INITIAL DECISION RELEASE NO. 102 ADMINISTRATIVE PROCEEDING FILE NO. 3-8944 UNITED STATES OF AMERICA Before the SECURITIES AND EXCHANGE COMMISSION Washington, D.C. ______________________________ In the Matter of : : INITIAL DECISION RUSSELL PONCE, CPA : December 4, 1996 : ______________________________: APPEARANCES: Karen L. Matteson for the Division of Enforcement, Securities and Exchange Commission Kenneth M. Christison for Respondent Ponce BEFORE: Lillian A. McEwen, Administrative Law Judge PROCEDURAL HISTORY The United States Securities and Exchange Commission ("Commission") instituted these proceedings 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) (1996). The Order Instituting Proceedings ("OIP") was issued on February 13, 1996. On February 16, 1996, I issued an Order Making Findings and Imposing a Cease and Desist Order by Default Against American Aircraft Corporation ("AAC") in Administrative Proceeding File No. 3-8920. THE HEARING On April 23, 1996, a public hearing commenced before me in San Francisco, California. It concluded on April 25, 1996. The hearing record consists of the testimony of four witnesses, contained in 435 transcript pages. Three witnesses testified on behalf of the Division of Enforcement ("Division"), and Respondent Ponce testified on his own behalf. During the hearing, I admitted into evidence fifty Division exhibits. Two exhibits were offered on behalf of the Respondent at the hearing, but I neglected to admit them into evidence. Those exhibits, ==========================================START OF PAGE 2====== designated R-1 and R-2, are hereby admitted in the interest of justice.-[1]- After the hearing, the Division filed its Proposed Findings of Fact and Conclusions of Law and Brief in Support. The Respondent filed no papers after the hearing. However, I have considered Respondent's Hearing Memorandum, dated April 23, 1996, as a post-hearing brief. ISSUES The general issue before me is whether Ponce violated the Exchange Act. More specifically, the issue is whether the allegations of the Division and the Office of the Chief Accountant are established by a preponderance of the evidence.-[2]- They allege that: [D]uring fiscal years ended November 30, 1988 through November 30, 1991, Ponce caused AAC [American Aircraft Corporation] to overvalue certain aircraft designs (the "Designs") and to capitalize as assets certain research and development ("R&D") costs that should have been expensed, in violation of GAAP [Generally Accepted Accounting Principles]. As a result, AAC materially overstated its assets in amounts ranging from $5,509,069 to $7,097,332 and materially understated its net losses in amounts ranging from $366,062 to $1,153,829 for fiscal years 1988 through 1991 in interim and annual financial statements filed with the Commission in Forms 10-Q and 10-K. Ponce provided audit reports on the annual financial statements, which reports were also included in AAC's Forms 10-K. . . . . Ponce engaged in improper professional conduct, within the meaning of Rule 102(e) of the Commission's Rules of Practice, during his audits of AAC's fiscal 1988 through 1991 financial statements by failing to comply with three of the ten basic standards of Generally Accepted Auditing Standards ("GAAS"). As discussed below, Ponce failed to: (1) maintain his independence; (2) exercise due professional care; and ---------FOOTNOTES---------- -[1]- Citations to Division exhibits will be noted as "Div. Ex. ___." Citations to the transcript pages of the hearing will be noted as "Tr.___." -[2]- For purposes of this decision, references to the "Division" include acts and allegations of the Office of the Chief Accountant. ==========================================START OF PAGE 3====== (3) render an accurate audit report. As a result of these failures, Ponce did not report that AAC materially overstated its assets and materially understated its expenses and net losses. . . . . Ponce willfully violated Section 10(b) of the Exchange Act and Rule 10b-5 thereunder . . . in that he, in connection with the purchase or sale of securities, directly or indirectly, by the use of means or instrumentalities of interstate commerce, or of the mails, or of the facilities of a national securities exchange, with scienter: (a) employed devices, schemes or artifices to defraud; (b) made untrue statements of material fact or omitted to state material facts necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading; or (c) engaged in acts, practices, or courses of business which operated or would operate as a fraud or deceit upon other persons. Ponce willfully caused AAC's violations of Section 13(a) of the Exchange Act and Rules 12b-20, 13a-1 and 13a-13 thereunder in that he, by engaging in the conduct alleged . . . caused AAC to file with the Commission annual reports on Commission Form 10-K and quarterly reports on Commission Form 10-Q for the periods ending February 29, 1988, through November 30, 1991, which reports contained untrue statements of material fact and omitted to state material facts necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading. Ponce willfully caused AAC's violations of Section 13(b)(2) of the Exchange Act in that he, by engaging in the conduct alleged . . . failed to make and keep books, records, and accounts, which, in reasonable detail, accurately and fairly reflected the transactions and dispositions of AAC's assets. Ponce, by engaging in the conduct alleged . . . within the meaning of Rule 102(e) of the Commission's Rules of Practice: (a) engaged in unethical or improper professional conduct; and, (b) willfully violated or willfully aided and abetted the violations by AAC and Moody [William F. Moody, Jr.] of Sections 10(b), 13(a) and 13(b)(2) of the Exchange Act and Rules 10b-5, 13a-1 and 13a-13 thereunder. (OIP at 2-3, 5, 7.) ==========================================START OF PAGE 4====== The findings and conclusions herein are based on the entire record and on my observation of the demeanor of the witnesses at the hearing. I applied preponderance of the evidence as the applicable standard of proof. FINDINGS OF FACT I find that the following facts were established by a preponderance of the evidence in the record: Russell Ponce, age 56, was licensed as a certified public accountant in 1965. He worked for Peat Marwick in San Francisco as an auditor. By 1988, he had been an auditor for twenty years, and he operated as a sole proprietor. (Tr. 379.) He was AAC's independent auditor for fiscal years 1988 through 1991. (Div. Exs. 4-56, 5-63, 6-64, 8-32, 9-33, 10-34, 12-36.) He is a CPA in California, but in September 1994 he let his license lapse. (Answer; OIP at 2.) AAC is an Oregon corporation that was based in Long Beach, California. AAC's common stock is registered pursuant to Section 12(g) of the Exchange Act. AAC was primarily engaged in developing vertical flight aircraft, but had not succeeded in selling any of its aircraft. On March 4, 