UNITED STATES OF AMERICA Before the SECURITIES AND EXCHANGE COMMISSION SECURITIES ACT of 1933 Release No. 7358 / October 17, 1996 SECURITIES EXCHANGE ACT of 1934 Release No. 37833 / October 17, 1996 ACCOUNTING AND AUDITING ENFORCEMENT Release No. 843 / October 17, 1996 ADMINISTRATIVE PROCEEDING File No. 3-9169 ------------------------------- : : ORDER INSTITUTING In the Matter of: : PROCEEDINGS PURSUANT TO : SECTION 8A OF THE : SECURITIES ACT OF 1933 CAMBRIDGE BIOTECH : AND SECTION 21C OF THE CORPORATION, : SECURITIES EXCHANGE ACT : OF 1934, MAKING FINDINGS Respondent. : AND IMPOSING A CEASE-AND- : DESIST ORDER : : -------------------------------- I. The Securities and Exchange Commission ("Commission") deems it appropriate that public administrative proceedings be instituted pursuant to Section 8A of the Securities Act of 1933 ("Securities Act") and Section 21C of the Securities Exchange Act of 1934 ("Exchange Act") against Cambridge Biotech Corporation ("CBC"). II. In anticipation of the institution of these proceedings, CBC submitted an Offer of Settlement ("Offer"), which the Commission has determined to accept. Solely for the purpose of these proceedings and any other proceedings brought by or on behalf of the Commission or in which the Commission is a party, and without admitting or denying the Commission's findings contained herein, but admitting the jurisdiction of the Commission over CBC and the subject matter of this proceeding, CBC consents to the issuance of this Order Instituting Proceedings, Making Findings and Imposing a Cease-and-Desist Order (the "Order"). ==========================================START OF PAGE 2====== III. FINDINGS On the basis of this Order and the Offer, the Commission makes the following findings: -[1]- A. FACTS 1. Respondent CBC is a Delaware corporation headquartered in Worcester, Massachusetts. CBC reports its financial results on a fiscal year ending December 31. CBC made its initial public offering of common stock in March 1983, and secondary public offerings in April 1986, June 1988, October 1991 and December 1993. CBC's shares are registered with the Commission pursuant to Section 12(g) of the Exchange Act and, at times relevant hereto, were traded through the National Association of Securities Dealers Automated Quotation System. -[2]- 2. Summary Between June 1991 and December 1992, CBC recognized revenue from a series of nine sales and license transactions even though they failed to meet the revenue recognition requirements of Generally Accepted Accounting Principles ("GAAP"). -[3]- These transactions were structured by the former Chief Executive Officer (the "CEO") and the former Chief Financial Officer (the ---------FOOTNOTES---------- -[1]- The findings are not binding on anyone other than the respondent. -[2]- CBC filed for bankruptcy on July 7, 1994, and its plan of reorganization was confirmed by order of the Bankruptcy Court on July 18, 1996. Pursuant to the plan of reorganization, a newly-formed holding company, Aquila Pharmaceuticals, Inc., will be the successor to CBC for Exchange Act reporting purposes, and CBC is anticipated to cease to be a reporting company. -[3]- GAAP with regard to revenue recognition is set forth in Financial Accounting Standards Board ("FASB") Statement of Financial Accounting Concepts No. 5 ("CON 5"), entitled Recognition and Measurement in Financial Statements of Business Enterprises. ==========================================START OF PAGE 3====== "CFO") of CBC. -[4]- Recognition of the revenue falsified CBC's sales records and caused it to report materially inflated revenues and earnings. The transactions included shipments of product with no expectation of payment, premature recognition of license fee revenues, and use of corporate funds to resolve outstanding receivables by creating the false appearance that CBC had purchased unrelated goods and services, when in fact CBC had simply "bought" its own product back. During the audit of CBC's 1991 and 1992 financial statements, the CEO and the CFO attempted to deceive CBC's independent auditors by directing the completion of the circular transactions, by obtaining false audit confirmations, and by obtaining false documentation of agreements having been reached in earlier periods. CBC thereby overstated revenue by $2.652 million (10.1%) and reported a net income before taxes of $497,851, instead of a net loss before taxes of $1.836 million for the year ended December 31, 1991, and overstated revenue by $3.571 million (10.3%) and reported a net loss before taxes of $11.404 million instead of a net loss before taxes of $14.765 million for the year ended December 31, 1992. The fraudulent operating results were included in CBC's annual reports on Form 10-K ("Form 10-K") filed with the Commission for its fiscal years ended December 31, 1991 and December 31, 1992, in CBC's Form S-3 Registration Statement ("Form S-3") for its public offering in October 1991 (the "public offering"), in CBC's Form S-3 for its shelf registration in December 1993 (the "shelf registration"), and in most of CBC's quarterly reports on Form 10-Q ("Form 10-Q") filed with the Commission during the period. 