (Div. Ex. 49.) In this memorandum dated January 5, 1996, Burns also summarized his follow-up telephone conversation with Conway, as requested by Sutton's January 3 e-mail. This portion of the memorandum reiterated the fact that OCA's approval of the strategic alliance would be predicated on clearance by Market Regulation by stating the following:
My discussion [today] with [ ] Conway was fairly brief. I told him that OCA was comfortable with the proposals he had made but we could not give him any approval or clearance until the Market Regulation issues were resolved. He seemed to accept that without argument and said that he took that to mean unless something blows up in the Market Reg[ulation] discussions, OCA would no longer object based on auditor independence concerns.
(Div. Ex. 49.)
(iv) Confirmation Letters between Conway and Sutton
As suggested by Sutton in their December 28, 1995 telephone call, Conway wrote to Sutton on January 29, 1996, to verify Peat Marwick's understanding of the discussions with OCA during the period from September 1995 until January 1996 concerning its strategic alliance with BayMark. (Div. Ex. 53.)
Conway's letter set forth the terms and conditions of the agreement Peat Marwick had reached with OCA. (Div. Ex. 53.) Peat Marwick would make the following modifications to the strategic alliance: (i) removing the "KPMG" initials from use by BayMark including its subsidiaries, Capital and Strategies; (ii) eliminating the 5% royalty fee; and (iii) requiring Maughan, Taffet, Armel, and Olson to repay their existing $100,000 loans. (Div. Ex. 53.) Conway added that all modifications remained subject to negotiation with BayMark and noted that:
OCA also has informed [Peat Marwick] that the OCA reserves the right to reopen this determination if . . . Market Regulation concludes that [Peat Marwick] is required to register as a 'broker' . . . by virtue of the activities performed by [Peat Marwick] itself or by [ ] Capital in the context of the strategic alliance.
(Div. Ex. 53.)
Sutton then sent Conway a reply letter dated January 31, 1996. (Div. Ex. 54.) As part of his response, Sutton agreed that "the OCA would not raise objections based on independence grounds if certain conditions [the three set out above] are met."37 (Div. Ex. 54.) Whereas Conway's understanding was that OCA had the "right to 'reopen'" the independence issue depending on the outcome of Market Regulation's findings, Sutton's understanding was that "the independence issues raised by OCA . . . [would] remain open until all issues raised by . . . Market Regulation ha[d] been resolved" with OCA's final decision "based on the information provided to the staff by Peat [Marwick] and BayMark." (Div. Ex. 54.) According to Sutton, the distinction was needed since the issue about whether or not BayMark was controlled by Peat Marwick "was a very important issue in terms of assessing . . . the independence of BayMark as an entity and its relationship with Peat Marwick." (Tr. 163.) Sutton also testified that he had no discussion or expectation that the name, royalty, loan repayment, or market regulation issues would be resolved in any particular sequence. (Tr. 164.)
Conway replied by letter dated February 14th, 1996, and stated that "[o]ur respective recollections are generally consistent." (Div. Ex. 61.) Conway also affirmed Peat Marwick's previously made oral representation "that a hypothetical failure by BayMark to repay the balance of the revolving line of credit would not be material to the income or benefits of any individual [Peat Marwick] partner." (Div. Ex. 61.) After the February 14 letter, Sutton did not recall having any further personal involvement in the matter, although he knew that discussions were underway with Market Regulation. (Tr. 165.)
d. The Porta Audit - Sturm's March Contact with Conway
Sturm's first contact with Conway occurred after March 22, 1996,38 the date the audit report39 was completed and signed.40 (Tr. 731.) While reviewing a draft of Porta's Form 10-K, Sturm noticed that "Olson was listed as KPMG BayMark" so he called Conway to determine whether or not that was proper. (Tr. 731-32.) Conway told him that the "KPMG" initials were in the process of being removed from BayMark's name, but the name change would not be effective until BayMark had its annual meeting to legally change the name. (Tr. 732.) Sturm also stated that in this conversation or one which followed within twenty-four hours, he asked Conway again to verify that there were no independence problems. (Tr. 732-33.) Conway replied that there were none. (Tr. 733.) Sturm affirmed that neither he nor any member of his audit team had any knowledge concerning the terms of Peat Marwick's relationship with BayMark such as the loan to Olson, the royalty, or the financing arrangements during the time they were conducting the audit. (750-52.)
Olson too, testified that he had gone out of his way not to be involved with the auditing process due to independence concerns as instructed by Vasquez prior to the time BayMark began operating its business. (Tr. 587-88.) Instead, he focused on the operational aspect of Porta's business in an effort to get the company running efficiently, not on Porta's financial operations. (Tr. 589.) Olson also testified that no one from Peat Marwick controlled him or told him what he should be doing at Porta. (Tr. 590.)
e. OCA's Determination that Peat Marwick Lacked Independence
In the spring of 1996, Sutton learned that Van Brunt had made a search on the Commission's Electronic Data Gathering, Analysis, and Retrieval system (EDGAR) in which he matched up the names of Peat Marwick and BayMark and found a filing under the name Porta Systems. (Tr. 166, 604-05.) The EDGAR search led to the discovery that Peat Marwick had conducted an audit for Porta, that a BayMark subsidiary was providing "turnaround services" for Porta, and a BayMark officer was also serving as an officer for Porta. (Tr. 605-06.) Upon learning this, Sutton stated that he was "stunned." (Tr. 166.) He "couldn't understand how Peat Marwick would have considered itself to be independent with respect to that engagement when you looked at the facts and circumstances" including: Olson acting as president, the loan to Olson, a contingency or "success" fee, and a royalty payment, all of which would impair Peat Marwick's independence based on SEC rules. (Tr. 166-67.)
Before departing on vacation, Sutton instructed Burns and Van Brunt to speak with Peat Marwick about the situation and to gather facts. Sutton planned to address the issue upon his return. (Tr. 170.) Subsequently, and as reflected by a Memorandum of Telephone Call prepared by Burns dated May 21, 1996, Burns, along with Van Brunt, Bayless, and members of Market Regulation called Conway on May 20, 1996, to inform him that the staff concluded that Peat Marwick was not independent with respect to the Porta audit. During this telephone call, Burns explained to Conway that the staff's conclusion was based on two reasons. First, until the agreed-upon changes were instituted, OCA still considered Peat Marwick and BayMark to be one entity so that Peat Marwick could not be both auditor and manager for one client. (Div. Ex. 71.) Secondly, the capital loans to BayMark, of which Olson was a 25% owner, would, in effect, be a loan from an auditor to a member of its client's management and would violate independence in fact and in appearance. Burns told Conway that the matter had been discussed with Sutton who "was surprised that BayMark had assumed management of one of Peat [Marwick]'s SEC audit clients." According to Burns, Conway replied that Peat Marwick informed the staff in the fall of 1995 that BayMark was managing turnaround companies. Burns responded that he did not recall receiving such information and even if it was known that BayMark might provide management services, the staff certainly did not have any idea that such services would be offered to audit clients. In the end, Conway expressed his desire to speak with Sutton before the matter was referred to the Division of Corporation Finance (Corporation Finance). (Div. Ex. 71.)
On May 22nd, Conway wrote to POB41 and set out his understanding of the tentative agreement with the SEC concerning the issue of auditor independence including the required changes to the structure of Peat Marwick's alliance with BayMark, as reflected in Conway's January 29 letter to Sutton. (Div. Exs. 72, 53.)
Conway then wrote to Sutton on May 30 to explain why Peat Marwick believed that its independence was not impaired with respect to the Porta audit. (Div. Ex. 73.) Conway stated, in part:
[I]n light of the nature and content of Peat Marwick's contacts with [OCA], I must confess that I found the views conveyed by [Burns] to be both surprising and troubling.
As you know, Peat Marwick has taken a number of steps to keep the OCA apprised of developments in connection with the strategic alliance in general and with SEC attest clients in particular. Peat Marwick consulted with the OCA prior to and following the establishment of the strategic alliance. During these consultations, Peat Marwick also informed the OCA that it proposed to make loans to its strategic alliance partner for working capital purposes. During those consultations, Peat Marwick informed the OCA that its strategic alliance partner intended to provide services to troubled companies in the context of turnaround or bankruptcy, including providing personnel to run companies on an interim basis.
In addition, Peat Marwick disclosed to the OCA in general terms (without naming individual clients) the existence of certain engagements between BayMark and SEC attest clients of Peat Marwick. In this regard, Peat Marwick revealed the nature of the Porta [ ] engagement to the OCA in late 1995, including specifically that [ ] Strategies provides personnel to run companies on an interim basis.
(Div. Ex. 73 at 1-2.)
Conway wrote further that Peat Marwick agreed to the changes that OCA wanted in order to resolve independence issues, but negotiating and implementing them was held up due to OCA's desire to defer final resolution until any outstanding issues with Market Regulation were resolved. (Div. Ex. 73 at 2.) He believed that "all relevant circumstances," within the meaning of Rule 2-01 of Regulation S-X were considered and that Peat Marwick was in fact independent from BayMark.42 (Div. Ex. 73 at 2.)
When Sutton returned from vacation, Burns reported that Conway had requested a meeting with OCA before any action was taken. (Tr. 170.) A meeting with Peat Marwick and its counsel took place on June 20, 1996. (Tr. 170.) Sutton advised Peat Marwick that OCA did not believe that it was independent with respect to the Porta audit. (Tr. 170-71.) According to Bayless, who took notes at this meeting, a "pretty heated dispute" took place between Conway and Sutton. (Tr. 653; Resp. Ex. 54.) Bayless recalled Conway saying: "I told you months ago about the Porta [ ] engagement and the fact that BayMark was managing the turnaround situation in that engagement." (Tr. 654.) According to Bayless, Sutton responded that he did not recall Conway saying this. (Tr. 656-57.) This exchange continued with Conway insisting again that he told Sutton about Porta and Sutton again denying it. (Tr. 910.) Conway believed that Sutton and his staff had objected to the Porta audit because someone from BayMark was performing management tasks at Porta. (Tr. 910.) As to Conway's insistence that he had informed Sutton of BayMark's management relationship with Porta, Bayless testified:
I think there was a general reference to providing services in turnaround situations at all times during the meetings with [Peat Marwick]. And I think [ ] Conway's comment [at the meeting] is consistent with [Peat Marwick]'s consistent representation. And that was that they provided services in turnaround situations.