1988, AAC, a public company, and Phalanx Organization, Inc. ("Phalanx"), a private company, completed a merger in which AAC acquired Phalanx's operations and management. As a result of the merger, Phalanx's president and controlling shareholder, William F. Moody, Jr., became president and CEO of AAC. Moody has a degree in Aeronautical Engineering and Mechanical Engineering from Massachusetts Institute of Technology. (Tr. 16.) AAC's common stock was quoted on the National Association of Securities Dealers Automated Quotation System ("NASDAQ") until April 1993, when it was delisted for failure to meet asset, equity, and bid price requirements. On December 20, 1994, AAC voluntarily filed for bankruptcy under Chapter 11 (Bankr. N.D. Cal. Case No. 94- 12938.) On August 14, 1995, AAC converted its Chapter 11 bankruptcy to Chapter 7. (Answer; OIP at 20.) After the merger, AAC intended "to carry on with the product line that American Aircraft had at that time, plus to carry on the commitment of Phalanx to create vertical flight aircraft." (Tr. 20.) The product line for both companies was military aircraft. "And that market went to hell." (Tr. 83.) In August 1990, AAC suspended all development work except for the Penetrator helicopter, which was a material modification of an existing UH-1 Huey helicopter. In 1991, AAC completed construction of a single pre-production prototype of the Penetrator helicopter, which has not yet completed testing. (Answer; Tr. 16-18; OIP at 2.) For fiscal years 1988 through 1991, AAC filed interim and annual financial statements with the Commission on Forms 10-Q ==========================================START OF PAGE 5====== (Div. Exs. 24-67, 25-68, 26-69, 27-70, 28-71, 29-72, 30-73, 31- 74, 32-75, 33-79, 34-80, and 35-81) and 10-K (Div. Exs. 1-82, 13- 85, 36-83, 37-84, 39-95, and 40-96). AAC Forms 8-K from March 22, 1988, to August 31, 1991, are Div. Exs. 38-86, 41-97, and 42- 98. Ponce provided audit reports on the annual financial statements; those reports were also included in AAC's Forms 10-K. Ponce placed $4,687,500 under "Investments and Other Assets" for "Investment in Moody Design Bureau" on the filing for 1988. (Div. Ex. 1-82; Tr. 105.) Ponce valued the shares. (Tr. 105-06.) The 1988 and 1990 Commission filings (Div. Exs. 1-82 and 21-58) listed the aircraft molds as assets pursuant to the resolution of the board, because they were to be used "for the manufacturing of the aircraft." (Tr. 116-18, 151-54, 176-79.) Ponce prepared the adjustments to the financial statements. (Tr. 119.) Adolfo Batista, a former accountant at Phalanx and AAC, and Ponce had many discussions about the transformation of the tooling costs and molds into assets. (Tr. 119-21; 163-65.) The prototypes for "three or four different versions of different aircraft" were eventually capitalized in the amount of $968,618. (Tr. 125-26.) Ponce did the cash flow audits for AAC for 1988 though 1991 with Batista. (Tr. 170-72.) AAC disclosed in its fiscal 1990 and 1991 Forms 10-K that it had not completed development of its Penetrator helicopter project. Moody signed management representation letters to Ponce concerning AAC's 1990 and 1991 financial statements. In these letters Moody represented to Ponce that AAC had progressed beyond the research and development stage in developing the Penetrator helicopter and other projects, and that AAC was properly capitalizing the related tooling costs. (Answer; OIP at 4.) During its fiscal years 1990 through 1991, AAC capitalized certain costs related to the manufacture of prototypes. AAC disclosed in its fiscal 1991 Form 10-K that since January 1990, it had been developing the Penetrator helicopter, consisting of major technological modifications to the obsolete UH-1 Huey helicopter. AAC's fiscal 1991 Form 10-K further disclosed that AAC had produced a single Penetrator, a "Proof of Concept" version, that would be disassembled and analyzed at the completion of test flights. (Answer; OIP at 4.) The investment of $4,687,500 (Div. Ex. 1-82 at 6) refers to the purchase of the licensing of Moody Design Bureau's design for 2.5 million shares of stock. (Tr. 21-22, 25.) The merger of Phalanx and AAC was contemplated at the time of the acquisition of the license. (Tr. 23.) Neither the patents nor the copyrights had been finalized at the time of the acquisition of the design licenses (Tr. 27-29), although some aircraft had been developed beyond the design stage. (Tr. 30-31.) The designs had first ==========================================START OF PAGE 6====== been created for use by the United States Army. "When the Soviet Union fell apart" the designs were modified for Taiwan. (Tr. 32.) Moody Aircraft Design Bureau was a sole proprietorship that could not be audited because there was "no way to break it out" for expenses for valuation. Thus the company itself was valued at zero, for lack of records. (Tr. 36.) By May 1990 an aircraft had been test flown and two others were "being fabricated." (Tr. 45.) Moody destroyed the Hind helicopter tooling in 1990-91 and the Penetrator was being test-flown. (Tr. 47.) Tooling was capitalized in the amended Form 10-K (Div. Ex. 1-82) for the Penetrator aircraft because "it was a certified aircraft that we were doing cosmetic surgery to." (Tr. 52.) Thus it "was not an R and D development" but rather "valuable" because Moody and others had "paid three or four million dollars for it . . . ." (Tr. 53.) "Tooling are devices that are fabricated from engineering drawings or from Computer Aided Designs, print-out designs, to develop . . . a plug, which is a master, from which . . . [the manufacturer] can then fabricate the complete aircraft structure." After test flying, "the tools wouldn't change . . . ." (Tr. 56.) The Penetrator aircraft described in the Commission filings was a prototype that would be sold to the public after flight testing, assuming that the company had "the need" and "the money" for distribution. (Tr. 59.) Because the Moody designs acquired by AAC had value, three poison pills were placed in the agreement for acquisition of licensing rights to the designs. (Tr. 69-70.) (Barron's Dictionary of Finance and Investment Terms (4th ed. 1995) defines a "poison pill" as a "strategic move by a takeover-target company to make its stock less attractive to an acquirer.") The aircraft industry takes 10 to 15 years "to develop an aircraft for production," which then has "a life [of] over 50 years." (Tr. 70.) AAC issued stock to acquire the assets of Phalanx. (Tr. 71.) The Penetrator was marketed for sale by a third company, American Aircraft International. (Tr. 72.) Moody considered the compensation in AAC shares to be adequate compensation for the licensing of his designs. (Tr. 78.) The AAC shares that Moody received "were worth something at the time," but Moody chose not to sell the stock because he "wasn't interested in money" but rather "in power." (Tr. 78.) Moody still gets calls "for orders for Penetrators" and