3. Fraudulent Transactions in 1991 a. Q2 - The English Distributor - $975,000 During June 1991, at the CEO's direction, CBC's English distributor agreed to place an order for $975,000 worth of product with no obligation to pay. In the fall of 1991, the CFO devised a scheme to retrieve the product and simultaneously make it appear that the $975,000 price was paid by the English distributor to CBC. In December 1991, at the CFO's direction, CBC's Irish subsidiary, Cambridge Biotech Limited ("CBL"), -[5]- ordered $1.097 million worth of a different product from a third company. The product that CBL purchased, however, was actually the same product that had been shipped to the ---------FOOTNOTES---------- -[4]- CBC terminated the CEO on May 9, 1994, and the CFO had previously resigned from CBC on June 30, 1993. -[5]- CBC sold CBL in 1995. ==========================================START OF PAGE 4====== English distributor. That product had been intentionally mislabelled as the different product to avoid detection of the scheme. The funds from this "purchase" were used to pay the English distributor's "debt" to CBC in full. b. Q3 - The Swiss Distributor - $817,000 During the summer of 1991, CBC began discussing with its Swiss distributor the possibility that CBC would acquire the Swiss distributor. In the fall of 1991, at the CFO's direction, the Swiss distributor agreed to take delivery of product with no obligation to pay for it. In November 1991 (after the revenue from this transaction had been included in CBC's reported results for the third quarter of 1991), CBC agreed to acquire certain of the Swiss distributor's assets for a purchase price that netted out the $817,000 receivable. c. Q4 - Two fraudulent transactions totalling $860,500 i. The English Trading Company - $600,000 During December 1991, at the CFO's direction, an English trading company agreed to order $600,000 of product for the manufacture of tests for the presence of the HIV virus, for ultimate delivery to CBL, and with no obligation to pay. The transaction arose in part because of a concern that U.S. Food and Drug Administration ("FDA") regulations did not permit CBC to supply certain raw materials for CBL's manufacture of HIV tests to be sold into third world countries. In December 1991, the CFO and the CEO had agreed to find a way around these regulations. In April 1992, the CFO and CEO devised a scheme to make it appear that the English trading company had paid for its $600,000 order. At the CFO's and CEO's direction, CBL bought raw material from a company related to the English trading company, paying $737,349, when the true vale of the material was $48,640. The sequence was: 1) CBL paid the related company $737,349 under cover of a purchase order for the raw material, 2) the related company bought the raw material, which was shipped to CBL, 3) the related company provided $600,000 to the English trading company, 4) the English trading company paid the $600,000 back to CBL. The English trading company and the related company retained the $88,709 difference as a 5% "commission" on the transaction, and for shipping costs, duties and taxes. ii. Q4 - The Irish Company - $260,500 During December 1991, at the CFO's direction, an Irish company that had previously supplied laboratory materials to CBL agreed to order $260,500 of product for the manufacture of tests for the presence of the HIV virus, for ultimate delivery to CBL, ==========================================START OF PAGE 5====== and with no obligation to pay. This transaction also was partly structured to evade the FDA regulations. The product was not properly refrigerated for shipment, however, and it spoiled. Nevertheless, at the CFO's direction, the sale was not reversed until the second and third quarters of 1992. 4. Fraudulent Transactions in 1992 a. Q2 - The Irish Company - $204,000 In June 1992, at the CEO's and the CFO's direction, the Irish company agreed to order $204,000 of product for the manufacture of tests for the presence of the HIV virus, for ultimate delivery to CBL, and with no obligation to pay. In October 1992, the CFO devised a scheme to make it appear that the Irish company had paid for its $204,000 order. At the CFO's direction, a CBL officer paid the Irish company $214,000 for consulting work that the CFO claimed that he had agreed to have the Irish company perform. The Irish company simultaneously used these funds to pay its $204,000 "debt." No such consulting work was ever performed or agreed to. b. Q3 - Three fraudulent transactions totalling $4.726 million i. The U.S. Company - $726,000 During the summer and fall of 1992, CBC and a U.S. company had attempted to negotiate an agreement for the joint development of a combination test for the presence of two infectious diseases. As proposed by CBC, the project included a requirement that the U.S. company purchase $726,000 of raw materials from CBC. By September 30, 1992, the U.S. company had not committed to fund the project. Despite this, in November 