The OCA staff then sent Porta a letter dated June 21, 1996, informing the company that OCA considered the financial statements for the year ended 1995 that were filed in Porta's Form 10-K to be unaudited because of "the existence of financial, operating, and other relationships among" Olson, Baymark, and Peat Marwick. (Resp. Ex. 20.) Therefore, Porta would be required to have another public accountant audit their financial statements for the year ended 1995. (Resp. Ex. 20.)
Bayless testified that OCA, in making the determination that Peat Marwick lacked independence, felt uninformed with respect to all aspects of Porta and there might have been additional facts learned in the investigation. (Tr. 664-65.) Bayless also stated that OCA was still unsure about all the facts surrounding the Peat Marwick-BayMark relationship, and he did not want any issues to develop that would not be part of the June 21 letter. (Tr. 665-66.) Moreover, a draft of this letter has a notation which states:
Roy [Van Brunt]:
I think, at this point, [OCA] may want to not focus on specific reasons-such as the loans-for a lack of independence. It may be better to leave it open-ended and see what develops in the investigation.
Also, we'll have to make sure George approves this before it goes out.
(Resp. Ex. 113.) As a result of OCA's decision that Peat Marwick was not independent, Porta had a second audit, paid for by Peat Marwick, conducted by another auditing firm which had reached the same results as the audit completed by Peat Marwick.43 (Tr. 239-40.)
f. Division of Market Regulation's Interactions with Peat Marwick and OCA
McGuire testified that in 1994 Market Regulation was advised by OCA that Peat Marwick was interested in creating an entity that might raise broker-dealer issues. (Tr. 372-73.) Although she had some expectation that Peat Marwick would contact her office regarding this proposed new entity, no such contact occurred at that time. (Tr. 373-75.) She first heard of a new broker-dealer called "KPMG BayMark" in September of 1995. (Tr. 375.) Because Market Regulation had no prior contact with Peat Marwick, they began doing routine fact gathering during November or December 1995 which consisted of examining the Form BD44 and the Peat Marwick-BayMark licensing agreement which was obtained from the National Association of Securities Dealers (NASD). (Tr. 375-76, 381.)
McGuire's first meeting with Peat Marwick and its counsel was on December 18, 1995. Also present were representatives of OCA and of the General Counsel's office. Her recollection was that the purpose of the meeting was for Peat Marwick to explain the business to those who had concerns about it. (Tr. 385.) McGuire knew that OCA and Peat Marwick held meetings prior to December 18; however, she had no idea what discussions had taken place between them or the content of any other meetings. (Tr. 411.)
McGuire next met with Burns on January 5, 1996, to discuss the Peat Marwick-Baymark situation. (Tr. 385-86; Div. Ex. 49.) She agreed with Burns's written assessment, expressed in his January 5, 1996 memorandum to Sutton, that she was optimistic about the entire situation, especially given Conway's proposed modifications. (Tr. 385-86; Div. Ex. 49.) McGuire stated that she was not clear on what OCA's position was because she never met directly with Sutton,45 and her attention was focused more on the fact that OCA might be "racing ahead" of Market Regulation on these matters, which she did not want to happen. (Tr. 415.) Nonetheless, she stated that her optimism was based on Peat Marwick's flexibility "about the royalty and the other issues" and eagerness "to work something out" as well as their willingness to "let Baymark be more free" in order to avoid the problems created by "being in charge of the relationship." (Tr. 386-87.) McGuire was also aware of the proposed repayment of the loans but not the removal of the "KPMG" name from BayMark. (Tr. 416-17.) McGuire also testified that sometime in early January, Burns or Sutton told her that OCA and Market Regulation could work on this matter together but that they did not want it to drag on. (Tr. 423.)
According to McGuire, some provisions of the licensing agreement, which she identified earlier as problem areas, would have to be changed. (Tr. 377, 387-89.) For example, McGuire believed that the royalty would have to be changed to a fixed fee from a percentage arrangement and that the broker-dealer function would have to be "set free" so it could function without approval of Peat Marwick. (Tr. 388-89.) She also expected to receive an opinion from Peat Marwick's counsel that it did not control the broker-dealer, and a no action letter with respect to any subcontracting issues that remained in the Peat Marwick-BayMark relationship. (Tr. 389-90.)
McGuire attended another meeting with Peat Marwick's counsel and BayMark's counsel on January 17, 1996. (Tr. 394; Div. Ex. 52.) Based upon Paula Jenson's (Jenson) notes of this meeting,46 McGuire remembered voicing her concern that Peat Marwick "appeared to be focusing on their relationship with [OCA]" but neglecting the broker-dealer issues. (Tr. 395; Div. Ex. 52.) She wanted to let Peat Marwick know that the broker-dealer issues were very important and had previously caused problems for Price Waterhouse. (Tr. 395; Div. Ex. 52.) McGuire also made a number of comments and requests for clarification at the meeting regarding the question of whether Peat Marwick was "engaged in the business of effecting transactions in securities." (Tr. 395-99.) The last reference to Jenson's notes related to McGuire's willingness to work with OCA. (Tr. 400.) However, because of a prior experience with another accounting firm where Market Regulation refused to approve the arrangement, she felt this would be an "uphill battle" unless Peat Marwick both limited itself to finder's activities in order to avoid having to register as a broker-dealer and filed a no action letter representing the same. (Tr. 400-01.) Otherwise, it would be determined that Peat Marwick was engaged in the investment banking business and would, therefore, have to register as a broker-dealer. (Tr. 401.) McGuire stated that Peat Marwick was under no legal obligation to seek a no action letter from her office before it carried out any type of business; its only legal obligation was to register if it was considered a broker-dealer. (Tr. 427.)
g. The No Action Letter Process
McGuire identified Burns's notes of a conference call she had on February 12, 1996, with Sidley & Austin, the law firm that represented Peat Marwick during the no action letter process. (Tr. 442-43; Resp. Ex. 44.) During this call, she identified eight items that she wanted covered by the no action letter which was initially submitted approximately two months after this conference call.47 (Tr. 443-45.) During that interim, McGuire was not sure if there were discussions between Market Regulation and Sidley & Austin or Market Regulation and OCA, and she was unable to recall whether anyone from OCA contacted her in February or March protesting how long the process was taking. (Tr. 445-46.)
McGuire indicated that BayMark seemed to want the no action letter finished before renegotiating the licensing agreement, but for her, the important thing was that the licensing agreement match whatever was set out in the no action letter. (Tr. 438-39.) She also explained that she thought it would make more sense to renegotiate the licensing agreement before preparing the no action letter. (Tr. 447-48.)
David Miles (Miles), a partner at Sidley & Austin who was responsible for the preparation of the first and second draft no action letters dated April 12, 1996, and June 13, 1996,48 respectively, participated in the February 12 conference call. (Tr. 443, 1129, 1131-32; Div. Ex. 67 (first draft), Div. Ex. 74 (second draft)). Miles testified that the discussion revolved around what items Market Regulation wanted to see in the no action letter and that he complied with McGuire's request by including the eight items she wanted in the first draft. (Tr. 1133, 1149-52; Resp. Ex. 44.) During the time between the conference call on February 12 and the submission of the first draft on April 12, Miles stated that there were "a number of things that need[ed] to be done" beginning with considering and comprehending what McGuire had gone over during the conference call. (Tr. 1152-53.) Additionally, there was a large amount of research and analysis involved with the first draft, as reflected by the numerous legal authorities cited, and many of the items that were raised by McGuire led to follow-up conversations with the Market Regulation staff. (Tr. 1153-56.) Miles stated that the first draft no action letter was lengthy because he wanted to make sure its description of what the Capital business would entail was "as clear and complete as" possible.49 (Tr. 1148-49.)
McGuire's optimism over Peat Marwick's willingness "to work things out" eventually turned to concern after Market Regulation's receipt of the first draft no action letter. (Tr. 391.) In McGuire's opinion, the letter was "too long to make the simple representations that [she] wanted to [be made]." (Tr. 404-05.) After its review of this draft, Market Regulation advised Peat Marwick's counsel on "what things he had to take out [of the first draft no action letter] and where he had to make stronger representations" in the draft. (Tr. 405.)
The second draft was submitted on or about June 13, 1996. (Tr. 406; Div. Ex. 74.) McGuire felt that this version was still too long and not what she wanted. (Tr. 406-07.) However, a third draft was never submitted because issues concerning Porta arose and led to the dismantling of the business alliance. (Tr. 1173; see also Resp. Ex. 20 (OCA letter to Porta dated June 21, 1996, stating that OCA considers its financials for the year ending 1995 to be unaudited)).
h. Expert Witness Testimony
(i) Dr. Douglas R. Carmichael
Dr. Douglas R. Carmichael (Carmichael) was qualified as an expert witness and testified on behalf of the Division. (Tr. 270; Div. Ex. 93.) He is a Certified Public Accountant (CPA) and Certified Fraud Examiner and currently holds the position of Wollman Distinguished Professor of Accountancy at Baruch College of the City University of New York (Baruch). (Tr. 270.) He has a Bachelor's Degree in Economics, a Master of Accounting Science Degree, and a Ph.D. in Accountancy, all from the University of Illinois. (Tr. 270.) In addition to teaching auditing for the past fifteen years at Baruch and several other universities, he has edited, published, and consulted on accounting, auditing, and ethics. (Tr. 271-73; Div. Ex. 93.) He has also testified as an expert witness for and against the then "Big 6" accounting firms. (Tr. 273.)
After reviewing relevant documents, investigative testimony, and various exhibits, Carmichael was of the opinion that Peat Marwick was not independent when it performed the Porta audit, which constituted a "very serious departure" from generally accepted auditing standards (GAAS). (Tr. 276-78.)
Carmichael explained that independence requires both "independence in fact" and "independence in appearance." (Tr. 278.) He described "independence in fact" as the auditor's mental attitude: "What's going on in the auditor's own mind. It's the auditor's ability to act with integrity, to tell the truth, as the auditor sees it." (Tr. 279.) "Independence in appearance," on the other hand, includes "precepts that the accounting profession collectively has decided are necessary to maintain the confidence of the investing public" as well as other things that might, in a particular set of circumstances, cause doubt as to an auditor's independence in the minds of the people using the auditor's work. (Tr. 279.) "Independence in appearance" is very important because it involves things people can observe; "independence in fact" is not observable as it requires assessing the auditor's thought processes. (Tr. 280.)