he is the largest creditor of AAC and "the biggest loser"; he has not sold his stock in the company and he has a $25 million deal "with an investment banker," that is "subject to AAC getting out of" bankruptcy reorganization. (Tr. 80.) Ponce was not involved in the payment of 2.5 million shares to Moody for the licensing. (Tr. 355-56.) In his 1988 audit Ponce considered "whether it was new technology or just the ==========================================START OF PAGE 7====== application of existing technology which the company was capable of doing." (Tr. 356.) After conversations with a director, Lee Phillips, and with Moody, Ponce concluded that the valuation of the company stock was correct. (Tr. 356-57.) AAC's filing (Div. Ex. 1-82 at n.5) informs "the reader of the financial statement that this alterative method, less desirable than the cost method, was used because there was no alternative, well there was no visible alternative. And to let the reader know that this is just a way of doing it, and it may or may not be correct." (Tr. 358.) For November 30, 1990, the treatment-of-expenditures analysis by Ponce resulted from Moody's "insistence that this was not new technology and his insistence that he had contracts on hand" for immediate production. (Div. Ex 37-84; Tr. 360.) Heated discussions "with Mr. Moody, Mr. McCann and Mr. St. John" occurred before Ponce generated the ultimate figures. (Tr. 360.) By 1990 the Penetrator aircraft had been built and an "outside" person who "was an expert" evaluated the replacement cost of the "tools." A manufacturing company also evaluated the aircraft "and put a price on it" consistent with the figure that Moody had suggested. (Tr. 362-63, 392-95.) Note 5 in the 1990 filing with the SEC (Div. Ex. 37-84) also refers to the Moody Design Bureau investment. (Tr. 364.) In 1992, Ponce changed the method of accounting in the financial statements and filings, at the suggestion of Commission staff. (Tr. 374-78.) Ponce had not obtained from a specialist a valuation of the company stock which was exchanged. (Tr. 379-83.) The 1988 audit occurred a year after the AAC acquisition of Phalanx (Tr. 385- 87.) Three aircraft were developed from Moody's designs, and at least one of them, the Penetrator, flew. (Tr. 389.) Test flights occurred in December 1991. (Tr. 394-95; Div. Ex. 40-96 at 4.) Ponce evaluated the aircraft based on contracts and "agreements in the making" for financing, and orders that did not materialize. (Tr. 398-99.) Ponce did not believe that he was required to obtain the opinion of a specialist in his evaluation of "restricted securities." (Tr. 400.) Ponce performed the audits in spite of being owed some fees by Moody or one of the corporations because he did not feel that he "was being put upon by the company." (Tr. 404.) As of November 14, 1990, Ponce was due $31,000. (Div. Ex. 9-33; Tr. 62.) Ponce was a creditor in the AAC bankruptcy reorganization. (Tr. 62.) Investors in AAC consisted of "Moody's friends and acquaintances." (Tr. 406-07.) As a sole practitioner, with nobody to supervise, Ponce had no need to plan in great detail or to supervise the audits. (Tr. 413.) The company had "basic internal controls" in place for financial management. (Tr. 413-14.) ==========================================START OF PAGE 8====== Ponce treated the prototypes and models as assets in his assessment of risk because there appeared to be "ready buyers" for the aircraft that the company had produced from 1988 through 1991. (Tr. 417-19.) CONCLUSIONS OF LAW Contentions of the Parties I. The Division The Division contends that the aircraft designs that AAC acquired in February 1988 from Moody were worthless (Division Post Hearing Memorandum at 6), were research and development, and "should instead have been treated as expenditures." This contention is based on the fact that "most of the Designs never went beyond being on paper, and only one was developed into a prototype." (Id. at 6.) In addition, Moody valued them at zero himself. As for the exchange for AAC restricted shares, "Ponce's valuation of those shares had no basis in GAAP, and simply resulted in an inflated stock value with no economic substance." (Id. at 7.) This inaccurate valuation of shares in turn substantially inflated the value of AAC's assets. The Division argues that Ponce could not have acted in good faith with regard to the stock exchange valuation because Phalanx and AAC merged eighteen days after the acquisition of the Moody designs. On the date of the merger, AAC valued its own shares at $ 0.00443 per share, rather than at the $1.875 per share price it attached to the shares in the Moody exchange. Thus it concludes that "Ponce deliberately inflated the value of AAC's assets by attributing a multimillion dollar value to worthless Designs." (Id. at 9.) Second, the Division contends that Ponce caused research and development costs to be improperly treated as assets when he converted the tooling costs to assets. It concludes that "Ponce's conduct was deliberate and calculated to mislead investors" because Ponce reversed Batista's entries every quarter over a four-year period and because AAC's own Forms 10-K place the prototype tooling in the category of research and development costs as described in "authoritative literature." (Id. at 10- 12.) The Division dismisses the Management representation letters from 1990, 1991, and 1992 as "false" representations. (Id. at 13-14.) The improper capitalization of tooling costs was such a gross violation of GAAP and GAAS that Ponce must have intended that AAC investors be misled. Expenses associated with the prototype are listed as an asset under "inventory" on the balance sheet and are not separately disclosed. Thus, Ponce's conduct was "fraudulent." (Id. at 15.) As a result of the improper treatments of the acquisition of the designs and of the tooling costs, Ponce violated GAAS standards by: (1) failing to exercise due professional care in ==========================================START OF PAGE 9====== his failure to use a specialist to value the restricted AAC securities, and in his exclusive reliance on management's representations as to the status of the prototypes; (2) failing to disclaim an opinion or to issue an adverse opinion; and (3) failing to maintain his independence in light of substantial fees owed to him for the 1988-91 audits. (Id. at 15-21.) The Division claims that it is entitled to a cease and desist order as a result of its proof that Ponce violated the antifraud provisions and caused AAC's violations. Because the information that Ponce misrepresented pertains to the financial condition of AAC, it is presumed to be material, and because it is included in a registration statement, it is required to conform with GAAP. (Id. at 22-25.) The Division contends that Ponce acted "consciously and deliberately" to inflate AAC's assets by reckless reliance an management's assertions. By acceding to Moody's demands, Ponce