Initial Decision of an SEC Administrative Law Judge
In the Matter of
In the Matter of
ROBERT W. ARMSTRONG, III
April 6, 2004
Robert K. Levenson and Teresa J. Verges for the Division of Enforcement, Securities and Exchange Commission
Marc B. Dorfman and Bryan B. House of Foley & Lardner for Respondent Robert W. Armstrong, III
Carol Fox Foelak, Administrative Law Judge.
This Initial Decision sanctions Robert W. Armstrong, III, formerly controller of a former subsidiary of W.R. Grace & Co., for his role in the firm’s scheme to manipulate reported earnings to achieve predetermined targets. The Initial Decision concludes that he violated and caused violations of the antifraud, reporting, and books and records provisions of the securities laws and orders him to cease and desist from such violations. The Initial Decision dismisses additional charges brought under a Securities and Exchange Commission rule under which it can censure, suspend, or bar professionals, such as accountants, who appear or practice before it.
A. Procedural Background
The Securities and Exchange Commission (Commission) initiated this proceeding by an Order Instituting Proceedings (OIP) on December 22, 1998, 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) (Rule 102(e)).1
The undersigned held an eight-day hearing in Washington, D.C., October 8-10, 14-17, and 20, 2003. The Division of Enforcement (Division) called seven witnesses from whom testimony was taken, including Respondent Robert W. Armstrong, III (Armstrong).2 Armstrong called three additional witnesses from whom testimony was taken. About 300 exhibits were admitted into evidence.3
The findings and conclusions in this Initial Decision are based on the record. Preponderance of the evidence was applied as the standard of proof. Steadman v. SEC, 450 U.S. 91, 97-104 (1981). Pursuant to the Administrative Procedure Act, 5 U.S.C. § 557(c), the following posthearing pleadings were considered: (1) the Division’s December 30, 2003, Proposed Findings of Fact and Conclusions of Law; (2) Armstrong’s February 11, 2004, Proposed Findings of Fact and Conclusions of Law and Post-Hearing Brief; (3) and the Division’s February 25, 2004, Post-Hearing Reply Brief. All arguments and proposed findings and conclusions that are inconsistent with this Initial Decision were considered and rejected.
B. Allegations and Arguments of the Parties
This proceeding concerns W.R. Grace & Co. (Grace) and its former subsidiary National Medical Care, Inc. (NMC). The OIP alleges that, during the period 1991 through 1996, relating to fiscal years 1991 through 1995 (the relevant period), Grace engaged in fraudulent conduct by filing false and misleading periodic reports with the Commission that smoothed NMC’s reported income by creating and releasing reserves not in conformity with Generally Accepted Accounting Principles (GAAP).4 The OIP alleges that Armstrong, who was vice president and controller of NMC, together with other NMC officers implemented the allegedly manipulative scheme with the knowledge of, or at the direction of, Grace officers, in NMC’s books and records prior to the consolidation of NMC’s financial information into Grace’s financial statements. Thus, the OIP alleges, Armstrong willfully violated or caused violations of antifraud and books and records provisions of the securities laws – Exchange Act Sections 10(b) and 13(b)(5) and Rules 10b-5 and 13b2-1 – and caused violations of reporting provisions – Exchange Act Sections 13(a) and 13(b)(2) and Rules 12b-20, 13a-1, and 13a-13.
Armstrong argues that he relied on management at the level of the parent company, Grace, and its auditors for resolving issues concerning booking the reserves. Thus, Armstrong argues, he was not responsible for any violations.
The Division requests that Armstrong be ordered to cease and desist from violations of Exchange Act Sections 10(b), 13(a), 13(b)(2), and 13(b)(5) and from violations of Exchange Act Rules 10b-5, 12b-20, 13a-1, 13a-13, and 13b2-1. The Division also requests that Armstrong be censured pursuant to Rule 102(e). Armstrong requests that the proceeding be dismissed.
C. Procedural Issues
1. Statute of Limitations
Armstrong argues that much of this case is barred by the statute of limitations, citing 28 U.S.C. § 2462, a statute of general applicability that provides a five-year statute of limitations for “an action, suit, or proceeding for the enforcement of any civil fine, penalty, or forfeiture, pecuniary or otherwise.” See Johnson v. SEC, 87 F.3d 484 (D.C. Cir. 1996).5 Specifically, Armstrong argues, 28 U.S.C. § 2462 bars any claims that are based on conduct that occurred before December 22, 1993 – five years before the December 22, 1998, institution of this proceeding. This argument is unavailing. The Division seeks two sanctions: a cease-and-desist order pursuant to Section 21C of the Exchange Act and a censure pursuant to Rule 102(e). Cease-and-desist orders are not subject to 28 U.S.C. § 2462. Herbert Moskowitz, 77 SEC Docket 481, 500-02 (Mar. 21, 2002). As to a censure pursuant to Rule 102(e), the OIP alleges violative conduct within, as well as outside, the five-year period. Acts outside the statute of limitations may be considered to establish a respondent’s motive, intent, or knowledge in committing violations that are within the statute of limitations. Sharon M. Graham, 53 S.E.C. 1072, 1089 n.47 (1998) (citing Fed. R. Evid. 404(b) and Local Lodge No. 1424 v. NLRB, 362 U.S. 411 (1960)), aff’d, 222 F.3d 994 (D.C. Cir. 2000); Terry T. Steen, 53 S.E.C. 618, 623-24 (1998) (citing H.P. Lambert Co. v. Sec’y of the Treasury, 354 F.2d 819, 822 (1st Cir. 1965)). Further, such acts may be considered in determining the appropriate sanction if violations are proven. Steen, 53 S.E.C. at 623-25.
2. Unreasonable Delay
Armstrong also argues that the proceeding should be dismissed because of unreasonable delay, citing Section 555(b) of the Administrative Procedure Act, 5 U.S.C. § 555(b).6 Armstrong notes that more than twelve years have elapsed since the beginning of his alleged misconduct, and almost five years elapsed between the date of the OIP and the hearing. Armstrong refers specifically to the three-year delay occasioned by the Commission’s interlocutory review of a ruling of the undersigned7 and further delay occasioned by the Commission’s subsequent rejection of a proposed settlement that the parties had negotiated. In addition to stating that the pendency of the proceeding had a negative impact on his career, Armstrong notes that some potential witnesses have died, including Albert J. Costello, Grace’s chief executive officer (CEO) during part of the relevant period, and Thomas J. Scanlon, lead partner on the audit by Price Waterhouse LLP (Price Waterhouse) of Grace for the 1995 fiscal year. Additionally, Harold Eckmann, a member of Grace’s audit committee during the relevant period, had become too frail by the time of the hearing to appear and testify.
Armstrong’s argument that the proceeding should be dismissed because of unreasonable delay is unavailing. This argument is, in essence, a defense of laches, which is not available against a United States government agency acting in the public interest. United States v. Summerlin, 310 U.S. 414, 416 (1940); United States v. Alvarado, 5 F.3d 1425, 1427 (11th Cir. 1993); David Disner, 52 S.E.C. 1217, 1223 (1997).