In his opinion, "Peat Marwick violated both the letter and the spirit of ethical and technical standards on independence." (Tr. 280-81.) Peat Marwick violated not only GAAS, specifically the general standard on independence as explained in literature promulgated by the American Institute of Certified Public Accountants (AICPA),50 but also Rules 101 and 30251 of the AICPA Code of Professional Conduct (AICPA Code) which are referred to by the GAAS standards in determining independence. (Tr. 281-82.) Carmichael was also of the opinion that Peat Marwick violated SEC Rules 2-01 and 2-02 of Regulation S-X, which deal with independence and issuing a report in conformity with GAAS, respectively. (Tr. 282-83.) He stated that the SEC regulation is, in effect, "referring to the standards of the accounting profession as the standard to be followed." (Tr. 283.) Carmichael understood that he was called upon to testify as an expert on independence and GAAS in so far as they may be referred to in Regulation S-X. (Tr. 284.)
In reviewing the relevant independence standards and explaining the interrelationship between the rules of the SEC and the principles of GAAS, Carmichael pointed out that independence in appearance is required in order for audits to comply with GAAS and that once independence is found to be impaired, neither the accuracy nor care in carrying out the audit matters. (Tr. 285-310; Div. Ex. 94.) Carmichael cited several factors as the basis for his opinion that Peat Marwick's independence was impaired: (i) Olson had a loan from Peat Marwick while he served as president and COO of Porta, (ii) the arrangement for Peat Marwick to receive fees of 5% of BayMark's income which in turn would receive a flat fee plus a success fee from Porta, i.e., a royalty or contingent fee arrangement, (iii) Peat Marwick effectively controlled BayMark, and (iv) Peat Marwick had a material indirect financial interest in Porta. (Tr. 310, 312-13, 316, 323; Div. Ex. 95.)
With respect to the royalty or contingent fee arrangement, Carmichael acknowledged that Peat Marwick never actually received a royalty; however, it was the arrangement among Peat Marwick, BayMark, and Porta permitting Peat Marwick to receive a determinable fee that constituted a violation, not the actual receipt of any funds. (Tr. 339-40.)
He believed, in regard to control, that Peat Marwick violated the AICPA rules because it qualified as having control over BayMark. (Tr. 342.) However, Carmichael testified that he did not, in fact, apply the "concept of control that is discussed in FASB Statement 94" which is referenced as a source for the definition of control in Interpretation 101-9 of the AICPA Code. (Tr. 343-46; Resp. Ex. 201.) He also explained that although "the fact that Peat Marwick was the sole source of funding for the equity and the debt of BayMark [wa]s certainly a part of [his] opinion," under the AICPA standards and pronouncements, a loan, by itself, does not necessarily establish that the lender controls the borrower. (Tr. 362-63, 366.)
Finally, in addition to constituting a contingent fee arrangement in violation of Rule 302, which deals with contingent fees, Carmichael opined that the business arrangements between Peat Marwick and BayMark, and BayMark and Porta constituted a "material indirect financial interest" by Peat Marwick in Porta as that term is used in the independence rules. (Tr. 452-53.) His assessment that the indirect financial interest was "material" was based on a qualitative standard wherein he believed that Peat Marwick considered the relationship as material and important to it, not a quantitative standard. (Tr. 453-55.)
Carmichael did not interpret the independence rules to mean that if something "looks bad" or does not "look independent," an accountant can be sanctioned for it. (Tr. 463.) Rather, he testified, that "the basic notion is that you would look to whether a reasonable person informed of all the facts and considering the normal constraints that apply to professional activity and the [countervailing] forces that apply, would reach a conclusion that there was a serious risk of impairment." (Tr. 464-65.)
(ii) Thomas P. Kelley
Thomas P. Kelley (Kelley), a CPA, was qualified as an expert witness for Respondent on issues of auditor independence. (Tr. 986-90.) He retired in 1995 and now spends about 25% of his time as a consultant assisting firms in the area of professional standards. (Tr. 986.) He earned a Bachelor's Degree in Accounting from Merrimac College in 1961 and immediately joined Arthur Andersen, an accounting firm, where he remained until 1973. (Tr. 986.) He then left Arthur Andersen as a senior audit manager to join the staff of the AICPA. (Tr. 986-87.)
Kelley was an auditor for twelve years and worked on approximately 200 audits. (Tr. 987.) He served on several AICPA committees and, from 1984 until 1995, held the position of AICPA Group Vice President - Professional in which he oversaw all professional activities except for taxation. (Tr. 987-89; Resp. Ex. 205.) His area of responsibility included auditing and ethics, the self-regulatory efforts of the divisions and firms such as the SEC practice section, and the professional ethics division. (Tr. 988.) This position also exposed Kelley to independence rules promulgated by the AICPA because the Director of the Professional Ethics Division, which is the division that promulgates the independence rules for the industry, had to report directly to Kelley. (Tr. 988-89.) Furthermore, as part of his responsibilities in ethics, Kelley "was to obtain and review the agenda materials for the meetings, to edit drafts, occasionally write drafts from scratch, participate in as many meetings in the ethics executive committee as [he] could and offer [his] input, both on drafts of interpretations and rulings that were underway." (Tr. 988.)
To prepare for his testimony, he read the OIP and other documents relating to the formation and capitalization of BayMark, along with the royalty agreement and dissolution papers. (Tr. 990-91.) He also read investigative transcripts, the report and hearing testimony of the Division's expert, the Porta Form 10-K, Peat Marwick's financials, the relevant technical and ethical standards of the AICPA, the relevant rules of the SEC, and other documents. (Tr. 991-92.)
Based upon his analysis of the documents and testimony, his opinion was that Peat Marwick "was independent in fact with respect to its audit of Porta [ ] in 1995, during the period of the professional engagement and up to and including the date of the issuance of its report." (Tr. 992-93.)
Kelley described "independence in fact" as a "quality," a "state of mind" and "a personal characteristic of integrity." (Tr. 993.) Overall, the question of "[w]hether the auditor is independent is a decision [the auditor] reaches based on the application of professional judgment." (Tr. 999.) As a basis for his opinion, Kelley first determined whether the audit team was, in fact, independent. (Tr. 993-94.) He noted that the "audit team had no knowledge of the formation of BayMark, the financial arrangements incident to the formation," or the loan to Olson. (Tr. 994.) The audit team "complied with its quality control policies and procedures to obtain reasonable assurance that they were maintaining independence." Kelley could not discern any intent of the audit team other than to comply with GAAS. (Tr. 994.)
He also considered that Olson was temporarily president of Porta, and therefore, Kelley had to determine what role Olson had in the audit process. (Tr. 994.) Based on Olson's testimony and the record, Kelley concluded that Olson had no role in the audit process and had absolutely no relationship with the audit team. (Tr. 994-95.) Kelley next took into account that the SEC did not allege any problem with the quality of the audit. (Tr. 995.) He also found it significant that the auditors issued a going concern letter and that another firm reaudited Porta and issued the same conclusion. (Tr. 995-96.) Finally, Kelley noted that Peat Marwick had engaged another expert who, after conducting a review and evaluation of the Porta audit, also concluded that independence was maintained in conducting the audit. (Tr. 996-97.)
Kelley further testified that since he joined the profession in 1961, the expansion of literature concerning auditing standards and what financial statements should show has made it easier to evaluate independence and allowed him to be "comfortable" in making his assertions. (Tr. 997-98.) He also explained that the quality of an audit is a factor in determining independence in fact, whereas rules governing independence in appearance are geared toward protecting the public, the auditor, and its client from "unconscious biases." (Tr. 1000.) Therefore, based on "[a]n appropriate review of the work as outlined [in his opinion]," Kelley was reasonably sure "that no unconscious biases existed in the [Porta] audit." (Tr. 1000-01.)
In terms of SEC Rule 2-01, Kelley testified that the Rule speaks only to independence in fact and not independence in appearance. (Tr. 1001.) Kelley's opinion was that, in conducting the Porta audit, Peat Marwick "was in compliance with all of the rules of conduct at the AICPA, with the exception of a technical violation of Rule 101 related to the loan that existed with [ ] Olson as temporary president [and] COO of Porta." (Tr. 1002.) Kelley referred to the violation of Rule 101 as "technical" because the loan to Olson was not made to him as president and COO of Porta, but rather as a principal of BayMark; therefore, the loan, at the time it was given, was proper under AICPA professional standards. (Tr. 1002-03.) He also believed it to be a technical violation because Olson's role as president and COO of Porta was temporary, and because Olson functioned more as a consultant than as a policy maker as "contemplated by the rule prohibiting a loan to an officer." (Tr. 1003.) Kelley described "technical violation" as a term of art meaning a violation which the professional ethics committee would not consider so serious as to warrant public discipline if a letter of corrective action, assuring that the type of error that occurred is not likely to occur again, is given to the committee. (Tr. 1003-04.)
Kelley disagreed with Carmichael's opinions as to contingent fees, royalties, materiality, and control. (Tr. 1005-08.) With respect to contingent fees, the AICPA has a separate rule for contingent fees while none exists under Rule 101 on independence. (Tr. 1006.) Moreover, the proper rule may apply in "situations where a fee is received [for] a professional service . . . rendered for a client where an audit . . . [is] being provided by the auditor," but here, Peat Marwick did not render any professional services. (Tr. 1006.) Furthermore, Peat Marwick never received any royalties from Porta, and although the royalties "did consist of an indirect financial interest in Porta," the interest, in Kelley's opinion, was not material, and therefore, no violation of Rule 302 occurred. (Tr. 1006-07.) Kelley also disagreed with Carmichael on the issue of materiality because materiality is always judged by quantitative, not qualitative measures; for example, the materiality of an indirect financial interest may be evaluated in relation to the net worth of the member and his firm or the net worth of other identified parties. (Tr. 1007.) As to control, Kelley pointed out that "FASB 94" defined control as "ownership of the majority voting interest." However, Peat Marwick had no voting interest in BayMark, and according to Kelley, it was wrong of Carmichael to contend that another definition of control should apply. (Tr. 1008.)
(iii) Thomas J. Mangold
Thomas J. Mangold (Mangold), a CPA and a partner with Coopers & Lybrand, was qualified as an expert and testified on behalf of Respondent with respect to the Porta audit. (Tr. 1106-09; Resp. Ex. 206.) Mangold graduated from the University of Cincinnati in 1973 with a Bachelor of Business Administration and then joined the firm of Coopers & Lybrand as a staff accountant. (Tr. 1107.) He became a partner at Coopers & Lybrand in 1985, and for the past thirteen years he has been the engagement partner on several audits of telecommunications companies, manufacturing companies, and other companies. (Tr. 1107.) He is the chairman of the AICPA Committee for Telecommunications and understood that Porta manufactured telecommunications equipment and sold it to the telecommunications industry. (Tr. 1107-08.)