became "an active participant in a fraudulent scheme to inflate the value of AAC's worthless assets in order to make it appear that AAC was worth millions of dollars, when in fact it was an insolvent research [and] development company." (Id. at 26.) The Division also contends that Ponce caused AAC to violate the books and records, and issue reporting provisions by making false entries in AAC's books and records, pursuant to his valuation of the Designs and his incorrect adjustments to journal entries for tooling and prototype costs. Pursuant to Rule 102(e), the Division requests that Ponce be permanently barred from appearing or practicing before the Commission because of his incompetent, unethical, and fraudulent conduct over a four-year period. (Id. at 30-32.) II. Respondent Ponce contends that AAC was not in the development stage in 1988, because it had produced and sold a substantial number of aircraft. Thus the value he assigned to the securities in the exchange for the Moody Designs was fair. (Respondent's Hearing Memorandum at 6-7.) The tooling was analyzed by a consultant. His use of the consultant's analysis plus the business plan for AAC were the basis for the allocation of the tooling to capital and of other costs to expense. (Id. at 7-8.) Because Ponce had worked out a reasonable payment plan with Moody, he assumed that he would be paid in a reasonable length of time. Therefore, Ponce maintained his independence in doing the audit. (Id. at 8- 9; Answer at 2.) Ponce claims that he exercised due professional care and that his decisions were made on the basis of GAAP, without the benefit of hindsight. The original valuation for the Designs was proper. (Answer at 2; Respondent's Hearing Memorandum at 9.) Because he took reasonable steps to disclose the issues ==========================================START OF PAGE 10====== surrounding the valuation of the Designs and the research and development expense, the reports submitted to the Commission were accurate and no securities laws or regulations were violated as a result of the Respondent's actions. "The violations alleged by the Division are based on hindsight which was not available to the Respondent at the time of his audits and for which he should not be held accountable." (Respondent's Hearing Memorandum at 10.) Evaluation of the Evidence Ponce did not violate Rule 102(e) of the Commission's Rules of Practice. He is not lacking in character or integrity, and he did not engage in unethical or improper professional conduct. He did not willfully violate or willfully aid or abet the violation of any provision of the federal securities laws or the rules or regulations thereunder. Of course, the most serious allegations in the OIP are violations of Sections 10(b), 13(a), and 13(b)(2) of the Exchange Act and the related rules. Section 10(b) states in relevant part that "[i]t shall be unlawful for any person . . . [t]o use or employ, in connection with the purchase or sale of any security . . . any manipulative or deceptive device or contrivance" in contravention of Commission rules. Pursuant to that Section, the Commission has adopted a general antifraud provision, Rule 10b-5, 17 C.F.R.  240.10b-5. Section 10(b) and Rule 10b-5 are the most essential weapons in the Commission's battle against securities fraud. A person who makes a fraudulent statement with the reasonable expectation that it will be disseminated to the securities markets satisfies the requirement of Section 10(b) that the fraud be "in connection with" the purchase or sale of securities. This principle was first enunciated in 1968 by the Second Circuit in the landmark case of SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 (2d Cir. 1968) (en banc), cert. denied, 394 U.S. 976 (1969), and has since then been uniformly followed by all other courts of appeal to address the issue. See e.g., SEC v. Rana Research, 8 F.3d 1358, 1362 (9th Cir. 1993); Akin v. Q-L Invs. Inc., 959 F.2d 521, 528-29 (5th Cir. 1992); SEC v. Savoy Indus., 587 F.2d 1149, 1171 (D.C. Cir. 1978), cert.denied, 440 U.S. 913 (1979); Mitchell v. Texas Gulf Sulphur Co., 446 F.2d 90, 100-02 (10th Cir.), cert. denied, 404 U.S. 1004 (1971). The Commission has long relied on the Texas Gulf test in bringing securities fraud actions against corporations and others who disseminate false or misleading statements to the securities markets. Often, such statements are made at a time when the party making the statement is not itself making a securities offering or otherwise involved in a securities transaction. Public corporations are under continuous disclosure obligations under the Exchange Act, and virtually all corporations make ==========================================START OF PAGE 11====== voluntary disclosure, through press releases and otherwise, about corporate developments. In addition, statements are commonly made by other persons to the securities markets. As in the instant case, accountants routinely provide audit letters which they know will be included in public filings made with the Commission, and which are as a matter of course disseminated into the securities markets. It is well recognized that such public statements are taken into account by market participants, and are reflected in trading and pricing decisions about the securities. Where the statements are false or misleading, they can work great damage on the investors who rely on them and on the fairness and integrity of the securities markets. Under Texas Gulf and its progeny, a person violates Section 10(b) if they make a fraudulent statement that can reasonably be expected to be disseminated to the trading markets. The Supreme Court has held generally that the "in connection with" requirement is met by "deceptive practices touching" the purchase or sale of securities. Superintendent of Insurance v. Bankers Life & Casualty Co., 404 U.S. 6, 12-14 (1971). The Supreme Court has never directly decided the validity of the Texas Gulf test, but it did quote the test in Basic Inc. v. Levinson, 485 U.S. 224, 235 n.13 (1988), a case in which it held that the defendant company's press releases could be materially misleading, in violation of Section 10(b) and Rule 10b-5. The statement must be "of a sort that would cause reasonable investors to rely thereon, and, in connection therewith, so relying, cause them to purchase or sell a corporation's securities." Texas Gulf, 401 F.2d at 860. The person must make the statement "in a manner reasonably calculated to influence the investing public." Id. at 862. An audit report given for inclusion in a Form 10-K necessarily will be communicated to investors. The filing of a report on Form 10- K is mandatory for publicly held reporting companies. See Section 13 of the Exchange Act. It is mandatory that the form include audited financial statements and a report of the auditor. See 17 C.F.R.  210. Forms 10-K and other corporate disclosure statements are not filed merely to provide