1992, the CFO instructed that the $726,000 purchase of raw materials be recorded as revenue for the third quarter of 1992. In December 1992, the U.S. company's president wrote to CBC that funding could not be committed to until at least 1993. Both the CEO and the CFO received copies of the letter. Despite this, the sale was not reversed. During early 1993, the U.S. company's president told the CEO that the U.S. company did not want to pursue the project. Despite this, in the fall of 1993, the CEO devised a scheme to make it appear that the U.S. company had paid its "debt." At the CEO's suggestion, the U.S. company and its joint venture partner agreed to pay the amount of the outstanding receivable to purchase from CBC certain "clones" for the production of antigens. In November 1993, the U.S. company and its joint venture partner each paid one-half of the amount of the outstanding receivable for the purchase of three clones each. Despite the substitution of these transactions for the original ==========================================START OF PAGE 6====== transaction, CBC did not restate its results for the third quarter of 1992 to reflect that the original revenue was improperly recognized. ii. Q3 - The European Company - $2 million In September 1992, CBC and a European company entered into an agreement that granted the European company a license to commercialize a CBC product in certain vaccines, and required CBC to supply raw material. The agreement stated that the license fees for 1992 and 1993 were to be paid as follows: $2 million by September 30, 1992, and $3 million on January 15, 1993. In October 1992, the CFO suggested to the CEO that, to improve the appearance of CBC's third quarter results, the European company "could have" agreed in September to have the 1992 license fee be $4 million (instead of $2 million), and to have the 1993 license fee be $1 million (instead of $3 million), which would have allowed CBC to recognize an additional $2 million for the third quarter of 1992. At the CEO's request, and using language provided by the CEO, the European company provided a letter that falsely suggested that the companies had agreed in September 1992 that the 1992 license fee would be $4 million, $2 million of which would be payable on January 15, 1993, along with the $1 million license fee for 1993. This agreement had not in fact occurred. Despite this, in November 1992, at the CFO's direction, the additional $2 million from the European company was recorded as revenue for the third quarter of 1992. iii. Q3 - The Second European Company - $2 million During 1992, CBC attempted to reach an agreement with a second European company for it to pay CBC $2 million for rights to a vaccine technology. No agreement was reached by September 30, 1992, however. Despite this, in November 1992, at the CFO's direction, CBC booked $2 million in license fee revenue from the second European company. In February 1993, CBC and the second European company entered an agreement that granted the second European company rights to the vaccine technology and to another vaccine, for a payment of $3 million, the first $1 million of which was paid in April 1993. During the 1992 audit, the CEO misrepresented to CBC's auditors that he had reached an oral agreement with the second European company in September 1992 concerning the $2 million for the original vaccine technology, but that the execution of the agreement had been delayed until February 1993 as the companies attempted to expand the scope of the joint venture to include, among other things, the other vaccine. CBC's auditors insisted that the second European company confirm these facts. ==========================================START OF PAGE 7====== Accordingly, at the CEO's request, the second European company's general counsel countersigned a letter on CBC letterhead signed by the CEO. The letter falsely stated that the second European company made a commitment by September 30, 1992 to pay CBC $2 million for rights to the vaccine technology. c. Q4 - The Irish Company - $612,000 In December 1992, the CEO and the CFO agreed that CBC should effect another sale to the Irish company. At the CFO's request, the Irish company agreed to order $612,000 of product with no obligation to pay. In January 1993, CBC's auditors sought to confirm this sale with the Irish company. The CFO agreed to pay the Irish company's principal $42,000 to falsely confirm the transaction. At the CFO's direction, $42,000 of CBC funds was transferred to the Irish company's principal's personal bank account, and the Irish company's principal then confirmed the transaction with CBC's auditors. In May 1993, the CFO devised a scheme to make it appear that the Irish company had provided services in exchange for its debt. At the CFO's direction, CBC began writing down the receivable from the Irish company at the rate of $75,000 per month by charging an expense account for consulting services purportedly provided by the Irish company to CBL, which in fact were never agreed to or provided. 