In preparation for his testimony, he reviewed the OIP and the Porta audit papers, and interviewed both the audit partner, Sturm, and the second audit partner, John Adamovich, about the conduct of the audit and the decisions they reached. (Tr. 1109-10.) However, he did not review the licensing agreement between Peat Marwick and BayMark, and he was not aware of any of the structural relationships between Peat Marwick and BayMark. (Tr. 1124.) Sturm, though, did inform Mangold that, based on several conversations Sturm had with DPP in regard to Porta, the SEC was aware of the situation and the Porta audit was "grandfathered." (Tr. 1126.)
Based on this review, Mangold's opinion was that the Porta audit was done in accordance with GAAS. (Tr. 1111.) The conclusions contained in the audit were well substantiated and documented, and there was "no evidence whatsoever during the course of that audit that the audit team ever had an independence issue." (Tr. 1111.) Mangold testified to examples of the auditors taking a hard line with the client, including insisting upon the issuance of a "going concern" opinion when the client had expressly asked that none be issued. (Tr. 1112-13.) In reviewing with Sturm the level of staffing used for the Porta audit, Mangold noted that Peat Marwick went out of its way, due to the risk that Porta presented to it as an auditor, to utilize the most experienced people available, people who would be familiar with these types of problems and issues and who could bring the requisite degree of professional skepticism. (Tr. 1118-19.) Mangold found the second partner review adequate as well. (Tr. 1119-20.) In his opinion, the auditors were independent. (Tr. 1111-12.)
(iv) A. Marvin Strait
A. Marvin Strait (Strait) was qualified and testified for Respondent as an expert on auditor independence. (Tr. 1193-97; Resp. Ex. 207.) Strait became a CPA in 1960 and is currently in his own practice in Colorado. (1194.) Previously, he worked as an auditor with several firms in Colorado and has participated in about 100 audits. (Tr. 1194-95.) He served as Chairman of the Board of the AICPA in 1987-88. (Tr. 1195.) He is currently a member of the Governing Counsel of the AICPA, which is the "final authority on policy and decisions for the AICPA," and Chairman of the Continuing Professional Education Board of Management of the AICPA. (Tr. 1196.)
In preparation for his testimony, Strait reviewed numerous documents which he considered relevant to his analysis of the independence issue including Carmichael's testimony and report. (Tr. 1198.) In general, his opinion was that Peat Marwick was independent in fact in conducting its 1995 audit of Porta in terms of SEC Rule 2-01. (Tr. 1199-1200; Resp. Ex. 207.) Further, he opined that Peat Marwick did not control BayMark and that there was no material involvement by Peat Marwick in BayMark entities. (Tr. 1199.)
Strait further testified that, based on appearance, the loan to Olson would constitute a technical violation of the independence rules under the AICPA Code because its rules encompassed both independence in fact and in appearance. (Tr. 1200.) However, the violation of the AICPA Code due to the loan would not impair the in fact independence of the actual auditors of Porta under the SEC's rules. (Tr. 1200-01.) This was because, as Strait explained, the auditors who conducted the audit had no knowledge of the Olson loan, so their opinion was not influenced by it. (Tr. 1201.) He also noted that the loan issue did not impair the in fact independence of Peat Marwick as a firm because even though there was information about the loan within certain parts of the firm and information about the Porta audit in others, there was no one place within the firm where this information came together. (Tr. 1201-02.)
In terms of the idea that Peat Marwick exerted control over BayMark through the licensing agreement, Strait read the agreement as primarily protecting the "KPMG" name and use of the name and logo. (Tr. 1202.) Moreover, Peat Marwick had no control of BayMark's "fiscal policies, the management of the business, [or] the conduct of the engagements"; nor did they have any ownership or voting rights in BayMark. (Tr. 1202.) Thus, in his opinion, Peat Marwick had no control over BayMark. (Tr. 1202.)
In terms of "material" indirect financial interests, Strait referred to "AU 312" as establishing a quantitative and qualitative audit standard for "materiality." (Tr. 1206-07.) However, he emphasized that based on his experience, the use of qualitative factors to determine materiality would be unusual unless, for example, fraud was involved. (Tr. 1207.) Consequently, Strait asserted that when Carmichael ignored the quantitative factors, "the facts and figures and numbers," in determining materiality during Carmichael's testimony, that was "the first time [he had] seen somebody do that when they address[ed] materiality." (Tr. 1207.) Strait also stated that there was no contingent fee and that there was nothing contingent about the audit fee that was to be paid. (Tr. 1207-08.) In any event, Strait concluded that Peat Marwick's $8 million investment in BayMark did not constitute a material indirect financial interest given Peat Marwick's $2.5 billion in domestic revenues and $500 million in partners equity. (Tr. 1208.)
(v) Mary Beach
Mary Beach was qualified as an expert witness for Respondent on matters relating to Commission staff processes, including communications by Corporation Finance and OCA with outside professionals including accounting firms. (Tr. 1298-1305; Resp. Ex. 209.) She practiced for thirty years at Corporation Finance and left the division in 1993 as a Senior Associate Director. (Tr. 1298-99.) Currently, Beach is a sole practitioner in securities law. (Tr. 1298.)
On voir dire, she testified that she never personally signed or authorized a no action letter, but she was sure that she would have been one of "the top people" in Corporation Finance consulted for "the more important [no action] letters" and that she generally participated in the decision to issue them. (Tr. 1301-02.) She assumed that the various Commission divisions had similar policies on when to issue a no action letter which varied with respect to "the difference[s] in the regulations," and she claimed that she knew the procedures in each division based on her experience. (Tr. 1303-04.)52
In preparation for her testimony, she read the investigative testimony of Conway and Perry, and the hearing testimony of Riley and Sutton. (Tr. 1307.) She also looked at the notes of the December 26 meeting and the December 28 telephone call as well as "the notes and the outline that [were] presented in connection with" the 1994 meeting between OCA and Perry. (Tr. 1308.)
Her opinion of Peat Marwick's conduct during its 1994, 1995, and 1996 dealings with the OCA staff was that "there was a sincere effort on the part of Peat Marwick to inform the Commission of what they were doing and to follow what they thought were the desires of the Commission." (Tr. 1309.) She was also of the opinion that Peat Marwick handled these communications in an appropriate and professional manner. (Tr. 1309.)
She further explained, in the context of the 1994 meeting, that it is a common practice for professionals to meet and speak with the SEC staff on future actions which may pose problems under the securities laws. (Tr. 1309-10.) It is also common practice for professionals to furnish a letter before meeting with the SEC and, when meeting with senior members of the SEC staff, to rely on what they say and proceed accordingly. (Tr. 1310.) Therefore, it was not unusual for Perry to rely on what Riley told him. (Tr. 1310.) However, she conceded that OCA misunderstood the information it received while Peat Marwick misunderstood what they could do; nonetheless, because she believed that Peat Marwick's misunderstanding was an honest one, she did not think Peat Marwick did anything wrong. (Tr. 1310.)
Beach also concluded that Peat Marwick did nothing that represented a threat to the regulatory process. (Tr. 1311.) She agreed that full and fair disclosure is the essence of the no action process, and the party seeking a no action letter must disclose all the material facts they know. (Tr. 1314.) If they do not, the no action letter would be ineffective. (Tr. 1314-15.)
a. The Applicable Standard Under Rule 102(e)(1)(ii)
Under Rule 102(e)(1)(ii) of the Commission's Rules of Practice, the Commission may censure or deny "temporarily or permanently, the privilege of appearing or practicing before it" any professional if it finds that such professional lacks "character or integrity" or has engaged in "unethical or improper professional conduct."53 17 C.F.R. § 201.102(e)(1)(ii).
Accountants and auditors, through the preparation and certification of financial statements respectively, provide information which is integral to the Commission's disclosure system and consequently, to any investor in the midst of making investment decisions. Amendment to Rule 102(e) of the Commission's Rules of Practice, 68 SEC Docket 0707, 0708 (Oct. 19, 1998) [hereinafter Amendment]. Thus, because investors rely upon the accuracy of these financial statements and the Commission has limited resources which prevent it from closely scrutinizing them, the Commission must depend on the "competence and independence" of both auditors and accountants. Id. Thus, the impetus for Rule 102(e) arose as a "means to ensure that those professionals, on whom the Commission relies heavily in the performance of its statutory duties, perform their tasks diligently and with a reasonable degree of competence." Touche Ross & Co. v. SEC, 609 F.2d 570, 582 (2d Cir. 1979). Otherwise, "[a]n incompetent or unethical accountant can damage the Commission's processes and erode investor confidence in our markets." Amendment at 0708.
The Commission instituted this proceeding on December 4, 1997. However, because of the decision in March 1998 by the U. S. Court of Appeals for the District of Columbia Circuit in Checkosky v. SEC, 139 F.3d 221 (D.C. Cir. 1998), regarding the proper mental state required under Rule 102(e) as applied to accountants,54 Respondent made an application requesting that either a scienter standard be applied in this case or that the hearing be deferred until such uncertainty was cleared up by the Commission. Thereafter, at a Pretrial Conference held on May 21, 1998, I ruled that I will apply a scienter standard because of the Checkosky holding and the circumstances that brought about this proceeding. (Transcript of Pretrial Conference at 6.)
Subsequently, in response to the Checkosky decision, the Commission amended Rule 102(e) to describe three types of conduct which would constitute "improper professional conduct." Amendment at 0709. The first type of violative conduct involves intentional or knowing conduct, including reckless conduct. Amendment at 0709-10 (footnote omitted). In contrast, the second and third types of conduct encompass negligent violations of applicable professional standards.55 Amendment at 0710.
The Commission will apply amended Rule 102(e), regardless of when the violation at issue occurred, "in all cases considered after the [A]mendment's effective date, except where a trial before an Administrative Law Judge has already commenced." Amendment at 0708. However:
Where a hearing has already commenced, an Administrative Law Judge may use the Rule 102(e) standard adopted today if such use would not unfairly prejudice any party . . . [and] may also supplement or re-open the record, if necessary, to give any party so requesting the opportunity to provide particular evidence or briefing on the Rule 102(e) standard.