II. FINDINGS OF FACT
A. Respondent and Related Entities
Armstrong was the controller and vice president of NMC during the relevant period. Tr. 65. As such, he was the chief internal accounting officer for NMC, responsible for monthly, quarterly, and annual financial reporting of NMC’s results, for NMC’s internal audit department, and for consolidating the results of NMC’s operating subsidiaries. Tr. 65-66, 72-87. Armstrong was never an officer, director, or employee of Grace. Tr. 196. He is not a certified public accountant (CPA), and was not a CPA during the relevant period. Tr. 67-68. Armstrong had been a CPA, licensed in Massachusetts, from 1977 through 1983.8 Tr. 68. Armstrong graduated from Bowdoin College in 1971 and earned a degree in entrepreneurial management from the Wharton School in 1975. Tr. 67. He worked at Touche Ross & Co. from 1975 to 1980, auditing the books of small businesses and health care facilities, all private companies. Tr. 69-70. He first joined NMC in 1980 and worked there during the relevant period; he left in 1997, after its 1996 takeover by a German company, Fresenius AG. Tr. 63-64, 188, 190-91. Thereafter, he was employed as chief financial officer (CFO) for a privately held manufacturing company but was terminated after receiving a Wells notice concerning the charges that led to this proceeding. Tr. 63, 191. After working off and on as a consultant, he obtained his present position in 2002 as CFO of a privately held manufacturing company. Tr. 59-60. Armstrong intends to continue working as a corporate financial executive in the future. Tr. 67, 192. Witnesses who worked with Armstrong at NMC consider him to be honest and a man of integrity. Tr. 354, 525-26.
2. Grace and NMC
Grace was a multinational conglomerate with a variety of businesses and revenues of $5 to $6 billion during the relevant period. Tr. 200. It was a public corporation. Tr. 73. As such, it filed with the Commission the Forms 10-Q and 10-K periodic reports required by the securities laws. Exs. 191-207. Its fiscal year was the calendar year. Exs. 191-207. During most of the relevant period, until March 1995, Jean-Paul Bolduc (Bolduc) was Grace’s president and CEO. Tr. 302-03, 351; Ex. 203 at 21. During most of the relevant period, until August 1995, Brian Smith (Smith) was Grace’s CFO. Tr. 105-06, 237; Ex. 191 at 21, Ex. 195 at 18, Ex. 199 at 20, Ex. 203 at 23, Ex. 207 at 33. Richard Sukenik (Sukenik) was Grace’s controller. Tr. 158. Phillip J. Ryan, III (Ryan), was Grace’s assistant controller. II Tr. 145. During the relevant period, Grace’s financial statements filed as part of its Forms 10-K and 10-Q reported industry segment information on specialty chemicals, health care, and other businesses. Exs. 187-207.
NMC was co-founded in 1968 by Constantine Hampers, M.D. (Hampers). Tr. 300. It was not a public company during the relevant period, but had been at one time. Tr. 300. NMC first became a subsidiary of Grace in 1984 and was a wholly owned subsidiary of Grace during the relevant period. Tr. 301-02. NMC’s business was dialysis services, provided at clinics in the United States and elsewhere, and related products and services. Tr. 307. Prior to becoming a wholly owned subsidiary of Grace, NMC had stand-alone financial statements, separate from Grace. Tr. 300-02.
During the relevant period, NMC comprised most, if not all, of Grace’s Health Care Group (the HCG). Tr. 71, 74, 313, 382-83, II Tr. 147-49. The HCG was one of Grace’s core businesses and was reported as a separate business segment in Grace’s consolidated financial statements. II Tr. 148-49; Exs. 191-203. The HCG was Grace’s fastest growing division; in 1991 and 1992 it contributed about 40% of Grace’s revenue but about 60% of the profit. Tr. 313; Exs. 191, 195. Grace touted NMC’s contributions to its income. Ex. 191 at 45, Ex. 195 at 45. NMC submitted monthly, quarterly, and annual reports to Grace’s financial reporting division by submitting data electronically into Grace’s databases, which were used to prepare Grace’s consolidated financial statements. II Tr. 168-71. The NMC reports submitted to Grace included revenues, cost of revenues, operating expenses, and balance sheets. Tr. 74-75, 169. An employee who reported to Armstrong inputted the data. Tr. 75-76. Armstrong reviewed the information that was sent to Grace. Tr. 76-77. Overall, Grace consolidated about 250 companies and forty reporting entities for its consolidated financial statements. II Tr. 233-34.
During the relevant period, Hampers, a dynamic, hands-on manager, was CEO and the dominant figure in NMC. Tr. 300-01. Hampers did not allow Grace to interfere in running NMC’s business. Tr. 304-06. When Bolduc was appointed CEO of Grace, Hampers judged that Bolduc had no experience in running any company and knew nothing about health care. Tr. 303. Hampers demanded an interview with Bolduc and informed him that he had serious doubts about his capabilities; Hampers told Bolduc that he would stay on only if allowed to run NMC independent of day-to-day interference. Tr. 303-04. Bolduc agreed, and thereafter, conducted himself largely to Hampers’s satisfaction. Tr. 304, 350. Hampers was of the opinion that Grace was stodgy and not profit-oriented or cost-conscious, in stark contrast to his operation of NMC. Tr. 304-05. Hampers was a member of Grace’s board of directors during the relevant period. Tr. 302.
Hampers reported to Bolduc at Grace. Tr. 304. Armstrong reported to Miles Nogelo (Nogelo), NMC’s CFO and treasurer. Tr. 72-73. Armstrong and Nogelo were part of Hampers’s immediate staff, above NMC’s three main divisions and their operating units. Tr. 307. Grace’s link to Nogelo and Armstrong was Smith, its CFO. Tr. 380; Exs. 12, 33, 44, 46, 51-54, 57, 65, 88-89, 99, 110, 112, 225. Nogelo and Armstrong worked as a team. Tr. 374-75, 414-17, 435, 438, 465, 469; Exs. 33, 44, 51. Armstrong’s contact with Smith was always with or through Nogelo. Tr. 135, 435, 465, 469.
3. Price Waterhouse
Price Waterhouse was Grace’s auditor. Exs. 115-44. The firm’s Boston office (PW Boston) audited NMC. Tr. 198-99; Exs. 115-25, 133-37, 139, 143, Ex. 163 at 19-21. The firm’s Grace audit team (PW Grace), located in New York and then, following Grace’s headquarters move, in Florida, audited Grace at the corporate level. Exs. 124, 126, 128-32, 138, 140-41. PW Grace provided unqualified opinions on Grace’s consolidated financial statements throughout the relevant period. Ex. 191 at 57, Ex. 195 at 54, Ex. 199 at F-3, Ex. 203 at F-3, Ex. 207 at F-3. NMC had a full audit of stand-alone financial statements for 1990; thereafter, during the relevant period, PW Boston performed agreed-upon procedures at the instructions of PW Grace. II Tr. 9-10, 51-57; Ex. 163 at 19-21. Finally, PW Boston carried out audit procedures related to 1993, 1994, and 1995 in conjunction with a Form 10 registration statement filed in anticipation of a spin-off of NMC. Div. Ex. 163 at 20-21. During the relevant period, George Jamieson (Jamieson) was the PW Boston partner on the NMC audit, agreed-upon procedures, and audit procedures. II Tr. 10; Ex. 163 at 21-22, 24-26. Eugene Gaughan (Gaughan) was the PW Grace partner on the Grace audit during the relevant period through the audit for 1994. II Tr. 503. Thomas J. Scanlon became the lead partner on the Grace audit for 1995. II Tr. 510; Ex. 161 at 17.