5. False Filings In its Form 10-Q for the second quarter of 1991, CBC reported revenues of $7.072 million, and a net loss before taxes of $420,000. Without the fraudulent $975,000 product sale to the English distributor in June 1991, however, the revenues would have been $6.097 million, and the net loss before taxes would have been $1.13 million. Recording this sale overstated second quarter 1991 revenues by 16%, and understated the net loss before taxes by $710,000. On August 23, 1991, CBC filed the Form S-3 for the public offering. The public offering of 3.8 million shares at $7.75 per share, or approximately $27 million, was declared effective on October 16, 1991. The Form S-3 included the results reported on Form 10-Q for the second quarter of 1991. In its Form 10-Q for the third quarter of 1991, CBC reported revenues of $7.363 million for the quarter, and a net loss before taxes of $229,005. Without the fraudulent $817,000 product sale to the Swiss distributor in September 1991, however, third quarter revenues would have been $6.546 million, and the net loss before taxes would have been $775,415. Recording this sale overstated third quarter 1991 revenues by approximately 12.5%, and understated the net loss before taxes by $546,410. ==========================================START OF PAGE 8====== In its Form 10-K for 1991, CBC reported revenue of $28.981 million for the year, and net income before taxes of $497,851. Of total revenues, however, $2.652 million was improperly recognized for the June 1991 sale to the English distributor, the September 1991 sale to the Swiss distributor, and the December 1991 sales of $600,000 to the English trading company and $260,500 to the Irish company. These transactions overstated revenues by 10.1%. Net income before taxes was overstated by $2.334 million. In its Form 10-Q for the second quarter of 1992, CBC reported revenues of approximately $10.936 million for the quarter, and net income before taxes of $899,000. Without the fraudulent $204,000 sale to the Irish company in June 1992, however, net income before taxes would have been $706,000. Accordingly, second quarter revenues were overstated by 1.9%, and net income before taxes was overstated by 27%. In its Form 10-Q for the third quarter of 1992, CBC reported revenues of approximately $12 million for the quarter, and a net loss before taxes of $5.691 million. Of total revenues, however, $4.726 million was improperly recognized for the three transactions that, in November 1992, the CFO had directed be recorded as revenue as of September 30, 1992: the $726,000 product sale to the U.S company in connection with the joint development project, the $2 million license fees to be paid by the European company, and the $2 million license fees to be paid by the second European company. These transactions overstated revenue by approximately $4.726 million, and the net loss before taxes should have been reported as $10.362 million. Thus, revenues for the third quarter of 1992 were overstated by approximately 64%, and the net loss before taxes was understated by $4.671 million. In its report on Form 10-K for 1992, CBC reported revenue of approximately $38.138 million for the year, and a net loss before taxes of $11.404 million. Of total revenues, however, approximately $3.571 million was improperly recognized for the June 1992 sale to the Irish company, the $612,000 sale to the Irish company in December 1992, the product sale to the U.S company in connection with the joint development project (including an additional $29,425 booked in December 1992 when the lots that had been isolated from stock were priced), and the license fees to be paid by the European company. These transactions overstated revenues by 10.3%. The net loss before taxes was understated by $3.361 million. On May 21, 1993, CBC filed the Form S-3 for the shelf registration. On October 29, 1993, during review of the filing by the Commission staff, CBC restated its third quarter 1992 results, and its 1992 results, reversing the $2 million in revenue from the second European company and stating that it ==========================================START OF PAGE 9====== would be recognized over successive periods. The restatement and the Form S-3, however, did not disclose that 1) there were no facts supporting recognition of the revenue from the second European company as of September 30, 1992, 2) third quarter 1992 results had been overstated by an additional $2.726 million, 3) 1992 results had been overstated by an additional $1.571 million or that 4) 1991 results had been overstated by $2.652 million. The offering went effective on December 23, 1993, and CBC sold a total of $6.6 million worth of common stock during January and February 1994. B. LEGAL ANALYSIS 1. The Antifraud Provisions Section 10(b) of the Exchange Act and Rule 10b-5 thereunder proscribe the making of materially false and misleading statements "in connection with the purchase or sale of any security." Section 17(a) of the Securities Act prohibits the making of such statements in connection with the "offer or sale" of securities. Violations of Section 10(b) and Rule 