Id. at n.9. Neither party has asked to reopen the record. Moreover, neither party has shown that they would suffer unfair prejudice from the application of the scienter standard, including recklessness. I will, therefore, apply the definition of recklessness announced by the Commission for Rule 102(e), as amended, which reads as follows:
[T]he standards of professional practice are not fraud based, the Commission agrees 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. "Recklessness" under the antifraud provisions "is not merely a heightened form of ordinary negligence; it is an 'extreme departure from the standards of ordinary care, . . . 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.'" This recklessness standard is a lesser form of intent.
Id. at 0710 (footnotes omitted).
(i) Peat Marwick did not Recklessly Engage in Improper Professional Conduct
In his 1994 meeting with Riley and the OCA staff regarding Peat Marwick's proposed creation of KPMGCF, Perry, at Van Brunt's request, provided OCA with an outline of the proposed new entity and its relationship with Peat Marwick. Among other details, the draft stated that Peat Marwick would license its "KPMG" name to KPMGCF, Peat Marwick would provide a working capital loan of $5 million to KPMGCF, Peat Marwick would receive a royalty from KPMGCF under the licensing agreement, and KPMGCF would provide turnaround and bankruptcy services to troubled companies. Each of these details was discussed at the September 29, 1994 meeting. At the conclusion of the meeting, Riley informed Perry that he had not heard anything which would cause him to object on independence grounds.
At the October 19, 1995 meeting, both Sutton and Van Brunt stated that BayMark was very similar to or the same as the KPMGCF concept presented in 1994; nonetheless, Sutton explained that OCA was now concerned about BayMark's use of the "KPMG" initials, the royalty arrangement, and the financing of BayMark. Although it requested more information from Peat Marwick about the 5% royalty fee, the $5 million loan, the licensing agreement, and the staffing for services, OCA did not object to the BayMark structure. In his November 6, 1995 letter to OCA, Perry provided additional information and also reiterated that Peat Marwick had proceeded with the BayMark strategic alliance based on the fact that the OCA staff did not object to the similarly proposed alliance in 1994.
On December 5, 1995, an internal e-mail authored by Trattou was circulated to various members of Peat Marwick expressing concern over an inquiry by a Peat Marwick office regarding the appropriateness of Olson acting as an interim president for a public audit company. However, this e-mail was not copied to Perry or Conway and did not mention that Olson was one of the BayMark principals who received a $100,000 loan from Peat Marwick. Conway did have a general concern over the fact that Strategies was going to place someone in a key management position at a troubled company which was also a public audit client, but his concern was focused more on the reputational risk if something went wrong since Strategies was using the "KPMG" initials. Conway's concern has to be understood in the context that he and Perry had already met with OCA and knew that OCA had concerns about the Peat Marwick-BayMark structure, but discussions would continue in order to obtain OCA's approval.
At the December 6, 1995 meeting, another issue raised by OCA and POB, in addition to the use of the "KPMG" name, the loans, and royalty arrangement, was the prohibition against providing broker-dealer and independent auditor services to the same client. Again, Sutton did not insist at this meeting that Peat Marwick should stop auditing any BayMark clients although he testified that "in substance" it was discussed along with his concern over viewing BayMark as being an independent entity separate and apart from Peat Marwick. Yet, two drafts of letters by OCA, which expressed objections to the alliance on independence grounds, were never sent. The latter draft was dated December 7, the day after Sutton informed Conway that the OCA staff was working under the assumption that Peat Marwick effectively controlled BayMark. Therefore, notwithstanding the "working assumptions" that the OCA staff had about the control issue, Peat Marwick was never told that it had to discontinue any BayMark-related activities.
Sutton agreed that OCA was attempting to resolve the issues during its series of meetings with Peat Marwick, and Burns described the situation to Pitt prior to their December 18 meeting, as one in which the staff knew that Peat Marwick was continuing its BayMark activities while both sides tried to work out a resolution. Pitt confirmed that Sutton gave no directives at the December 18 meeting but did express a desire to find a "workable solution." Additionally, Sutton knew that BayMark-related work was going on but felt it was more of a concern to Conway than himself. Overall though, as Burns's December 21 memo reflected, no additional issues or concerns beyond those already discussed at the December 6 meeting, i.e., the removal of the "KPMG" name, cancellation of the royalty, and repayment of the loans, were raised at the December 18 meeting.
During the December 26, 1995 meeting between Conway and Sutton, both sides again agreed, as discussed in the two prior meetings that, at a minimum, the "KPMG" name would have to be removed, the royalty arrangement would have to be canceled, and the loans would have to be repaid in order to have OCA not object to the Peat Marwick-BayMark relationship. More importantly, as supported by Sutton's notes of this meeting, Conway definitely discussed that Peat Marwick had audit engagements with clients that were also clients of BayMark. Conway specifically brought to Sutton's attention not only the eighteen engagements on hold but also the six ongoing engagements. The Porta audit was included among the six, but instead of being referred to by name it was described as "1 strategies-assistance to troubled companies; work-out; top line management [KPMG could not do]" as reflected by Sutton's notes. Conway stated that he wanted to make sure Sutton knew about the ongoing projects and also wanted Sutton's "yea or nay as to whether or not they could go forward." Sutton acknowledged that Conway was seeking a quick resolution of the independence issues because of business activities that were ongoing during these discussions. Moreover, Sutton never told Peat Marwick at this meeting, or at any other time, to stop any of the six engagements. Because there was no directive to stop, it was entirely rational for Conway to believe that Sutton did not object to allowing the six engagements to proceed.
As a follow-up to their December 26 meeting, Conway and Sutton spoke again by telephone on December 28, to discuss the minimum changes that OCA insisted upon for the staff not to object to Peat Marwick's independence. Conway agreed that Peat Marwick would be able to make those changes, subject to negotiation with BayMark, but with no assurance that BayMark would agree to them.
Conway sent out an internal e-mail dated December 29, 1995, summarizing the status of the negotiations with OCA. The e-mail confirmed that the only changes to the Peat Marwick-BayMark structure required by OCA were (i) removal of the "KPMG" name; (ii) cancellation of the 5% royalty; and (iii) repayment of the loans. The e-mail also confirmed that before any structural changes occurred, Peat Marwick was to have discussions with Market Regulation regarding any market regulation issues that might exist. It was also understood that, assuming there were no problems with Market Regulation, all independence issues were addressed and resolved by the structural changes proposed by OCA and accepted by Peat Marwick, but that Sutton would still need to discuss the proposed solution with others at the Commission before giving final approval to these changes.
Subsequently, Conway telephoned Sutton on January 3, 1996, to let him know that Peat Marwick was ready to negotiate the proposed changes with BayMark and to find out whether Peat Marwick could begin its negotiations with BayMark and if there were any other changes required. However, instead of allowing Peat Marwick to start its negotiations with BayMark, Sutton told Conway to wait another day or two for Sutton to get back to him. Sutton then e-mailed Burns that same day to let him know about the conversation he had with Conway and then instructed Burns to speak with Market Regulation to inform them of what was going on so that OCA could properly give Conway further direction on how to proceed.
Eventually, Conway was told by Burns on January 5 as well as through a letter from Sutton dated January 31, 1996, that the proposed structural changes negotiated with Sutton would satisfy OCA's independence concerns, but that before proceeding with any of these changes, Peat Marwick would have to first meet with Market Regulation to discuss and address any possible problems from their viewpoint. Conway was clearly trying to resolve OCA's concerns and was fully cooperative during the process.
From October 1995, when meetings between Peat Marwick and OCA began, the name, royalty, and loans were the primary concerns ever raised by OCA. Thus, in January 1996, it was reasonable for Peat Marwick to conclude that the changes needed to resolve OCA's independence concerns were the (i) removal of the "KPMG" name; (ii) cancellation of the 5% royalty; and (iii) repayment of the loans. It was also reasonable for Peat Marwick to conclude that, after negotiating in good faith and reaching an agreement, the six ongoing engagements could proceed. In fact, after his January 3 telephone conversation with Conway, Sutton felt that the situation was thereafter simply procedural because OCA and Peat Marwick had reached an agreement in principle that he was comfortable with.
Peat Marwick cooperated with Market Regulation in an effort to resolve the eight broker-dealer issues that Market Regulation raised about the Peat Marwick-BayMark alliance. Peat Marwick's counsel submitted an initial draft of a no action letter on April 12, 1996. After Market Regulation reviewed this initial draft and requested further revisions, Peat Marwick's counsel submitted a second draft on June 13, 1996. Peat Marwick did not provide a third draft because an investigation was initiated and the discussions with Market Regulation ceased. Furthermore, McGuire testified that Market Regulation was not addressing any independence issues that may have existed in the Peat Marwick-BayMark structure, but was only interested in any possible broker-dealer issues.
A. The Porta audit
Sturm acted properly when he contacted Peat Marwick's DPP office in October 1995 because he knew Porta, a public audit client, was about to engage BayMark and he did not know enough about BayMark to determine whether there would be a problem with this arrangement. Trattou told Sturm that there would be no problem with Porta engaging BayMark given the particular structure of the alliance and because Peat Marwick's business alliance with BayMark was discussed with the SEC staff and received no objections. Moreover, the Porta audit took place because Conway reasonably believed that he had an agreement with OCA to finish the six ongoing engagements.
In December 1995, when Sturm inquired at DPP about Olson's role at Porta, Trattou told Sturm he needed to confer with others at DPP and would get back to him. Subsequently, Trattou told Sturm that the Porta situation, by name, had been discussed with the SEC and that the audit could proceed. Trattou also explained that both sides had reached an agreement that would modify the alliance so that the SEC would have no further objections to it. Sturm testified that this conversation occurred after December 8 but before December 27, 1995, the same time period during which Conway was negotiating with Sutton. Therefore, it appears that Trattou based his guidance upon the December 26 meeting between Conway and Sutton because the information that Trattou gave was consistent with the results of that meeting.
The Completion Memorandum for the Porta audit signed on or about March 29, 1996, which explained how the audit was "grandfathered" by the SEC staff despite Olson's interim role as president and COO of Porta, provides further evidence that Peat Marwick relied on the agreement reached on December 26, 1995. I conclude that both Sturm and Conway believed that OCA would not object to finishing the engagements underway. The worst that can be said is that there was a misunderstanding. It is simply not reasonable to believe that Conway or Sturm would have permitted the Porta audit to go forward if either had thought there was an independence problem. There was no reason for Conway or Sturm to doubt the appropriateness of conducting the Porta audit although Olson had taken an interim management position with Porta. Instead, as Sturm testified, if independence problems existed, Peat Marwick would simply have told Porta to have another firm conduct their audit.