B. Excess Reserves
NMC had profit-sharing and other incentive compensation arrangements with the physicians in charge of the dialysis clinics. Tr. 110-11, 305, 316-17. Estimated payments due the physicians under these arrangements were accrued in the physicians’ compensation account. Tr. 110-11, 316-17. Toward the end of 1990, NMC’s revenues began to increase.9 Tr. 315. The increase, which continued in later years, was due to a change in Medicare billing for dialysis patients. Medicare payments for administration of Epogen, a drug that had proven to benefit dialysis patients, increased; additionally, Medicare commenced paying for dialysis at a later stage in treatment, so that private insurance companies, which reimbursed for dialysis treatments at a higher rate than Medicare, were paying for longer periods of patients’ treatments. Tr. 104-05, 230, 316. Corresponding increased accruals were booked in the physicians’ compensation account. Tr. 110-11, 316-17. At the end of 1990, there was a relatively small excess booked in this account over the amount actually owed to physicians.10 Tr. 316, II Tr. 36; Ex. 163 at 139.
Higher earnings continued during 1991, and Hampers told Nogelo and Armstrong to consult Smith on how to handle this positive development. Tr. 321, 404. Smith ordered them to report only enough income to Grace to hold NMC’s growth rate to 24%. Tr. 109-10, 141, 322. Accordingly, NMC reported excess reserves in the physicians’ compensation account to offset the higher-than-expected revenues so as to achieve a 24% growth rate in 1991. Tr. 110, 141; Ex. 120 at PW0984. Thus, the excess reserves reached about $22 million by the end of the year. Tr. 137-38; Ex. 121 at PW0369. In January 1992, during the closing process for 1991, Armstrong asked Ryan how the reserves were being handled for Grace’s financial statements; Ryan said they were being handled by Smith and PW Grace. Tr. 215.
There was a similar standing order to manipulate reported income throughout the relevant period. The excess reserves grew to about $49 million by the end of 1992. Tr. 142-44; Ex. 15 at N00342. They were about $50 million at the end of 1993 and about $49 million at the end of 1994. Tr. 166-69; Ex. 8 at N003559, Ex. 16 at N003378. The level of excess reserves fluctuated in interim quarters. Tr. 244. At times, the reserves were reduced on Smith’s orders to increase income to the level Smith desired. Tr. 161-62, 164, 168, 175-76, 245-47, 514-15; Ex. 99, Ex. 139 at PW3753A-3754. The result of the manipulation of the reserves during the relevant period was to reduce the range of fluctuations in the HCG’s reported growth rates and to present a picture of a more steady earnings trend than was actually the case. Ex. 147 at 6-9. The reported income growth of the HCG ranged from 22.7% to 37.1% during the relevant period; without the manipulation of the reserves, the range would have been from a loss of 7.9% to 60.5%. Ex. 147 at 6. Grace touted the HCG’s reported earnings, steady growth, and contribution to Grace’s bottom line in quarterly and year-end press releases during the relevant period. Exs. 170-84.
Every year, Jamieson of PW Boston, included the excess reserves on the net effects schedule that he discussed with NMC management.11 Tr. 138, 154, 168, 322. However, NMC never reversed the reserves; instead, the results that NMC sent to Grace, Grace’s consolidated financial statements, and the segment disclosures for the HCG in Grace’s financial statements contained the effect of the excess reserves, as Armstrong was aware.12 Tr. 139, 156, 168, 174. Grace’s financial statements for 1991 reported consolidated income from continuing operations before income taxes as $358.7 million and pretax operating profit of the health care segment as $139 million. Ex. 191 at 58, 71. The values reported for Grace and the health care segment, respectively, were $224.4 million and $176 million for 1992, $221.2 million and $247 million for 1993, and $139.1 million and $249 million for 1994. Ex. 195 at 55, 73, Ex. 199 at F-5, F-23, Ex. 203 at F-5, F-23. For 1995, Grace reported a consolidated pretax loss of $312.4 million and reported the health care segment as a discontinued operation. Ex. 207 at 51, 54.
1. Armstrong Carried Out Smith’s Instructions.
Armstrong carried out Smith’s instructions to meet the earnings targets Smith specified for the quarters and years during the relevant period; after determining earnings for the quarter or year, Armstrong determined the amount to be held in excess reserves and instructed his staff accordingly. Tr. 74-77, 81-82, 109-12, 141, 146, 149, 155, 157-61, 165-69; Ex. 16 at N3378, Ex. 26 at N843, Ex. 33. The excess reserves were always added back into income for purposes of computing taxable income. Tr. 156. They were added back to income for the purpose of computing income-based bonuses for key NMC personnel, as well. Tr. 177-79.
2. Armstrong Knew the Reserves Did Not Accord with GAAP.
Armstrong considered that there were no probable or reasonable estimable liabilities or exposures that would have justified the overaccrual in the physicians’ compensation account. Tr. 112-14, II Tr. 211. Armstrong did not believe that the overaccrual was in accordance with GAAP, specifically FAS 5.13 Tr. 115, 291, II Tr. 211. Additionally, the overaccrual would have been material to NMC’s results, had NMC had stand-alone financial statements. Tr. 116. Jamieson agreed. Tr. 130, 476-77, 497; Ex. 163 at 63-70.
Armstrong would not have recorded the excess reserves during the relevant period if the decision were up to him. Tr. 294-95. However, Armstrong had no power to change any directive from Smith regarding the reserves. Tr. 246-48, 361. If Armstrong had not complied with Smith’s orders concerning the reserves, he would have been forced to resign or been fired. Tr. 216, 361. He discussed his concerns throughout the relevant period with Hampers, Nogelo, Jamieson, Ryan, and Smith. Tr. 315, 322-23, 352-53, II Tr. 211. When Armstrong and Nogelo asked Smith how he could justify the reserves, Smith replied that it was none of their business and that he was handling it with PW Grace. Tr. 431, 435, 464-65, 531-32. Similarly, Jamieson did not receive straight answers from PW Grace when he asked how the reserves were justified.14 Tr. 448, 497. In 1995, NMC filed a Form 10 with the Commission in connection with Grace’s plan to spin off NMC. Ex. 2. The Form 10 contained stand-alone financial statements for NMC for the three previous years, and at Armstrong’s insistence, the excess reserves were returned to income in the years in which the income had been earned. Tr. 176-77, 295, 554-56; Ex. 1, Ex. 2 at 106-133, passim, Ex. 3. There was resistance at Grace to this. Tr. 259-60, 554-56, II Tr. 228-31.
3. Armstrong Knew Smith Established the Excess Reserves to Achieve a Targeted Growth Rate.
Smith’s sole reason for establishing excess reserves was to achieve a targeted growth rate.15 Tr. 523. Armstrong knew this. Tr. 109-110, 139-42; Exs. 33, 51. Smith told Armstrong and Nogelo that Grace would not receive credit from analysts and the markets for additional growth beyond the target. Tr. 112. Armstrong knew, when the excess reserves were accruing, that they would be used to increase income at some point. Tr. 114-15. Jamieson and PW Boston also were aware, by the time of the 1991 agreed-upon procedures, of the purpose of the overaccrual of reserves.16 Ex. 120 at PW0979, PW0984.
Whenever Armstrong and Nogelo asked Smith about the legitimacy of the reserves, he told them not to question him and that PW Grace had approved the handling of the reserves. Tr. 536-39. Armstrong reasoned that the PW Grace auditors who opined on Grace’s consolidated financial statements had much more information concerning all of Grace than he did, and that he could rely on the auditors’ unqualified opinions throughout the relevant period. Tr. 248. He also learned that Grace’s audit committee had looked into the reserves and, in a June 1993 meeting, decided to take no action. Tr. 255-56.
Armstrong did not know how PW Grace resolved the issue of the excess reserves as he never was privy to the Grace net effect schedules and never learned how the items on the NMC net effect schedules were resolved at the Grace level. Tr. 249. Armstrong never learned from Gaughan or from anyone else at PW Grace how PW Grace analyzed the excess reserves. Tr. 251, II Tr. 535. Armstrong theorized that there might be exposures outside NMC that he was unaware of, but conceded that no one ever told him of such exposures. Tr. 179-81, 219.