10b-5 occur when an issuer makes material misstatements in registration statements, prospectuses or periodic reports filed with the Commission and trading thereafter occurs in the issuer's securities. SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 (2d Cir. 1968), cert. denied, 394 U.S. 976 (1969). The filing of false and misleading periodic reports also is a violation of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, because reports of publicly traded companies affect the markets for the offer, sale and purchase of their securities. SEC v. World-Wide Coin Investment, Ltd., 657 F. Supp. 724, 746 n.35 (N.D. Ga. 1983); SEC v. Benson, 657 F. Supp. 1122, 1131 (S.D.N.Y. 1987). The misstatements and omissions in the filings must be material. Id. Further, to hold an issuer liable under Section 10(b) of the Exchange Act and Section 17(a)(1) of the Securities Act, a showing of scienter is necessary. Aaron v. SEC, 446 U.S. 680, 697 (1980). -[6]- The misrepresentations and omissions in CBC's Form S-3, Form 10-Q and Form 10-K filings were material. Figures relating to revenue, sales and net income are critical in determining an issuer's financial condition. It is well settled that "information concerning the financial condition of a company is presumptively material." SEC v. Blavin, 557 F. Supp. 1304, 1313 (E.D. Mich. 1983), aff'd, 760 F.2d 706 (6th Cir. 1985); SEC v. ---------FOOTNOTES---------- -[6]- Scienter does not have to be shown for violations of Sections 17(a)(2) or 17(a)(3) of the Securities Act. Aaron v. SEC, 446 U.S. at 697 (1980). ==========================================START OF PAGE 10====== Murphy, 626 F.2d 633, 653 (9th Cir. 1980); SEC v. Shapiro, 494 F.2d 1301, 1307 (2d Cir. 1974); Burlington Industries v. Edelman, 666 F. Supp. 799, 815 (M.D.N.C. 1987). A reasonable investor would have viewed the differences between the real and reported figures as significantly altering the total mix of information made available. CBC acted with the requisite scienter. CBC committed the fraudulent acts through the acts of the CEO and the CFO. The scienter of the CEO and the CFO is imputed to CBC. See, SEC v. First Securities Co. of Chicago, 463 F.2d 981, 985-88 (7th Cir.), cert. denied, 409 U.S. 880 (1972). The CEO and the CFO knew or were reckless in not knowing that the misrepresentations and omissions would cause the filings to be materially misstated. 2. Reporting and Recordkeeping Provisions Section 13(a) of the Exchange Act and Rules 13a-1 and 13a-13 thereunder require issuers of registered securities to file with the Commission annual and quarterly reports, respectively. Courts have uniformly held that it is implicit in this requirement that the information provided be accurate. See, e.g., SEC v. Savoy Industries, Inc., 587 F.2d 1149, 1165 (D.C. Cir. 1978), cert. denied, 440 U.S. 913 (1979). Regulation S-X, 17 C.F.R.  210.4, provides in part, that, unless the Commission has provided otherwise, financial statements not prepared in conformity with generally accepted accounting principles ("GAAP") are presumed to be misleading. Section 13(a) also requires that issuers comply with the disclosure requirements of Regulation S- K, 17 C.F.R.  229.10 et seq. In addition, Exchange Act Rule 12b-20 requires that these periodic reports contain all information necessary to ensure that statements made in them are not materially misleading. No showing of scienter is necessary to establish a violation of Section 13(a) or the rules thereunder. Id. at 1167. Section 13(b)(2)(A) of the Exchange Act requires issuers to make and keep books, records, and accounts which accurately and fairly reflect the transactions and dispositions of their assets. No showing of scienter is necessary to establish a violation of Section 13(b)(2)(A) or the rules thereunder. SEC v. World-Wide Coin Investments, Ltd., 567 F. Supp. 724, 749 (N.D. Ga. 1983). CBC, during 1991, 1992 and 1993, violated Section 13(a) of the Exchange Act and Rules 13a-1, 13a-13 and 12b-20 thereunder by filing annual and quarterly reports that contained false and misleading financial statements. CBC also violated Section 13(b)(2)(A) of the Exchange Act by maintaining false and misleading books, records and accounts which improperly reflected sales from transactions that did not qualify as revenue under GAAP. ==========================================START OF PAGE 11====== ==========================================START OF PAGE 12====== Based on the foregoing, the Commission concludes that: CBC violated Section 17(a) of the Securities Act and Sections 10(b), 13(a) and 13(b)(2)(A) of the Exchange Act and Rules 10b-5, 12b-20, 13a-1 and 13a-13 thereunder. IV. ORDER Accordingly, IT IS HEREBY ORDERED, pursuant to Section 8A of the Securities Act and Section 21C of the Exchange Act, that Cambridge Biotech Corporation cease and desist from committing or causing any violation and any future violation of Section 17(a) of the Securities Act and Sections 10(b), 13(a) and 13(b)(2)(A) of the Exchange Act and Rules 10b-5, 12b-20, 13a-1 and 13a-13 thereunder. By the Commission. Jonathan G. Katz Secretary