In Sturm's only conversation with Conway, which took place after March 22, 1996, the date the audit report was completed, Conway told Sturm that there were no independence problems with the Peat Marwick-BayMark relationship. From Conway's viewpoint, his earlier meetings with Sutton had concluded with the acceptance of a plan to modify the alliance to the satisfaction of the OCA staff with their knowledge that one of Peat Marwick's ongoing engagements was an audit client which was also employing Strategies in a management capacity.
I conclude that Peat Marwick did not engage in an extreme departure from the standards of ordinary care by conducting the Porta audit while attempting to establish an acceptable alliance with BayMark. I further conclude that Peat Marwick did not recklessly engage in improper professional conduct within the meaning of Rule 102(e), as amended.
b. Peat Marwick Violated Rule 2-02 of Regulation S-X
In closing argument, Respondent conceded that the loan to Olson violated the independence rules. Respondent stated that, in terms of the loan, Peat Marwick "made a mistake" and "[e]very witness [including Conway] . . . has admitted it."56
Rule 2-01(b) of Regulation S-X states that "[t]he Commission will not recognize any certified public accountant or public accountant as independent who is not in fact independent." 17 C.F.R. § 210.2-01(b). In making this determination, "[t]he Commission views both the fact and appearance of independence as essential in order that the public may justifiably view the audit process as a wholly unbiased review of management's presentation of the corporate financial picture." Codification of Financial Reporting Policies, Section 600 - Matters Relating to Independent Accountants, Fed. Sec. L. Rep. (CCH) ¶ 72,901 at 73,251.57 Rule 2-02 of Regulation S-X, entitled "Accountants' reports," sets forth, in pertinent part, that an accountant's report "[s]hall state whether the audit was made in accordance with" GAAS. 17 C.F.R. § 210.2-02(b). Therefore, in determining whether Respondent violated Rule 2-02 by stating that the 1995 Porta audit was performed in accordance with GAAS, it is necessary to examine the components of GAAS.
In 1948, the Committee on Auditing Procedure, the predecessor to the AICPA, approved ten standards as the components of GAAS, "including three general standards, three standards of field work, and four standards of reporting." Office of the Chief Accountant, Staff Report on Auditor Independence, at 42 n.120 (Mar. 1994) (citing Codification of Statements on Auditing Standards, AU § 150.02). Further guidance is offered by the Statements on Auditing Standards (SAS) which are issued by the Auditing Standards Board of the AICPA.58 Implementation of Section 10A of the Securities Exchange Act of 1934, 64 SEC Docket 0149, 0150 n.6 (Mar. 12, 1997). For example, in terms of independence, General Standard No. 2 states, "[i]n all matters relating to the assignment, an independence in mental attitude is to be maintained by the auditor or auditors." Codification of Statements on Auditing Standards, AU § 150.02. However, SAS 1 makes it clear that "[t]o be independent, the auditor must be intellectually honest; to be recognized as independent, he must be free from any obligation to or interest in the client, its management, or its owners." Id. at AU § 220.03 (italics in original). For example, even though "[a]n auditor with a financial interest in a company might be unbiased in expressing his opinion . . . the public would be reluctant to believe that he was unbiased"; therefore, auditors should be independent in fact and should also "avoid situations that may lead outsiders to doubt their independence." Id.
Practically, though, it is the rules and interpretations promulgated pursuant to the AICPA Code, "rather than the auditing standards, [that] embody the AICPA's specific independence requirements and regulations." Office of the Chief Accountant, Staff Report on Auditor Independence, at 43 (Mar. 1994). Specifically, under Rule 101 of the AICPA Code, "[a] member in public practice shall be independent in the performance of professional services." AICPA Code ET § 101.01. Moreover, to better illustrate situations in which an auditor's independence would be considered impaired, the Interpretation of Rule 101 gives the example of an auditor or auditor's firm having "any loan to or from the [client] or any officer, director, or principal stockholder of the [client]" during the time of the engagement. Id. at ET § 101.02.
Therefore, as already conceded by Respondent, I conclude that Peat Marwick's loan to Olson, as an officer of Peat Marwick's audit client, Porta, constituted an independence violation under the professional standards set forth by the AICPA. Thus, because the SEC rules on independence incorporate those of the AICPA, I further conclude that Peat Marwick violated Rule 2-02 of Regulation S-X.59
c. Peat Marwick's Loan to Olson Caused a Violation of Section 13(a) of
the Exchange Act and Rule 13a-1 Thereunder
Section 13(a) of the Exchange Act and Rule 13a-1 thereunder provide that those issuers with securities registered under Section 12 of the Exchange Act must file an annual report certified by an independent public accountant as required by the Commission's rules and regulations. Regulation S-X, along with the Financial Reporting Releases, "set[ ] forth the form and content of and requirements for financial statements required to be filed as a part of an annual report." 17 C.F.R. § 210.1-02(a)(2). Peat Marwick audited the financial statements which Porta filed as part of its 1995 annual report. As set out above, Peat Marwick was not independent at the time it certified the financial statements, and the annual report thus failed to comply with Section 13(a) and Rule 13a-1. Peat Marwick, therefore, caused Porta's violations of those provisions.
a. Rule 102(e)
As previously discussed, I have concluded that the record has not established that Peat Marwick recklessly engaged in improper professional conduct in creating a strategic alliance with BayMark or in allowing the Porta audit to be completed. Consequently, there is no basis to impose any sanction pursuant to Rule 102(e).
b. Cease and Desist
Section 21C(a) of the Exchange Act allows the Commission, upon a finding that a "person is violating, has violated, or is about to violate any provision of this title, or any rule or regulation thereunder," to impose a cease and desist order on "such person, and any person that is, was or would be a cause of the violation, due to an act or omission the person knew or should have known would contribute to such violation."
As concluded above, Respondent Peat Marwick violated Rule 2-02 of Regulation S-X and caused Porta to violate Section 13(a) of the Exchange Act and Rule 13a-1 thereunder. However, in determining whether to impose a cease and desist order, the following factors should be taken into consideration:
[T]he egregiousness of the defendant's actions, the isolated or recurrent nature of the infraction, the degree of scienter involved, the sincerity of the defendant's assurances against future violations, the defendant's recognition of the wrongful nature of his conduct, and the likelihood that his occupation will present opportunities for future violations.
Joseph J. Barbato, 69 SEC Docket 0178, 200 n.31 (Feb. 10, 1999) (quoting Steadman v. SEC, 603 F.2d 1126, 1140 (5th Cir. 1979), (citation omitted), aff'd on other grounds, 450 U.S. 91 (1981)). Furthermore, a finding that a respondent has violated the federal securities laws does not necessarily mandate the imposition of such an order. See, e.g., Warren G. Trepp, 70 SEC Docket 2037 (Sept. 24, 1999).
In evaluating Respondent's conduct in terms of the factors outlined above, it is significant that the audit itself was not challenged, and a second audit reached the same results. The violations were not recurring, and they grew out of highly unusual circumstances. Further, there is no evidence that they had an adverse impact on investors.
Although it has entered into two alliances subsequent to the termination of its alliance with BayMark, Peat Marwick points out that its current contractual arrangements with both of these entities preclude any recurrence of a Porta-type situation. For example, the new entities may not use the "KPMG" name, there is no royalty arrangement, and each of the allied entities is restricted from working for Peat Marwick audit clients. (Resp. Ex. 65.) Peat Marwick, therefore, has taken considerable steps to ensure that events that gave rise to this proceeding will not occur again. It would be too speculative to impose a cease and desist order merely because Peat Marwick entered into other alliances where steps had been taken to prevent violations such as occurred here. I conclude, therefore, that the Cease and Desist Order and the reporting requirements requested by the Division are disproportionate to the violations in this case when viewed in the highly unusual context in which they occurred. Therefore, it is not necessary or appropriate in the public interest to order Respondent to cease and desist from violating Rule 2-02 of Regulation S-X or from causing violations of Section 13(a) of the Exchange Act and Rule 13a-1 thereunder.
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 July 28, 1999.60
IT IS ORDERED that this administrative proceeding, insofar as it alleges that Respondent engaged in improper professional conduct pursuant to Rule 102(e) of the Commission's Rules of Practice, 17 C.F.R. § 201.102(e), IS DISMISSED.
IT IS FURTHER ORDERED that the Division's request for entry of a cease and desist order against Respondent pursuant to Section 21C of the Exchange Act IS DENIED.
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 decision. It shall become the final decision of the Commission as to each party who has not filed a petition for review pursuant to Rule 360(d)(1) within twenty-one days after service of the initial decision upon such party, unless the Commission, pursuant to Rule 360(b)(1), determines on its own initiative to review this initial decision as to any party. If a party timely files a petition for review, or the Commission acts to review as to a party, the initial decsion shall not become final as to that party.
Robert G. Mahony
Administrative Law Judge
1 "(Tr. ___.)" refers to the transcript of the hearing. I will refer to Division and Respondent exhibits as "(Div. Ex. ___.)" and "(Resp. Ex. ___.)," respectively. "(Ans. para(s). ___.)" refers to Respondent's Answer.
2 The Department of Professional Practice consists of experts who give advice and guidance on technical issues as well as areas of ambiguity, including independence. (Tr. 681.)
3 According to Riley, Perry said that KPMGCF "may provide certain services to troubled companies," but Riley was not sure what the scope of the turnaround or bankruptcy services (as stated in Division Exhibit 5) would really encompass, and did not remember specifically discussing the nature of the turnaround services. (Tr. 108-09.)
4 Burns suggested to Perry that he confer with the Division of Market Regulation (Market Regulation) in regard to possible broker-dealer issues arising from the alliance structure between Peat Marwick and KPMGCF; however, even though OCA advised Market Regulation about the matter, no meeting between Peat Marwick and Market Regulation took place at this time. (Tr. 98-99, 373-75.)
5 Riley testified that on or about January 4, 1996, he had a conversation with Burns about what he remembered concerning their 1994 meeting with Perry. (Tr. 110.) In that conversation, he reiterated his 1994 opinion that he had heard nothing which would cause him to object to Peat Marwick's proposed business arrangement. (Tr. 110-11.) He also told Burns that he believed "it would be difficult for the [OCA] staff to go back and raise independence questions regarding any specific items that were discussed in [their] meeting with [ ]. Perry," specifically "the licensing of the name, the royalty, and the capitalization money." (Tr. 111.) Riley also informed Burns that he had also said the same to Michael Conway, the head of DPP. (Tr. 111; see infra note 13.)