information for use by the Commission. They provide highly important information to the trading markets. The Supreme Court has observed that "[c]orporate financial statements are one of the primary sources of information available to guide the decisions of the investing public," United States v. Arthur Young & Co., 465 U.S. 805, 810 (1984), and that "[i]n an effort to control the accuracy of the financial data available to investors in the securities markets, various provisions of the federal securities laws require publicly held corporations to file their financial statements with the Securities and Exchange Commission." Id. at 810-11 (footnote omitted). ==========================================START OF PAGE 12====== The Supreme Court also has recognized that public corporate information is disseminated into the market and is taken into account by investors, and that as a result "most publicly available information is reflected in market price . . . ." Basic Inc., 485 U.S. at 247. The link between public corporate statements and securities trading is so clear that, the Basic Inc. court held, "an investor's reliance on any public material misrepresentations . . . may be presumed for purposes of a Rule 10b-5 action." Id. Issuing a false statement that one reasonably expects will reach traders certainly is "positive action" consisting of "using" or "employing" a deceptive device in connection with trading. See Anixter v. Home-Stake Production Co., 77 F.3d 1215, 1226 (10th Cir. 1996) ("Reading the language of 10(b) and 10b-5 through the lens of Central Bank of Denver, we conclude that in order for accountants to 'use or employ' a 'deception' actionable under the antifraud law, they must themselves make a false or misleading statement (or omission) that they know or should know will reach potential investors"). Finally, the legislative history is consistent with the Texas Gulf standard. The Supreme Court has stated: The most relevant exposition of the provision that was to become  10(b) was by Thomas G. Corcoran, a spokesman for the drafters. Corcoran indicated: "Subsection (c) [ 9(c) of H.R. 7852 -- later  10(b)] says, 'Thou shalt not devise any other cunning devices.' . . . . Of course subsection (c) is a catch- all clause to prevent manipulative devices. I do not think there is any objection to that kind of clause. The Commission should have authority to deal with new manipulative devices." Ernst & Ernst v. Hochfelder, 425 U.S. 185, 202-03 (1976), quoting Hearings on H.R. 7852 and H.R. 8720 Before the House Committee on Interstate and Foreign Commerce, 73d Cong., 2d Sess. 115 (1934). The word "deceptive" was added to the statute by the Senate, after Corcoran testified before the House (S. 3420, 73d Cong., 2d Sess. 24 (1934)), and the Senate Report on the Exchange Act is quite explicit that Section 10(b) "authorizes the Commission by rules and regulations to prohibit or regulate the use of any other manipulative or deceptive practices which it finds detrimental to the interests of the investor." S. Rep. No. 792, 73d Cong., 2d Sess. 18 (1934). A fraudulent statement is, under any reasonable reading, a deceptive device or contrivance. Similarly, the Supreme Court has held that Section 10(b) is a broad antifraud provision: "Section 10(b) is aptly described as a catchall provision, but what it catches must be fraud." Chiarella v. United States, 445 U.S. 222, 234-35 (1980). The Designs ==========================================START OF PAGE 13====== The largest figure that the Division characterizes as inflated is the $4.6 million value assigned to the 1988 acquisition of the Designs. Its proof consists largely of the testimony of its expert witness. Reliance on his opinion is misplaced. Loreto Thomas Tersigni was qualified as an expert in the area of accounting principles and auditing standards. (Tr. 205.) In his expert opinion, Moody Design Bureau had nothing of value that could be acquired because there was no patent. Furthermore, no product had been manufactured and sold that had been generated from the Moody Design Bureau licenses. (Tr. 260-65.) The calculation of $4.6 million as the value of the investment in Moody Design Bureau resulted from multiplying the number of shares issued to Moody (2.5 million) by the bid price on February 17, 1988. (Tr. 265-66.) The value was inflated because there is no evidence to suggest that 2.5 million shares of the company "could be sold at $3.50 a share." (Tr. 267.) He also opined that AAC stock was worthless in February 1988 because the company had a history of operating losses and it was insolvent. (Tr. 268.) Eighteen days later, on March 7, 1988, Phalanx stockholders were issued 28 million shares of the same stock at a total value of $124,000. (Tr. 270-73.) Thus, according to Tersigni, for 1989, assets were overstated by 122 percent, and losses were understated by 53 percent. Figures therefore were similar for later years. (Tr. 280-82.) Tersigni failed to take into account the difficulty any auditor faces when making accounting judgments that form the basis for a conclusion that assertions conform to objective criteria: Those judgments are often extremely difficult and require significant analytical and interpretive skills. For example, an assertion that inventories are properly valued at the lower of cost or market requires the auditor to understand and evaluate the enterprise's methods of applying accounting principles for determining cost, which may be particularly difficult if sophisticated last-in, first-out costing methods are used or if a standard cost system is employed, to cite just two examples. That same assertion also requires the exercise of judgment in evaluating management's determination of replacement cost, estimated selling price, and normal profit margins in the course of ascertaining "market" value. Finally, the assertion also requires the auditor to evaluate the adequacy of any provisions for obsolete and slow-moving items, and conclusive evidence is rarely available to support those judgments. The types of judgments discussed in this paragraph are crucial to an audit of financial statements and usually require the auditor to be able ==========================================START OF PAGE 14====== to evaluate evidence that may be inconclusive and subject to varying interpretations. Jerry D. Sullivan et al., Montgomery's Auditing 7 (10th ed. 1985). The Division's argument fails to take into account the admonitions in Basic Inc.: "The determination [of materiality] requires delicate assessments of the inferences a 'reasonable shareholder' would draw from a given set of facts and the significance of those inferences to him." After much study, the Advisory Committee on Corporate Disclosure cautioned the SEC against administratively confining materiality to a rigid formula. Courts also would do well to heed this advice. 