4. Smith Masterminded the Excess Reserves.
The excess reserves were known at NMC as the “Brian Smith” reserves. Tr. 175, 238-39, II Tr. 212; Ex. 163 at 119. Smith dictated the policy on reserves to NMC and to his subordinates at Grace. II Tr. 210. Smith held information closely, disseminating it to Grace or NMC employees individually on a need-to-know basis. II Tr. 208. However, Nogelo created a paper trail, documenting his and Armstrong’s understanding of Smith’s instructions and of Smith’s representation that he had cleared his plan with PW Grace, starting with an October 7, 1991, memorandum to Smith.17 Tr. 139-42; Ex. 51. In September 1992, Nogelo again documented Smith’s instructions in a memorandum to Smith to make clear that it was not NMC’s plan or recommendation to create the excess reserves. Tr. 464-66; Ex. 33. Armstrong also documented this in a January 25, 1994, memorandum to Sukenik; Sukenik crossed out Armstrong’s statement, “This was done at the direction of Grace corporate,” with the notation “Grow up!” Tr. 256-58; Ex. 35.
The Division suggests that Armstrong, in effect, hatched the income-smoothing plan and concealed it until PW Boston uncovered it. This argument, however, is contrary to the evidence. The overwhelming evidence shows that Smith was the mastermind of the scheme and ordered NMC personnel, including Armstrong, to carry it out. The record also shows that Armstrong believed that the excess reserves were not in accord with GAAP, that he and Nogelo documented Smith’s instructions to make clear that Grace, not NMC, had ordered the excess reserves, and that when presented with the opportunity, in preparing the Form 10 in 1995, Armstrong reversed the excess reserves and recorded income in the year it was earned. The argument that Armstrong concealed the excess reserves from PW Boston is also inconsistent with the facts that PW Boston learned of an overaccrual in the physicians’ compensation account in 1990, before the income-smoothing scheme started,18 and discussed the excess reserves with NMC management every year thereafter when performing agreed-upon procedures.
C. Expert Testimony19
Arthur R. Wyatt (Wyatt) testified for the Division and was accepted as an expert in GAAP. II Tr. 422-76; Ex. 148. Lee J. Seidler (Seidler) testified for the Division and was accepted as an expert in accounting and auditing standards and the materiality of misstatements in financial statements. II Tr. 248-421; Ex. 147.
a. FAS 5
The accounting standards that apply to Grace and NMC’s deferral of revenue and increase in reserves (liabilities) are contained in Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards No. 5, “Accounting for Loss Contingencies,” issued in 1975 (FAS 5). II Tr. 427-35; Ex. 148 at 6. FAS 5 was issued to combat an age-old problem – using general reserves to manage reported income. II Tr. 272-73, 430; Ex. 147 at 3-5. FAS 5 describes a contingent loss as an existing condition, situation, or set of circumstances involving uncertainty that ultimately will be resolved when one or more future events occur or fail to occur. Resolution of the uncertainty may confirm the incidence of a loss or impairment of an asset or the incurrence of a liability. FAS 5 requires that two conditions be met before a loss contingency may be recorded in the accounts – that the loss be probable and estimable. If either of these two elements is not present, it is a violation of GAAP to record a reserve. II Tr. 271-72, 427-28; Ex. 147 at 6-8, Ex. 148 at 6-7. General reserves not related to a specific contingency are strictly forbidden by FAS 5. II Tr. 272-73, 429; Ex. 147 at 3-5, Ex. 148 at 6. FAS 5 does not permit a company to record a reserve for one liability and then use it to offset a different contingent liability that arises later. II Tr. 430. Further, a loss contingency that does not meet both criteria of FAS 5 may not be recorded, regardless of amount. Ex. 148 at 8. The concept of materiality applies only to actual transactions and events; GAAP does not contemplate inclusion of fictitious entries of any kind in financial statements, let alone fictional entries up to some materiality threshold. Ex. 148 at 8-9.
Accountants use 5% as a quantitative measure of materiality in comparing an item numerically to a chosen base. II Tr. 284-88; Ex. 147 at 12-14. This means that anything over 5% is material; it does not, however, necessarily mean that anything under 5% is not material. II Tr. 287, 290. A corporation’s shares are valued heavily on its growth rate and the smoothness of the trend of the growth rate. II Tr. 280; Ex. 147 at 21-24.
Wyatt opined that materiality was irrelevant to the excess reserves at issue. II Tr. 442. He observed that it is difficult enough in accounting to capture the economic effects of all the events that have taken place and transactions entered into; he opined that it was inappropriate to make entries for events and transactions that have not happened. II Tr. 434. There is nothing in accounting literature that permits a reporting entity to create a fictional entry, whether material or immaterial in size, and put it in the accounts with all the factual events and transactions that did happen. II Tr. 442.
2. Corporate Governance20
Seidler testified briefly on the role of parent and subsidiary management with regard to financial statements and was accepted as an expert on that topic. II Tr. 259-68, 309-15, 401-18; Ex. 147 at 27-29. John M. Riley (Riley) testified on behalf of Armstrong and was accepted as an expert on corporate governance, including the conduct of corporate officers and financial executives. II Tr. 563-635; Ex. 454. Riley opined that Armstrong fulfilled his responsibilities as a financial executive of a subsidiary of a public corporation. II Tr. 585-86, 608-610. His opinion is based on the facts that Grace management directed him to book the excess reserves and told him that this was acceptable to PW Grace, which was indicated by PW Grace’s unqualified opinions. II Tr. 592, 608-10; Ex. 454.
D. Missing Witnesses
Armstrong argues that an adverse inference should be drawn from the fact that the Division did not call Smith, whom he denominates a key witness, and whose testimony, he suggests, would have exculpated him. Armstrong states that the Division had available to it three key witnesses, Smith, Bolduc, and Sukenik, noting that each had agreed to assist the Division as part of his individual settlement with the Commission,21 and that each was on the Division’s final witness list but did not testify. In particular, Armstrong states that Smith was the undisputed architect of Grace’s plan to manage the growth rates of NMC, and that his testimony would have shed light on the creation of the excess reserves, Armstrong’s role, if any, and Smith’s interactions with PW Grace. Armstrong notes that the Division had represented that it would call Smith, but on the day on which Smith was scheduled to appear, the Division announced without explanation that it would not call Smith. II Tr. 182. In support of this argument, Armstrong cites cases discussing the “missing witness” jury instruction.
The undersigned has not drawn any inference adverse to the Division’s case, or to Armstrong’s, from the absence of Smith (or of Bolduc and Sukenik). They were not unavailable to Armstrong as witnesses. He could have subpoenaed them pursuant to Rule 232 of the Commission’s Rules of Practice, 17 C.F.R. § 201.232. Their investigative testimony was available to him long in advance of the hearing. Thus, the possibility of surprise in their testimony would have been minimal. Further, when a party calls a hostile witness or a witness identified with an adverse party, interrogation may be by leading questions. See generally Fed. R. Evid. 611(c); 1 Charles T. McCormick, McCormick on Evidence § 6, pp. 9-11 (4th ed. 1992).