6 Each of the four principals owned 25% of BayMark. (Tr. 546.)
7 Prior to this point, Olson had never heard of Armel, Taffet, or Maughan, and with the exception of one annual meeting, he had very little interaction with the other three principals. (Tr. 527-29, 546, 594-96.)
8 In the end, however, Olson testified that no leads for crisis management ever resulted and that even the acquisition of Porta as a client was a result of Strategies' own research, not any referrals received from Peat Marwick. (Tr. 583-84.)
9 Sutton had been a partner with Deloitte & Touche for approximately thirty-two years prior to joining the Commission as Chief Accountant in June 1995 and serving in that capacity until January 1998. (Tr. 125-26.)
10 The Public Oversight Board is a self-regulatory organization of the accounting profession that "oversees the quality control on a peer review program of the American Institute of Certified Public Accountants." (Tr. 128.)
11 Van Brunt testified that, based on the description of BayMark in a September 1995 Wall Street Journal article, the BayMark entity was "very similar or exactly what had been presented to [OCA] as a theory concept in 1994." (Tr. 610.) Furthermore, Sutton testified that during 1995 and 1996, he "probably" knew that the "KPMG" name issue had been reviewed in 1994 as had the "same or very similar" royalty arrangement. (Tr. 184-85.) He also knew that Peat Marwick specifically referred to a $5 million loan for capitalization in its 1994 presentation. (Tr. 185.) Sutton also agreed that "these were the [same] features that [he], after coming on board as chief accountant wanted changed and ultimately worked out an agreement with Peat Marwick to [have them] change[d]." (Tr. 185.)
12 Sutton stated that in the October meeting "and probably in every meeting," there was a reference to "the 1994 meeting but that Burns or Van Brunt disagreed that the staff had not objected, given a blanket no objection to the  arrangement." (Tr. 131-32.)
13 Michael Conway is a senior partner and the head of Peat Marwick's DPP and Chairman of the SEC Practice Section Executive Committee. (Tr. 680-81, 861, 922.) He has been a CPA since 1967 and has practiced with Peat Marwick or a predecessor firm since 1965 doing primarily audit work for public companies. (Tr. 860.) He has also served on the Financial Accounting Standards Board (FASB) Emerging Issues Task Force, the American Institute of Certified Public Accountant's (AICPA) Independence and Behavioral Standards Subcommittee, and various other professional groups. (Tr. 861.) Conway has known Sutton for about eight years through service on various professional committees. (Tr. 861.) At Deloitte & Touche, Sutton was Conway's counterpart before becoming Chief Accountant. (Tr. 861-62)
14 Perry learned, through his counsel in connection with this proceeding, about a Peat Marwick audit in which a BayMark principal who had received a loan of $100,000 from Peat Marwick was also an officer of the audit client. Perry conceded that such an arrangement would be violative of the independence rules under Interpretation 101-1 of the AICPA Code of Professional Conduct (AICPA Code). (Tr. 778-79.)
15 Perry did not recall whether he had any conversations with Burns or Sutton about the contents of the memorandum on or about the date of the memorandum. (Tr. 794-95.)
16 Olson eventually turned the company around, and at the time of the hearing, Porta was "[d]oing about $65,000,000 [and] [m]aking about $6,000,000." (Tr. 586-87.)
17 Although there was no testimony that Trattou had discussed the contents of this e-mail with Conway, Conway testified that there were subsequent discussions within the firm which Trattou might have attended. However, these discussions revolved around the general issue of control. (Tr. 927-28.)
18 Conway did not realize until May 1996 that Peat Marwick had an outstanding $100,000 loan to an officer of the audit client, Porta. One of the lawyers, who was drafting a response to the SEC staff, brought the fact of the loan to Conway's attention. Conway stated that he did not know Olson and never connected these events because he was focusing his attention on Peat Marwick's relationship with BayMark. (Tr. 913-14.) Nonetheless, Conway agreed that the loan to Olson was a technical violation of the independence rules. (Tr. 921.)
19 While reviewing the notes Conway prepared after the December 6 meeting, Olson testified that in the December 1995 time frame, nobody from Peat Marwick had ever told him that OCA or POB was raising issues with regard to the "KPMG" name, the royalty being paid to Peat Marwick, or any requirement that Peat Marwick register as a broker-dealer. (Tr. 538-39, 867-68; Div. Ex. 40.)
20 After having been shown Conway's notes of the meeting, Olson testified that no one from Peat Marwick had told him during the December 6 time frame that OCA had suggested that Peat Marwick could not audit BayMark clients or that OCA had effectively assumed that Peat Marwick controlled BayMark. (Tr. 538; Div. Ex. 40.)
21 Pitt's opinion regarding the independence issue was that there was no impairment of independence in fact and that, while he disagreed with the standard of appearance of independence being applied, it was his judgment that anyone fully informed about the facts would conclude that Peat Marwick's independence was not impaired. (Tr. 1081-82.)
22 In terms of the meetings and telephone calls which occurred on December 6, 18, 26 and 28, Sutton testified:
I recall that I had reached the point where we had heard the technical legal arguments for the second, third, fourth and fifth time, and that there wasn't any point in continuing to go over those technical legal arguments. We had heard those, and we'd heard them again, and we still felt that this was an improper situation.
23 Tr. 232.)
Similarly, Conway testified that his understanding at the end of the December 18 meeting was that Peat Marwick would consider the OCA staff's issues and that he would meet with Sutton again and continue to discuss the matter. (Tr. 874.) However, no other issues beyond those discussed at the December 6 meeting were raised at the December 18 meeting. (Tr. 875.)
24 Sturm explained earlier in his testimony that, based on his contract record summary, he knew that December 27, 1995, the date that he received final payment from Porta for their 1994 audit, was the exact date on which Peat Marwick started Porta's 1995 audit. (Tr. 691-92.) However, no field work or procedures were actually performed until January 1996. (Tr. 692.) Then, in terms of placing a date on his last conversation with Trattou, Sturm knew it occurred before December 27 because "at that point [he] knew . . . [he] had the money [for Porta's 1994 audit fees] in the bank." (Tr. 712-13.)
25 Conway summarized this "past protocol" as having discussions on matters with the SEC and expecting, at the most, a "we would not object to that" from the staff as opposed to an expression of "agreement." (Tr. 881.)
26 Conway identified a confidential summary of six engagements dated December 20, 1995, which were generically referred to in his notes; however, Conway was not sure when he first saw this document but did use it in preparing for his December 26 meeting with Sutton. (Tr. 884-85; Resp. Ex. 27.) One of the engagements listed on this summary is Porta with the notation, "Strategies/Acting as President." (Resp. Ex. 27.)
27 Some of these notes were made contemporaneously with the meeting while others were made afterwards. (Tr. 890.)
28 After reviewing Sutton's notes of the December 26 meeting, Conway was able to confirm that the engagements were discussed on that date. (Tr. 955; Resp. Ex. 38A.) Sutton could not confirm whether Respondent Exhibit 38A represented his notes from the December 26 meeting, but when it was compared to Respondent Exhibit 101, representing a set of Burns's notes, there was an entry marked "MS - 12/26/95" followed by information which parallels the information in Respondent Exhibit 38A regarding the six ongoing engagements. (Tr. 192-94.) Furthermore, on Division Exhibit 47, Sutton's notes from the December 28 meeting, two pages are headed with "12/28," but neither page has any notations regarding the six ongoing engagements. (Tr. 196.)
29 Respondent Exhibit 101, Burns's notes with the notation "MS - 12/26/95," also contained the following phrase, "18 'On hold' since, Oct 19 Mtg. -- will stay there on hold until we resolve."
30 Bayless testified that he was familiar with the concept of confidentiality restrictions in regard to accountants and client information. He stated that it would be reasonable for an accountant, in talking about a client, to refer to a client by describing the features of the client rather than by name. (Tr. 645-46.)
31 Sutton was aware that other accounting firms were interested in what was happening with respect to the alliance. He testified that OCA wanted to get some control over the matter before other accounting firms followed suit because of serious policy implications which he assumed were still being debated in the industry. (Tr. 221-22.)
32 Conway's internal e-mail was sent to Vasquez, with copies to Perry and others. (Div. Ex. 48.) In addition to Sutton's comments regarding the quick resolution of the matter, the e-mail also outlined the three conditions that had to be met to satisfy OCA and how the three conditions might be modified, along with the current status of the line of credit. Conway further wrote that Sutton indicated it was important for Peat Marwick to resolve any Market Regulation issues since an adverse determination by Market Regulation might alter Sutton's conclusions with respect to independence. According to Conway, Sutton indicated that he intended to make his determination independent of Market Regulation; nevertheless, Sutton made clear that "one arm of the SEC could not be in conflict with another arm." Conway then wrote that Peat Marwick and BayMark could not operate if Market Regulation determined that there was control such that Peat Marwick would have to register as a broker-dealer. Conway further reported that he had told Sutton that everything they had discussed was subject to negotiation with BayMark and there was no assurance that BayMark would agree. However, if BayMark was agreeable, Conway would ask Sutton to do whatever was necessary to get a final determination from OCA before Peat Marwick incurred the costs and went to the trouble of drafting new agreements. Conway concluded his e-mail as follows: "I am confident that Mr. Sutton will qualify any 'final decision' of the [OCA] with some reference to getting things straightened out with Market Reg[ulation]." (Div. Ex. 48.) After reviewing this e-mail, Olson testified that he did not recall anyone from Peat Marwick during this time frame informing him about the three "minimum conditions" or the fact that Peat Marwick was to have discussions with Market Regulation. (Tr. 540-41; Div. Ex. 48.)
33 Conway estimated that at that time, Peat Marwick had extended a line of credit of over $8 million to BayMark. (Tr. 904-05.)
34 After the discussions between Conway and Sutton at the end of December, the six engagements that Conway wanted "grandfathered" were not discussed between them again until June 1996; and with respect to BayMark, they had no more face-to-face conversations after December 26, 1995, until June 1996. (Tr. 907-08.)
35 Sutton did not have any more personal dealings with this matter until May 1996. (Tr. 246-48.)
36 McGuire stated that she initiated this conversation and, to her knowledge, it was not a result of Conway's January 3 inquiry as to whether Peat Marwick could go forward on the proposed modifications to the BayMark alliance. (Tr. 420.)