485 U.S. at 236 (quoting TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 450 (1976) (citations omitted). The Court also considered the Congressional Committee's Report: "Although the Committee believes that ideally it would be desirable to have absolute certainty in the application of the materiality concept, it is its view that such a goal is illusory and unrealistic. The materiality concept is judgmental in nature and it is not possible to translate this into a numerical formula. The Committee's advice to the [SEC] is to avoid this quest for certainty and to continue consideration of materiality on a case-by-case basis as disclosure problems are identified." 485 U.S. at 236 n.14 (citations omitted). The expert failed to take into account the character of Phalanx at the time of the merger. Byron Bonadurer, CPA, signed the Phalanx Accountant Report dated February 22, 1988. In his notes at Note 9, he assigns no value to stock issued or to technology that Phalanx acquired "from a shareholder" whose cost was "not readily determinable." He describes Phalanx as a "development stage company" and explains that "certain expenses" may be capitalized in the future: At January 31, 1988, the company had a net operating loss carryforward for financial reporting purposes of $4,001,698. The future tax benefits related to the net operating loss carryforward have not been recognized since its realization is dependent upon the company's ability to generate future taxable earnings. ==========================================START OF PAGE 15====== Due to the developmental stage of the company, certain expenses which were deducted for financial reporting purposes may be required to be capitalized for federal income tax purposes. This treatment, pursuant to Internal Revenue Code Section 195, would require capitalization of certain expenses incurred prior to the date on which business begins. The Treasury Department has been directed to issue regulations which define when an active trade or business begins. Such regulations have not yet been promulgated. Thus, the net operating loss carryforward at November 30, 1987 for federal income tax purposes may be substantially less than the net operating loss carryforward for financial reporting purposes. (Div. Ex. 42-98 at Exhibit C.) Viewed in this context, the capitalization of the shares exchanged for the Designs might have been "required" by the Internal Revenue Service. The Division failed to establish that the value assigned to the Design acquisition and AAC stock exchange was substantially below the value that AAC assigned in its statements, pursuant to the standards in Accounting Principles Board ("APB") Opinions, which constitute GAAP. The list of "patents, designs and copyrights" that AAC acquired prior to the merger is extensive: Patent Application files Four-poster vector nozzle (binary system) utilizing plenum powertrain in conjunction with high bipass (3.0:1 or greater) gas turbines. Utilization of splitters in plenum powertrain for pitch &/or roll stabilization. Fluidic-vector designator-three dimensional vector nozzles in concert with plenum powertrain for four- poster nozzles aircraft. Variable area exit high aspect ratio vector nozzles. Vectoring high aspect ratio vector nozzles. Thrust augmentation with variable exit area fluidic amplifier. Vectoring thrust augmentation nozzles. Automatic stabilization of plenum-system powertrain to vector nozzles. ==========================================START OF PAGE 16====== Cross-over vector powertrain for plenum system for horizontal vector nozzles. Mode valve switching for plenum powertrain. Thrust augmentation utilizing variable area high aspect ratio nozzles. Copyrights Phalanx Dragon family of 4 poster blended wing-canard VTOL aircraft. Phalanx-Intra-Lift shoulder wing 4 poster blended wing- canard VTOL aircraft. Phalanx Hind-16C/ST Aggressor Trainer and/or Assault- Lift Gunship. Phalanx Hunter helicopter. Phalanx Falcon three seat military/civil light STOL aircraft. Design Patents Phalanx Dragon family of 4 poster blended wing-canard VTOL aircraft. Phalanx-Intra-Lift shoulder wing 4 poster blended wing- canard VTOL aircraft. Phalanx Hind helicopter. Phalanx Hunter helicopter. Phalanx Falcon three seat military/civil light STOL aircraft. (Div. Ex. 3-8 at 11-12.) Finally, the fact that applications had been filed for the patents (Tr. 29) is also a factor in the determination of their value. I conclude that the valuation of the Designs was consistent with their character as "intangibles purchased from others" that have "alternative future uses" and were properly capitalized in accordance with APB Opinion No. 17. (Div. Ex. 7- 16 11c.) The Division attaches great significance to the opinions and suggestions in the auditing literature as to valuation of stock. (Div. Exs. 46-87, 48, 50.) No auditor is required to accept the ==========================================START OF PAGE 17====== advice in the literature, however. The Division's contention that Ponce substituted management's views for his own professional judgment is contradicted by the fact that the client's representations are part of the evidential matter that an auditor must consider. (Div. Ex. 50.) Most importantly, if the Designs were not worth much, if the stock issued to Moody in exchange for the Designs was overvalued, and the two companies were therefore not worth very much, the Division has not proved these facts by a preponderance of the evidence. Thus, I cannot conclude that the figures in the statements filed with the Commission were false. Even if the figures were proved to be false, however, the Division would still have to prove "that the statements were misleading as to a material fact. It is not enough that a statement is false or incomplete, if the misrepresented fact is otherwise insignificant." Basic Inc., 485 U.S. at 238 (emphasis in original). The Division is unable to sustain its burden of proof as to materiality because the notes generated by Ponce are clear, objective elucidations of the figures in the filings. I conclude that no reasonable shareholder could have been misled by the figures, the filings, or the audit reports in the instant case. My evaluation of Ponce's notes begins with an assessment of the limitations of auditing as an endeavor: No audit provides complete assurance that the financial statements are free from material error arising from either incorrect processing of accounting data or incorrect judgments on the selection and application of accounting principles. As the Commission on Auditors' Responsibilities noted: Audited financial statements cannot be perfectly accurate, in part because of the ambiguity of the accounting concepts they reflect . . . . [Also,] accounting results - - the financial statements -- cannot be more accurate and reliable than the underlying accounting measurement methods permit. For example, no one, including accountants, can foresee the results of many uncertain future events. To the extent that the accuracy of an accounting presentation is dependent