III. CONCLUSIONS OF LAW
The charges against Armstrong include antifraud, reporting, and books and records violations, as well as improper professional conduct along with securities laws violations as a basis for Rule 102(e) sanctions. Specifically, Armstrong was charged with willfully violating or causing violations of antifraud and books and records provisions of the securities laws – Exchange Act Sections 10(b) and 13(b)(5) and Rules 10b-5 and 13b2-1 and with causing violations of reporting provisions – Exchange Act Sections 13(a) and 13(b)(2) and Rules 12b-20, 13a-1, and 13a-13. Additionally, Armstrong was charged with improper professional conduct within the meaning of 17 C.F.R. § 201.102(e)(1)(ii). In this section, it is concluded that Exchange Act charges are proven and that the Rule 102(e) charges are unproven.
A. Antifraud Provisions
Exchange Act Section 10(b) and Rule 10b-5 make it unlawful “in connection with the purchase or sale of any security,” by jurisdictional means, to:
1) employ any device, scheme, or artifice to defraud;
2) make any untrue statement of a material fact or omit to state a material fact necessary to make the statements made not misleading; or
3) engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon any person.
Scienter is required to establish violations of Exchange Act Section 10(b) and Rule 10b-5. Aaron v. SEC, 446 U.S. 680, 701-02 (1980). It is “a mental state embracing intent to deceive, manipulate, or defraud.” Aaron, 446 U.S. at 686 n.5 (quoting Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 n.12 (1976)); see also SEC v. Steadman, 967 F.2d 636, 641 (D.C. Cir. 1992). Recklessness can satisfy the scienter requirement. Disner, 52 S.E.C. at 1222 & n.20; see also Steadman, 967 F.2d at 641-42; Hollinger v. Titan Capital Corp., 914 F.2d 1564, 1568-69 (9th Cir. 1990). Reckless conduct is conduct which is “‘highly unreasonable’ and represents ‘an extreme departure from the standards of ordinary care . . . to the extent that the danger was either known to the defendant or so obvious that the defendant must have been aware of it.’” Rolf v. Blyth, Eastman Dillon & Co., 570 F.2d 38, 47 (2d Cir. 1978) (quoting Sanders v. John Nuveen & Co., 554 F.2d 790, 793 (7th Cir. 1977)).
Material misrepresentations and omissions violate Exchange Act Section 10(b) and Rule 10b-5. The standard of materiality is whether a reasonable investor or prospective investor would have considered the information important in deciding whether to invest. Basic Inc. v. Levinson, 485 U.S. 224, 231-32, 240 (1988); TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976); Steadman, 967 F.2d at 643.
Grace is accountable for the actions of its responsible officers, including Smith, Bolduc, and others. C.E. Carlson, Inc. v. SEC, 859 F.2d 1429, 1435 (10th Cir. 1988). A company’s scienter may be imputed from that of the individuals controlling it. SEC v. Blinder, Robinson & Co., 542 F. Supp. 468, 476 n.3 (D. Colo. 1982) (citing SEC v. Manor Nursing Ctrs., Inc., 458 F.2d 1082, 1096-97 nn.16-18 (2d Cir. 1972)).
In addition to being charged with “committing” violations, Armstrong is charged with “causing,” within the meaning of Exchange Act Section 21C, various violations of which Grace is the primary violator. Section 21C authorizes the Commission to order a person who was a cause of a violation, due to an act or omission the person knew or should have known would contribute to such violation, to cease and desist from committing or causing such violation and any future violation. To issue such an order the Commission must find that: (1) a primary violation occurred; (2) there was an act or omission by the respondent that was a cause of the violation; and (3) the respondent knew, or should have known, that his conduct would contribute to the violation.22 Robert M. Fuller, 80 SEC Docket 3539, 3545 (Aug. 25, 2003), appeal pending, No. 03-1334 (D.C. Cir.). Negligence is sufficient to establish liability for causing a primary violation that does not require scienter. KPMG Peat Marwick LLP, 74 SEC Docket 384, 421 (Jan. 19, 2001), reh’g denied, 74 SEC Docket 1351 (Mar. 8, 2001), pet. denied, 289 F.3d 109 (2002), reh’g en banc denied, 2002 U.S. App. Lexis 14543 (July 16, 2002). It is assumed that scienter is required to establish secondary liability for causing a primary violation that requires scienter. Id.
The Division requests sanctions pursuant to Rule 102(e)(iii). The Commission must find willful violations to impose sanctions under that provision. A finding of willfulness does not require an intent to violate, but merely an intent to do the act which constitutes a violation. Wonsover v. SEC, 205 F.3d 408, 413-15 (D.C. Cir. 2000); Steadman v. SEC, 603 F.2d 1126, 1135 (5th Cir. 1979); Arthur Lipper Corp. v. SEC, 547 F.2d 171, 180 (2d Cir. 1976); Tager v. SEC, 344 F.2d 5, 8 (2d Cir. 1965).
B. Antifraud Violations
Armstrong was charged with violating Exchange Act Section 10(b) and Rule 10b-5 and with causing violations of those provisions. The financial statements included with Grace’s periodic reports filed during the relevant period contained misstatements that were material misrepresentations: The HCG segment reported inaccurate earnings that were manipulated through recording reserves that were not in compliance with FAS 5 and therefore GAAP. Reserves not related to a specific contingency are strictly forbidden by FAS 5. A fortiori, accruing and releasing reserves for the purpose of manipulating reported earnings does not accord with FAS 5. Additionally, in some filings, the misstatements also exceeded a quantitative standard of 5%, or even 10%, of Grace’s or the HCG’s reported income. The misrepresentations were clearly material. A reasonable investor would have considered the information important in deciding whether or not to invest, both because of the fact that Grace management intended to deceive the public and because of the size of the misrepresentations. The misstatements were made knowingly, to attain a targeted income figure. The scienter of Smith and others who planned and directed the scheme is attributed to Grace. Grace’s material misrepresentations thus violated Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. Stated otherwise, Grace’s earnings management program was a scheme to defraud in violation of those provisions.
Armstrong’s participation in Grace’s scheme in itself violated Exchange Act Section 10(b) and Rule 10b-5. He cooperated, albeit with misgivings, in the execution of the program. Armstrong argues that he relied on Grace management and on the fact that PW Grace reported unqualified opinions on Grace’s financial statements. He knew, however, that the excess reserves did not accord with FAS 5 and were booked for the purpose of earnings management by Grace; he also knew that the misleading figures found their way into HCG segment of Grace’s filings. Thus, the record shows his scienter. Armstrong’s conduct was reckless – highly unreasonable and an extreme departure from the standards of ordinary care.
Armstrong argues that he had no choice but to follow Smith’s orders. Armstrong’s position at the firm vis-à-vis Grace management, however, does not excuse him from the consequences of his participation in Grace’s scheme. To hold otherwise would be contrary to the Commission’s clear position in cases involving scienter-based violations. See Charles K. Seavey, 79 SEC Docket 3455, 3462-64 (Mar. 27, 2003), appeal pending, No. 03-71565 (9th Cir.);23 Nicholas P. Howard, 79 SEC Docket 2332, 2338-39 (Feb. 12, 2003), appeal pending, No. 03-1098 (D.C. Cir.);24 Graham, 53 S.E.C. at 1084-86;25 cf. James J. Pasztor, 70 SEC Docket 2611, 2624 (Oct. 14, 1999).26 For the same reasons, Armstrong was a cause, within the meaning of Exchange Act Section 21C, of Grace’s primary violations. Armstrong’s cooperation in Grace’s scheme constituted acts that were causes of Grace’s violations, and the record shows scienter within the meaning of the securities laws.
In sum, it is concluded that Armstrong willfully violated and caused Grace’s violations of Exchange Act Section 10(b) and Rule 10b-5. His actions were clearly intentional. Thus, his violations were willful.