37 Olson, after reviewing this letter, testified that he did not recall anyone from Peat Marwick during this time frame telling him about the three modifications of the Peat Marwick-BayMark alliance that OCA sought. (Tr. 542-43; Div. Ex. 54.) In fact, the first time Olson learned that he might have to repay his $100,000 personal loan from Peat Marwick was in July 1996 when his attorney suggested that it might be a good idea to do so. (Tr. 543-44.) Although Olson did not know of any problems revolving around the royalty to be paid to Peat Marwick, he did know that the one or two royalty checks that had been issued were not forwarded to Peat Marwick but were given to Diane Aronica (Aronica), Chief Financial Officer of BayMark, who then put them into a special account held by BayMark. (Tr. 538-39, 543-45, 591-92.) Olson did not believe he was ever informed of the need to drop the "KPMG" initials from the BayMark name. (Tr. 545.) Olson made it clear that he dealt primarily with the business of Strategies, dealing with turnaround situations for clients, whereas other individuals such as Aronica and Dewing, the Chairman of BayMark, dealt more with the BayMark General Counsel and other BayMark attorneys. (Tr. 582.)
38 Sturm included, as part of the Completion Memorandum he drafted for the Porta audit which was signed on or about March 29, 1996, the following narrative reflecting his understanding that the Peat Marwick-BayMark-Porta relationship had been discussed with the SEC and was "grandfathered," such that Peat Marwick could do the Porta audit. (Tr. 754-56; Resp. Ex. 161.) In addition to Sturm, the Completion Memorandum was also signed by John Green, Peat Marwick's SEC concurring and review partner; Michael Percent, the engagement manager; and Michelle Witzer, the "senior or in-charge accountant." (Tr. 754-55.)
Through an introduction made by Len Sturm, engagement partner, Ed Olson of Baymark Strategies was hired by Porta Systems to function as the Company's C.O.O. and assist the Company in addressing its operational problems. He later received the title of President. After conferring with John Adamovich, Long Island office professional practice partner, John spoke to Glenn Perry at D.P.P., who indicated that this structure was one that was contemplated by our alliance with Baymark, and it did not impair our independence. Subsequent to those events, the SEC examined KPMG's relationship with Baymark. In those discussions, we were informed that Porta Systems was one of a number of specific situations discussed with the SEC. Based on a number of discussions with D.P.P. in December, 1995, we ultimately heard from Chris Trattou, who indicated that the SEC was aware of the Porta situation, and it was grandfathered and we should continue with the 1995 audit unless we heard otherwise. Finally, in reviewing the Form 10-K, Ed Olson was listed as working for "KPMG Baymark," although we understood that KPMG was to be dropped from the name. After a few discussions with Tom Vasquez, a partner in the Washington D. C. office who dealt with the Baymark agreement, and Mike Conway at D.P.P., on March 28, 1996, Mike concluded that "KPMG" could not be dropped from the name "Baymark" since it was still the legal name and that there should not be a trailer indicating the KPMG and Baymark relationship. The Form 10-K was filed in such a manner. Mike and Tom also reconfirmed that the SEC was aware that Baymark was performing the work at Porta, our independence has not been impaired, and that, due to the SEC review, we should not accept any subcontracted work from Baymark, which we have not to date.
39 Resp. Ex. 161 at 13-14.)
The audit report contained a "going concern" paragraph which stated that there was substantial doubt about the company's ability to continue as a going concern. (Tr. 814; Resp. Ex. 1.) This means that there is substantial doubt in the company's ability to meet its obligations for one year and one day from the balance sheet date. (Tr. 815.) Ed Kornfeld, Chief Financial Officer of Porta, made an effort to talk the auditors out of putting the paragraph in the audit report, but he was not successful. (Tr. 816-17.)
40 Olson signed a management representation letter on March 22, 1996, which documented certain representations made by Porta to the Peat Marwick auditors for the 1995 year-end audit but did not speak to anyone at Peat Marwick's DPP as to whether or not it was appropriate for him to sign the management representation letter. (Tr. 554-55, 746; Div. Ex. 63.) For the duration of the audit which was completed in March 1996, Olson maintained his status as a principal of BayMark and retained the $100,000 loan (until it was repaid in July or August 1996). (Tr. 555, 731; Resp. Ex. 161.)
41 This letter was in response to POB's May 14, 1996 letter to Conway expressing its concern over BayMark's being independent of Peat Marwick in light of the Porta audit and the agreement allowing BayMark "to provide interim management" to Porta, and requesting further information. (Div. Ex. 70.) A similar letter by POB was also sent to Arthur Siegel, Chairman of the AICPA SEC Practice Section Executive Committee. (Tr. 168; Div. Ex. 69.) Sutton thought that he spoke to Sullivan at POB about the results of OCA's EDGAR search before these letters were sent out and assumed that Sullivan incorporated this information into his own assessment of the circumstances. (Tr. 168-69.)
42 Conway enumerated the following relevant considerations in his May 30 letter: (i) no Peat Marwick officer or employee was connected to Porta as an officer or employee; (ii) Olson's temporary service at Porta was not relevant because Peat Marwick and Strategies were separate legal entities; (iii) management of Strategies was not controlled by Peat Marwick and Strategies made its own business decisions; (iv) Strategies was performing services for Porta, not Peat Marwick, and any fees paid to Strategies, because it was independent of Peat Marwick, could not be imputed to Peat Marwick; and (v) loans were extended by Peat Marwick to Strategies, not to Porta. (Div. Ex. 73 at 3-4.)
43 At the time of this hearing, Sutton was unaware of any harm incurred by any investors as a result of the audit conducted by Peat Marwick. (Tr. 240.)
44 A Form BD is used by the National Association of Securities Dealers and SEC for the registration of a broker-dealer in any state and requires information from the registrant such as "what business you're in, who controls you, whether you're financed by anybody else, [and] whether you're subject to any statutory disqualifications." (Tr. 375-76.)
45 At the time McGuire met with Burns on January 5, 1996, she did not know who Conway was. (Tr. 419-20.)
46 Jenson is a member of McGuire's staff and took notes at the January 17 meeting. (Tr. 393.)
47 McGuire agreed that it was not uncommon for lawyers to submit draft no action letters. (Tr. 444.)
48 Olson testified that no one from Peat Marwick told him about the draft no action letters submitted to Market Regulation. (Tr. 545.)
49 Of the eight items that McGuire required, Miles believed the three major items were broker-dealer issues; therefore, they really only concerned the subsidiary, Capital, not the Strategies subsidiary or BayMark itself, because only Capital would be the registered broker-dealer. (Tr. 1133-35.)
50 As explained by Carmichael, among the ten standards found in GAAS, there are three general standards dealing with the qualities of the auditor, including the second standard which addresses auditor independence. (Tr. 285-86; Div. Ex. 94.) Due to the broadness of the ten standards, the technical committee of the AICPA (now known as the Auditing Standards Board) provides official interpretations of these standards and codifies the interpretations in the AICPA Codification of Statements on Auditing Standards. (Tr. 285-86.)
51 Rule 101 addresses independence while Rule 302 addresses the use of contingent fees in relation to an auditor's independence. (Tr. 300, 305-06.)
52 The Division objected to Beach's qualifications concerning her ability to testify as an expert on when OCA might issue a no action letter. I overrule the objection as to her qualifications and admit her testimony as an expert in SEC procedures regarding the issuance of no action letters. (Tr. 1304-05.)
53 The Commission may also impose these types of sanctions on professionals who lack the "requisite qualifications to represent others" or have "willfully violated, or willfully aided and abetted the violation of any" federal securities laws, rules, or regulations. 17 C.F.R. § 201.102(e)(1)(i) and (iii).
54 "The Court of Appeals [ ] criticized the Commission for not clearly articulating in that case when an accountant would be deemed to have engaged in 'improper professional conduct' under Rule 102(e)(1)(ii)." Amendment at 0709.
55 Amended Rule 102(e) provides:
(iv) With respect to persons licensed to practice as accountants, "improper professional conduct" under § 201.102(e)(1)(ii) means:
(A) Intentional or knowing conduct, including reckless conduct, that results in a violation of applicable professional standards; or (B) Either 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.
(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.
17 C.F.R. 201.102(e)(1)(iv). Furthermore:
Each section of the final rule amendment refers to a violation of "applicable professional standards." The term "applicable professional standards" primarily refers to GAAP, GAAS, the AICPA Code . . . and Commission regulations. Also included are generally accepted standards routinely used by accountants in the preparation of statements, opinions, or other papers filed with the Commission.
Amendment at 0709 (footnote omitted).
56 See supra note 14 (testimony of Perry); note 18 (testimony of Conway); part II.h(i) (testimony of Carmichael); part II.h(ii) (testimony of Kelley); part II.h(iv) (testimony of Strait).
57 The Codification of Financial Reporting Policies is a compilation of information officially published by the SEC since 1934 regarding accounting and auditing issues including auditor independence. Office of the Chief Accountant, Staff Report on Auditor Independence, at 38 (Mar. 1994).
58 The most current and effective SAS are published by the AICPA in the Codification of Statements on Auditing Standards. Implementation of Section 10A of the Securities Exchange Act of 1934, 64 SEC Docket 0149, 0150 n.7 (Mar. 12, 1997).
59 Among other considerations, I credit the testimony of Sturm as well as that of Respondent's experts Kelley, Mangold, and Strait in finding that Sturm and his auditing team, as distinguished from the firm, Peat Marwick, were independent in fact when they conducted the 1995 Porta audit since they had no knowledge of the loan to Olson. However, Regulation S-X requires independence to be evaluated in the context of "all relevant circumstances." 17 C.F.R. § 210.2-02(c). By the express terms of Rule 101 of the AICPA Code and the Interpretation of Rule 101, the loan to Olson is the only relevant circumstance in concluding that the firm, Peat Marwick, was not independent.
60 By letter dated June 10, 1999, Respondent moved to include four additional documents into the evidentiary record. The documents are: (i) selected portions of the Staff Report on Auditor Independence prepared by OCA, in March 1994; (ii) a letter dated April 12, 1999, from Chief Accountant Lynn Turner (Turner) to William T. Allen (Allen), Chairman, Independence Standards Board; (ii) a letter dated April 15, 1999, from Allen to Turner; and (iv) a letter dated May 5, 1999, from Frank J. Pearlman, Chair, Professional Ethics Executive Committee, of the AICPA to Turner. These documents are collectively marked for identification as Respondent's Joint Exhibit 1. This exhibit was received long after the evidentiary record was closed, and I deny the motion to include Respondent's Joint Exhibit 1 into evidence.http://www.sec.gov/litigation/aljdec/id157rgm.htm
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