on an unpredictable future event, the accounting presentation will be inaccurate. The audited accounting presentation can be no more accurate, for the auditor cannot add certainty where it does not exist. Moreover, accounting measurement principles frequently provide more than one alternative to account ==========================================START OF PAGE 18====== for a given transaction or event. For example, there are several ways of accounting for the flow of inventory costs through an enterprise and for the depreciation of tangible assets. Neither the authoritative accounting literature nor logic supports the selection of one alternative over another. This flexibility of generally accepted accounting principles permits preparers of financial information to influence the information presented and thereby affect the reliability and accuracy of that information. Also, as noted on several occasions in this chapter, accounting principles often require interpretation and the application of judgment before they can be applied to specific transactions and other events and circumstances, and reasonable preparers of financial statements and auditors can disagree about those interpretations and judgments. In effect, the "established criteria" of generally accepted accounting principles against which financial statement assertions are evaluated are sometimes less than completely "established." Montgomery's Auditing, at 19 (footnotes omitted). Furthermore, I credit the testimony of Ponce and Moody that AAC was a manufacturing enterprise with ready buyers and that it was not a research and development company. (Tr. 50-56, 417-19; Div. Ex. 7-16 10.) Thus, the auditing tasks for Ponce were complex, for these accounts related to the production cycle: The production cycle and inventories constitute one of the most significant and difficult areas in auditing and in business management generally. In spite of the trend from a manufacturing to a service- based economy, many enterprises maintain significant amounts of goods awaiting or in process of production, or available for servicing customers. Difficulties arise in accounting for inventory and determining its appropriate valuation; in addition, management is concerned with attaining maximum production and distribution while minimizing costs, investment, and risk. . . . . The auditor's primary objective in this area is to gather evidence to support management's assertions about the existence, ownership, and valuation of inventory, and the accuracy of production costs. The audit risks associated with inventories vary based on the nature of an enterprise's inventory and its materiality to the financial statements. For example, there is a higher level of inherent risk associated with inventories such as precious metals or gems that ==========================================START OF PAGE 19====== can be easily converted to cash and have relatively high value. Accordingly, such inventories require a stronger system of accounting controls and procedures. Or, in estimating net realizable value, there is a higher level of risk associated with a product that must meet very strict technical standards or composition requirements than with a commodity that is generally acceptable to many potential users. . . . . The production cycle encompasses the production or purchase of tangible personal property for sale in the ordinary course of business. The term "inventory" is used to refer to tangible personal property held for sale, in process of production for sale, or consumed in the production of goods or services to be made available for sale. Inventory is usually characterized as either merchandise, raw materials, work in process, or finished goods. Montgomery's Auditing, at 599. Corroboration of this characterization of AAC may be found in the filings with the Commission, as in the November 30, 1988, notes to the financial statements by Ponce: The proposed agreement calls for the joint venture company, to be called American Aircraft Far East (AAFE), to pay the Company $16 million in licensing payments over the next four years for the coproduction rights to aircraft products in Taiwan. The company received an executed letter of Intent from Taipex, the Taiwanese company, along with a $200,000 down payment. Upon completion of the transaction, the Company will own 50 percent of AAFE, with the remaining 50 percent owned by Taipex and local Taiwanese investors. (Div. Exs. 1-82 n.12, 41-97 item 5.) The Beacon Hill Group contract negotiations are also described in the filings. (Div. Exs. 30-73, 32-75.) The doubts expressed by Ponce in the audit reports are consistent with his responsibilities and ethical obligations as to the assessment of the continued existence of AAC as a viable enterprise: One specific type of uncertainty that the auditor must consider, and that the authoritative auditing literature has addressed, is the client's continued existence as a 'going concern.' The concept that financial statements are prepared on the basis of a going concern is one of the basic tenets of financial ==========================================START OF PAGE 20====== accounting. The going concern assumption is that the carrying value of assets will be realized and liabilities will be liquidated in the ordinary course of continuing business activity. Because the going concern assumption is so basic, the standard auditor's report does not make reference to it. When a company becomes insolvent, however, or operates for long periods with net outflow of cash or is unable to meet currently maturing obligations, the going concern assumption must be questioned. That consideration immediately raises a number of questions about realizable value of assets, the order of payment of liabilities, and the proper classification and carrying amounts of both; the unexpired historical carrying amounts may become inappropriate (usually they are in excess of forced liquidation values). Reasonable assurance that the company will not have to suspend operations -- a decision that the company is a going concern -- must be explicitly considered, and if it cannot be obtained, the auditor's report must be qualified to report that fact. . . . . Another type of operational uncertainty results when a newly organized company has not yet achieved success and a solid financial position. In this case, the realizability of its assets (which are usually specialized plant and equipment, inventories, and sometimes deferred charges) can be questionable and the company's continuation not at all ensured. Montgomery's Auditing, at 916. In this context Ponce clearly delineated AAC's problems in his reports. For example, the November 30, 1988, audit report states: BASIS OF PRESENTATION - CONTINUED EXISTENCE The Company has experienced significant losses, and it has no working capital. In addition, certain intangible assets are the basis for the equity on the balance sheets, as discussed in Note 5. The