C. Periodic Reporting Violations
Exchange Act Section 13(a) and Rules 13a-1 and 13a-13 require a public corporation to file annual and quarterly reports (periodic reports) with the Commission. The annual report is known as Form 10-K, and the quarterly report, as Form 10-Q. The requirement that reports be filed carries with it the obligation that those filings be accurate. SEC v. Savoy Indus., Inc., 587 F.2d 1149, 1165 (D.C. Cir. 1978), cert. denied sub nom., Zimmerman v. SEC, 440 U.S. 913 (1979). Exchange Act Rule 12b-20 requires that periodic reports contain such further information as is necessary to make the required statements, in light of the circumstances under which they are made, not misleading. Financial statements included with the periodic reports must be prepared in accordance with GAAP. If not, they are presumed misleading, despite footnotes or other disclosures. 17 C.F.R. § 210.4-01(a)(1).27
Grace’s periodic reports during the relevant period included financial statements that were not in accordance with GAAP and were materially misleading. Thus, Grace violated Exchange Act Section 13(a) and Rules 12b-20, 13a-1, and 13a-13. For the reasons set forth above, Armstrong was a cause of those violations.
D. Books and Records Violations
Section 13(b)(2)(A) of the Exchange Act requires a public corporation to make and keep books and records that accurately reflect its transactions and disposition of assets. Section 13(b)(2)(B) requires it to devise and maintain a system of internal accounting controls sufficient to provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in conformity with GAAP. These sections can only be violated by an issuer, such as Grace. Exchange Act Section 13(b)(5) provides that no person shall knowingly falsify any book, record or account subject to Section 13(b)(2)(A). Exchange Act Rule 13b2-1 provides that no person shall, directly or indirectly, falsify or cause to be falsified any book, record or account subject to Section 13(b)(2)(A). These provisions can be violated by any person.
Grace’s income-smoothing scheme violated Exchange Act Section 13(b)(2). For the reasons set forth above, Armstrong was a cause of those violations. For the reasons set forth above, both Grace and Armstrong violated Exchange Act Section 13(b)(5) and Rule 13b2-1, and Armstrong was also a cause of Grace’s violations.
E. Rule 102(e)
Rules 102(e) provides, “The Commission may censure a person or deny, temporarily or permanently, the privilege of appearing or practicing before it in any way to any person who . . . (ii) . . . engaged in . . . improper professional conduct, or (iii) . . . willfully violated, or willfully aided and abetted the violation of any provision of the Federal securities laws or the rules and regulations thereunder.” The Commission has stressed that Rule 102(e) is intended to protect the integrity of its processes and to ensure that professionals adhere to professional standards and minimum standards of competence when they practice before it. Amendment to Rule 102(e) of the Commission’s Rules of Practice, 68 SEC Docket 707, 708, 63 Fed. Reg. 57,164, 57,165 (Oct. 26, 1998) (Rule 102(e) Amendment) (citing Touche Ross & Co. v. SEC, 609 F.2d 570, 579, 582 (2d Cir. 1979)). Rule 102(e), previously known as Rule 2(e), has been used almost exclusively against accountants, and at times, attorneys.28
At an earlier stage in this proceeding, the undersigned dismissed the Rule 102(e) proceeding against Armstrong on the basis that he was not a CPA. Jean-Paul Bolduc, 70 SEC Docket 330 (A.L.J. July 2, 1999). Thereafter, the Commission set aside the dismissal as premature, noting that the case was complicated, involving numerous parties and various provisions of the securities laws and accounting requirements. Jean-Paul Bolduc, 78 SEC Docket 2038 (Adopted July 18, 2002, Released Oct. 9, 2002). The Commission, noting that Armstrong was not a CPA, stated that the parties should be permitted to develop a record regarding the allegations related to Rule 102(e). Id. at 2039-40. Specifically, the Commission stated, “the parties should address the question of, if Armstrong is subject to the Rule, the nature of any professional standards to which he was subject during the period at issue. Similarly, the parties should address whether Armstrong’s actions constituted ‘appearing or practicing’ before the Commission and whether they threatened the integrity of the Commission’s processes.” Id. at 2039 n.9.
1. Rule 102(e)(1)(ii)
Evidence from the Division’s expert witnesses touched briefly on the general responsibility of management for accurate financial reports. Their evidence did not, however, distinguish the responsibility of Armstrong from, e.g., that of Nogelo and Hampers at NMC, or, indeed, from that of any employee of any public corporation. (This issue was discussed at the July 1, 2003, prehearing conference at Tr. 13-17.) In a word, there was no proof as to any “professional standards” to which Armstrong was subject. Thus, he cannot be sanctioned pursuant to Rule 102(e)(1)(ii).
2. Rule 102(e)(1)(iii)
Armstrong has willfully violated provisions of the federal securities laws and the Commission’s rules within the meaning of Rule 102(e)(1)(iii). He did not, however, “appear” or “practice” before the Commission.
Rule 102, by its terms, applies only to persons “appearing” or “practicing” before the Commission.29 Such persons include accountants serving as officers of public companies. Rule 102(e) Amendment, 68 SEC Docket at 708 & n.13, 63 Fed. Reg. at 57,165 & n.13. Armstrong was not, however, an officer of Grace during the relevant period. Rather, he was an officer of NMC, a non-public, wholly owned subsidiary of a public company. Nor did Armstrong prepare or sign any of Grace’s reports filed with the Commission. In short, there is no evidence in the record concerning appearing or practicing that distinguishes Armstrong from Hampers, Nogelo, or any employee of a corporation, public or otherwise.
When analyzing the threat to the integrity of the Commission’s processes posed by Armstrong’s actions, it must be remembered that Armstrong was powerless to change Grace’s course of conduct. Had he resigned, this would not have forced Grace to record NMC’s income in accordance with GAAP. Had he been empowered to do so, Armstrong would not have recorded the “Brian Smith” excess reserves. This is shown by his concern over the issue throughout the relevant period and by the Form 10 that he prepared for NMC. At Armstrong’s insistence, the financial statements filed with the Form 10 reversed the reserves and booked the income in the years in which it was earned in accordance with GAAP. These mitigating factors diminish any future threat to the Commission’s processes posed by Armstrong’s contribution to Grace’s false filings.
In sum, it is concluded that there was no proof as to any professional standards to which Armstrong was subject within the meaning of Rule 102(e)(1)(ii) and that he did not appear or practice before the Commission within the meaning of Rule 102(e)(1)(ii) and (iii). Accordingly, the Rule 102(e) charges against Armstrong will be dismissed.
The Division requests a cease-and-desist order pursuant to Section 21C of the Exchange Act and a censure pursuant to Rule 102(e). Armstrong argues that no sanctions are warranted. The Rule 102(e) charges will be dismissed. For the reasons discussed below, Armstrong will be ordered to cease and desist from committing or causing any violations or future violations of Sections 10(b), 13(a), 13(b)(2), or 13(b)(5) of the Exchange Act, or of Rules 10b-5, 12b-20, 13a-1, 13a-13, or 13b2-1 thereunder.
Section 21C of the Exchange Act authorizes the Commission to issue a cease-and-desist order against a person who “is violating, has violated, or is about to violate” any provision of the Act or rules thereunder.30 Whether there is a reasonable likelihood of such violations in the future must be considered. KPMG, 74 SEC Docket at 429. The Commission has held, “[i]n the ordinary case and absent evidence to the contrary, a finding of past violation raises a risk of future violation sufficient to support” a cease-and-desist order. WHX Corp., 80 SEC Docket 1318, 1336 (June 4, 2003), appeal pending, No. 03-1196 (D.C. Cir.). In determining whether there is “evidence to the contrary,” the Commission considers a range of additional factors:
including the seriousness of the violation, the isolated or recurrent nature of the violation, the respondent’s state of mind, the sincerity of the respondent’s assurances against future violations, the respondent’s recognition of the wrongful nature of his or her conduct, . . . the respondent’s opportunity to commit future violations[,] . . . whether the violation is recent, the degree of harm to investors or the marketplace resulting from the violation, and the remedial function to be served by the cease-and-desist order in the context of any other sanctions being sought in the same proceedings.
WHX Corp., 80 SEC Docket at 1337 (quoting KPMG, 74 SEC Docket at 436).
In this case, the presumption that a past violation indicates a likelihood of future violation is not outweighed by the additional factors that could constitute “evidence to the contrary.” Armstrong’s recognition of the wrongful nature of his conduct is indicated by the concern he expressed over the years about the excess reserves and by the fact that he appropriately reversed the reserves into income when he prepared the financial statements for the 1995 Form 10. Also, the violations were not recent. Nonetheless, the violations were serious, and they were recurrent over a period of several years. Concerning state of mind, Armstrong was reckless. Consistent with a vigorous defense of the charges against him, Armstrong did not explicitly give assurances against future violations. Armstrong’s occupation presents an opportunity to commit future violations. The degree of harm to investors or the marketplace cannot be quantified. No sanction other than a cease-and-desist order is being imposed.
In light of the above, a cease-and-desist order is appropriate. Accordingly, Armstrong will be ordered to cease and desist from committing or causing any violations or future violations of Sections 10(b), 13(a), 13(b)(2), or 13(b)(5) of the Exchange Act, or of Rules 10b-5, 12b-20, 13a-1, 13a-13, or 13b2-1 thereunder.
V. RECORD CERTIFICATION
Pursuant to Rule 351(b) of the Commission’s Rules of Practice, 17 C.F.R. § 201.351(b), it is certified that the record includes the items set forth in the record index issued by the Secretary of the Commission on March 19, 2004.
VI. ORDER ON MOTION TO DISMISS
During the hearing the undersigned reserved ruling on Armstrong’s motion to dismiss. Based on the findings and conclusions set forth above:
IT IS ORDERED that Armstrong’s motion to dismiss IS GRANTED as to the proceeding pursuant to Rule 102(e) of the Commission’s Rules of Practice, 17 C.F.R. § 201.102(e), as specified in OIP paras. II.F.4. and III.C., and IS OTHERWISE DENIED.
Based on the findings and conclusions set forth above:
IT IS ORDERED that, pursuant to Section 21C of the Securities Exchange Act of 1934, 15 U.S.C. § 78u-3, Robert W. Armstrong, III, CEASE AND DESIST from committing or causing any violations or future violations of Sections 10(b), 13(a), 13(b)(2), or 13(b)(5) of the Securities Exchange Act of 1934, 15 U.S.C. §§ 78j(b), 78m(a), 78m(b)(2), or 78m(b)(5), or of Rules 10b-5, 12b-20, 13a-1, 13a-13, or 13b2-1 thereunder, 17 C.F.R. §§ 240.10b-5, .12b-20, .13a-1, .13a-13, or .13b2-1.
IT IS FURTHER ORDERED that the proceeding pursuant to Rule 102(e) of the Commission’s Rules of Practice, 17 C.F.R. § 201.102(e), as specified in OIP paras. II.F.4. and III.C., IS DISMISSED.
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 Decision shall not become final as to that party.
Carol Fox Foelak
Administrative Law Judge
1 The proceeding was originally captioned Jean-Paul Bolduc, et al. and included six additional respondents. The proceeding ended previously as to each of those six. Jean-Paul Bolduc, 80 SEC Docket 3115 (Aug. 12, 2003) (A. Miles Nogelo); Jean-Paul Bolduc, 80 SEC Docket 3111 (Aug. 12, 2003) (Constantine L. Hampers); Jean-Paul Bolduc, 79 SEC Docket 3541 (Mar. 28, 2003) (Richard N. Sukenik); Jean-Paul Bolduc, 79 SEC Docket 2576 (Feb. 27, 2003) (J.P. Bolduc); Jean-Paul Bolduc, 78 SEC Docket 65 (July 15, 2002) (Philip J. Ryan, III); Jean-Paul Bolduc, 78 SEC Docket 60 (July 15, 2002) (Brian J. Smith).
2 Additionally, pursuant to 17 C.F.R. § 201.235(a), investigative testimony of Thomas J. Scanlon, deceased; Albert J. Costello, deceased; and George Jamieson, who was out of the United States, was admitted as Division Exhibit 161, Respondent Exhibit 449, and Division Exhibit 163, respectively. Also, Scanlon’s May 9, 1996, deposition in Eatough v. W.R. Grace & Co. was admitted as Respondent Exhibit 450. The investigative testimony and deposition in Eatough v. W.R. Grace & Co. of Harold Eckmann, who was unable to appear because of age and infirmity, were admitted as Respondent Exhibits 451 and 452, respectively.
3 The transcript for October 8-10 is paginated sequentially, and for October 14-20 is paginated sequentially in a separate sequence. Citations to the transcript for October 8-10 will be noted as “Tr. __,” and for October 14-20 will be noted as “II Tr. __.” Citations to exhibits will be noted as “Ex. __.” The Division’s exhibits are numbered 1 through 225, and Respondent’s are numbered starting at 300.
4 GAAP are the basic postulates and broad principles of accounting pertaining to business enterprises. These principles establish guidelines for measuring, recording, and classifying the transactions of a business entity. See SEC v. Arthur Young & Co., 590 F.2d 785, 789 n.4 (9th Cir. 1979).
5 In Johnson, the court ruled that a Commission “proceeding resulting in a censure and a six-month disciplinary suspension of a securities industry supervisor was a proceeding ‘for the enforcement of any civil fine, penalty or forfeiture, pecuniary or otherwise,’ within the meaning of § 2462.” 87 F.3d at 485.
6 Section 555(b) provides, in part, “With due regard for the convenience and necessity of the parties or their representatives and within a reasonable time, each agency shall proceed to conclude a matter presented to it.”
7 See Jean-Paul Bolduc, 78 SEC Docket 2038 (Adopted July 18, 2002, Released Oct. 9, 2002) (setting aside dismissal by the undersigned of Rule 102(e) charges against Armstrong).
8 He allowed his license to lapse in 1983 because he did not need it and the continuing education required to maintain it was burdensome. Tr. 192.
9 At first, Hampers was unsure whether the higher revenues would continue. Tr. 316.
10 PW Boston’s 1990 workpapers (which Jamieson reviewed and initialed) questioned a general reserve of $3 million. Ex. 116 at PW9392, PW9431. In his 1998 investigative testimony Jamieson did not recall learning of a 1990 overaccrual until after the 1990 audit. Ex. 163 at 133. Jamieson considered PW Boston’s unqualified opinion on NMC’s 1990 financial statements to be appropriate because the 1990 overaccrual was relatively insignificant. II Tr. 36; Ex. 163 at 138-39.
11 A net effects schedule documents the significant accounting issues that the auditor uncovered; it lists proposed adjustments that the auditor recommends. Tr. 135-37; Ex. 121 at PW0369. The auditor nets the debits and credits on the schedule and compares the net figure to the applicable materiality standard to see whether an adjustment by the client of its financial statements is required. Tr. 136; Ex. 450 at 21-22.
12 For many quarters, Armstrong reviewed drafts of the HCG segment, including the Management Discussion and Analysis. Of those that he reviewed, the numbers for the HCG always reconciled with the numbers NMC had provided to Grace. Tr. 87-95.
13 FAS 5 refers to Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards No. 5, “Accounting for Loss Contingencies.”
14 In his 1998 investigative testimony, Jamieson did not recall any discussions with PW Grace about the reserves. Ex. 163 at 76.
15 At the end of 1994, Smith asked Armstrong and Nogelo to quantify some exposures that had arisen; Nogelo theorized that Smith hoped to use the exposures to justify the reserves to PW Grace. Tr. 523, 532, 563.
16 In 1998, Jamieson did not recall knowing Smith’s purpose for the reserves. Ex. 163 at 60. However, he was aware of the purpose in January 1992; workpapers initialed by him noted, “overaccrual is based on [management’s] decision to show . . . 24% . . . growth in 1991.” Ex. 120 at PW0979, PW0984.
17 The October 7, 1991, memorandum was provided to PW Boston in December 1992 in a clandestine manner by someone at NMC. II Tr. 58-60; Ex. 124, Ex. 163 at 140-41, 147. Jamieson forwarded it to Gaughan at PW Grace. Ex. 124, Ex. 163 at 140, 144.
18 Ex. 116 at PW9392, PW9431, Ex. 117. Warren Barnes, who reported to Jamieson, was the senior accountant on the audit for 1990, and was a manager on the agreed-upon procedures performed for 1991 and 1992. II Tr. 9-10. Barnes testified that he learned of the reserves in the fall of 1991. II Tr. 24, 26-27. However, on cross-examination he conceded that he learned of reserves in 1990 but could no longer recall the details. II Tr. 86-89; Ex. 116 at PW9431, Ex. 117.
19 To the extent that the experts’ evidence does not lead to findings of fact, it will be summarized here and referred to as appropriate in the Conclusions of Law section of this Initial Decision.
20 Additionally, Philip Lochner opined that the actions of Hampers were reasonable and appropriate. Ex. 453. He testified, however, that he had not analyzed Armstrong’s situation and that his opinion regarding Hampers could not be applied to Armstrong. II Tr. 577.
21 Smith’s settlement provided, “Smith undertakes to cooperate with Commission staff in preparing for and presenting any civil litigation or administrative proceedings concerning any transaction that is the subject of this Order.” Jean-Paul Bolduc, 78 SEC Docket at 64.
22 The three elements that the Commission articulated for “causing” liability have parallels in the three elements of aiding and abetting liability. For aiding and abetting liability under the federal securities laws, three elements must be established: (1) a primary or independent securities law violation committed by another party; (2) awareness or knowledge by the aider and abettor that his or her role was part of an overall activity that was improper; also conceptualized as scienter in aiding and abetting antifraud violations; and (3) that the aider and abettor knowingly and substantially assisted the conduct that constitutes the violation. Graham v. SEC, 222 F.3d 994, 1000 (D.C. Cir. 2000); see also Woods v. Barnett Bank, 765 F.2d 1004, 1009 (11th Cir. 1985); Investors Research Corp. v. SEC, 628 F.2d 168, 178 n.61 (D.C. Cir. 1980); IIT v. Cornfeld, 619 F.2d 909, 922 (2d Cir. 1980); Woodward v. Metro Bank of Dallas, 522 F.2d 84, 94-97 (5th Cir. 1975); SEC v. Coffey, 493 F.2d 1304, 1316-17 (6th Cir. 1974); Russo Sec. Inc., 53 S.E.C. 271, 278-79 & n.16 (1997); Donald T. Sheldon, 51 S.E.C. 59, 66 (1992), aff’d, 45 F.3d 1515 (11th Cir. 1995); William R. Carter, 47 S.E.C. 471, 502-03 (1981). A person cannot escape aiding and abetting liability by claiming he was ignorant of the securities laws. Graham, 53 S.E.C. at 1084 n.33. The knowledge or awareness requirement can be satisfied by recklessness when the alleged aider and abettor is a fiduciary or active participant. See Ross v. Bolton, 904 F.2d 819, 824 (2d Cir. 1990); Cornfeld, 619 F.2d at 923, 925; Rolf, 570 F.2d at 47-48; Woodward, 522 F.2d at 97. A respondent who aids and abets a violation, a fortiori, is also a cause of the violation, within the meaning of Section 21C of the Exchange Act. Graham, 53 S.E.C. at 1085 n.35.
23 In Seavey, the Commission held an associated person of an investment adviser liable for aiding and abetting antifraud violations based on his participation in a letter to hedge fund investors that misrepresented the fund’s assets by including assets that the fund purchased from sellers who fraudulently failed to deliver. The Commission recognized that the associated person diligently attempted to obtain delivery and urged, albeit unsuccessfully, the investment adviser to inform the investors and to initiate civil and criminal proceedings against the fraudulent sellers. The Commission took these factors into account in ordering sanctions but emphasized that they did not excuse liability. 79 SEC Docket at 3462-64.
24 In Howard, the Commission held a broker-dealer’s vice president in charge of marketing liable for aiding and abetting the fraudulent closing of a part-or-none offering. He had relied on the broker-dealer’s corporation finance and compliance departments and on outside legal counsel for compliance with the securities laws. The Commission rejected this defense, stating that a securities professional has an ongoing obligation to familiarize himself with pertinent legal requirements to protect investors from illegality. 79 SEC Docket at 2338-39.
25 In Graham, the Commission held a registered representative liable for aiding and abetting a customer’s antifraud violations despite direction and assurance from the broker-dealer’s branch manager and owner that the trades were legal. The Commission emphasized the registered representative’s responsibility to comply with the law. 53 S.E.C. 1084-86; accord, Adrian C. Havill, 53 S.E.C. 1060, 1068-70 (1998).
26 In Pasztor, the Commission held that a branch manager failed reasonably to supervise a registered representative who aided and abetted a customer’s antifraud violations. The branch manager tried to stop the violative trades but was overruled by the broker-dealer’s owner. In finding his efforts insufficient, the Commission emphasized the branch manager’s responsibility despite his superior’s role in the violations. 70 SEC Docket at 2624-25.
27 Part 210 of 17 C.F.R. (17 C.F.R. §§ 210.1 - .12) is also known as Regulation S-X.
28 There have been only a few cases in the rule’s history since 1935 that did not involve either a lawyer or an accountant. Rule 102(e) Amendment, 68 SEC Docket at 717 & n.16, 63 Fed. Reg. at 57,174 & n.16 (dissenting statement of Commissioner Norman S. Johnson). The only such cases that are readily retrievable by public search methods are two settlements: Martin G. Browne, 54 SEC Docket 2542 (Sept. 9, 1993) (bogus engineer); and Robert W. McDowell, Jr., 14 SEC Docket 64 (Feb. 3, 1978) (geologist and engineer).
29 Rule 102, titled Appearance and Practice Before the Commission, is somewhat nonspecific as to what constitutes appearance and practice. See Rule 102(d)(1) (referring to an individual making a filing or otherwise appearing on his own behalf in a proceeding), (d)(2) (referring to a person making a filing or otherwise appearing in a representative capacity in a proceeding), (f) (providing that practice “shall include, but shall not be limited to: (1) transacting any business with the Commission; and (2) the preparation of any statement, opinion or other paper by any attorney, accountant, engineer or other professional or expert, filed with the Commission in any registration statement, notification, application report or other document with the consent of such attorney, accountant, engineer or other professional or expert.”).
30 As noted above, Section 21C also authorizes the Commission to order a person who was a cause of a violation, due to an act or omission the person knew or should have known would contribute to such violation, to cease and desist from committing or causing such violation and any future violation.
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