accompanying financial statements have been presented using accounting principles applicable to a going concern, which principles contemplate the realization of assets and satisfaction of liabilities in the normal course of business. The Company's continued existence is dependent on its ability to ==========================================START OF PAGE 21====== achieve profitable operations through product sales and to obtain additional equity and/or debt financing sufficient to finance production levels necessary for profitable operations. INCOME TAXES No income taxes are currently payable as the Company had no taxable income in 1988 and 1987. For financial statement purposes the Company has approximately $4,000,000 in Federal net operating loss carryforwards at November 30, 1988. Although no tax returns have been filed, it is estimated that the Federal net operating loss carryforward for tax purposes at November 30, 1988, is approximately $8,000,000 as the $4,000,000 net operating loss from Phalanx Organization, Inc. at the acquisition date qualifies, with certain statutory restrictions, as a useable net operating loss carryforward. Therefore, the Company may offset future taxable income by the $8,000,000 in Federal net operating loss carryforwards which expire in the year 2003. (Div. Ex. 1-82 at n.10 & n.11.) Note 5 in the same report is equally clear in its description of the Moody acquisitions: ==========================================START OF PAGE 22====== VALUATION OF INVESTMENT, CONTINUED MOODY AIRCRAFT DESIGN BUREAU On February 17, 1988, the Company's Board of Directors agreed to acquire from Moody Aircraft Design all of the designs, design patents (applications and pending), and all rights and an exclusive license to manufacture militarized design versions of the Company's Falcon XP and Hunter Bee Helicopter for 2,500,000 shares of the Company's authorized but unissued common stock. The Board also resolved to value the acquisition at 50 percent of the bid price on the date the shares were issued, the discounting being an attempt to account for the reduced market value of these shares by reason of the restrictions placed on them under Rule 144 of the Securities and [sic] Exchange Act. The valuation is as follows: Date of No. of Avg. Bid Discounted Issuance Shares Price Price Value 2/17/88 2,500,000 $3.75 $1.88 $4,687,500 VALUATION ANALYSIS The Company's investment in Hunter Helicopter and Moody Aircraft Design Bureau is based on management's estimate of value relating to the consideration paid by the Company in the form of its restricted common stock and not on appraised values or historical cost data of the assets acquired. This alternative method valuation is a less desirable test of value, however, appraisals of the intangible assets acquired, namely, designs, patents, FAA Certificate and related data may be difficult, if not impossible. Nevertheless, because the amounts recorded on the Company's books of account in both instances are so material as to represent essentially all of the stockholders' equity, the correctness of management's valuation is critical to the Company's continued existence as a going concern as discussed in Note 10. (Div. Ex. 1-82 n.5.) The April 28, 1989, Accountant's Report from Ponce to AAC, included with AAC's Form 10-K filing for November 30, 1988, also contains a typical objective assessment of the financial statements and of the status of the corporation: ==========================================START OF PAGE 23====== As explained in Note 10 to the financial statements, the Company's continued existence is dependent on its ability to achieve profitable operations through product sales and to obtain additional equity and/or debt financing sufficient to finance production levels necessary for profitable operations. The financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amounts and classification of liabilities that might be necessary should the company be unable to continue in existence. (Div. Ex. 1-82 at 4.) The Tooling, Molds, and Aircraft The second figure that the Division contends was inflated is the value assigned by AAC and Ponce to the tooling, molds, and aircraft. Its proof consists of the testimony of its expert witness. Tersigni testified that for 1988, tooling costs should have been reflected as expenses and were improperly capitalized as an asset (Tr. 243-44, 250-53, 291-92) and construction and testing of prototypes are costs. (Tr. 293.) In his opinion, in 1989 (as in 1988), the tooling costs were part of research and development and "should not have been reflected as assets, but rather charged as expenses in the profit and loss statement." (Tr. 298, 240-53.) Moody's assessment that designs had progressed beyond the research and development stage and that tooling costs should be capitalized should not have been accepted as a substitute for the application of accepted accounting principles. Rather, Ponce should have made an "independent determination" (Tr. 301-04) in Tersigni's opinion. Tersigni further testified that the Penetrator prototype capitalization was $948,618. By 1990, the amount had grown to $2.5 million that "should have been expended." (Tr. 308.) The result of the error, according to Tersigni, is that an investor would be misled by the description of the "preproduction prototype" figures in the financial statements because a footnote to the same document states that "research and development costs are expensed when incurred." (Tr. 310-11.) However, there is no such expense in the document. (Tr. 312-13.) Tersigni's testimony is contradicted by credible evidence that includes the testimony of Moody. On direct examination, Division counsel Matteson questioned Moody closely about the production of the aircraft. Moody's uncontradicted testimony clearly establishes that AAC produced valuable assets and inventory: A: Well, they're composite aircraft so we created -- first we created all the engineering, computer designed engineering, CAD Design. CAD Manufactured, we created ==========================================START OF PAGE 24====== all the composite tooling, because they were composite aircraft, completed all the wind tunnel testing, we completed all the electronics, all the air dynamics, all the flight control, all the stability control, all the different stress analysis, flutter analysis and the fabrication up until engine installation. Q: So, you never had a flying prototype? A: Couldn't get the engines. . . . . Q: Looking at the next one, which is the Phalanx- Intra-Life Shoulder wing four poster blended wing- canard VTOL aircraft, what stage did those aircraft reach? A: That was in a hold stage. The primary emphasis was on the Dragon, and then the secondary was on the Hind, the third item and the fifth item. Q: Okay. Well, let's just stick with the first one or the second one on the list, which is the Phalanx- Intra-Life shoulder wing -- A: There was nothing done at the time. . . . . Q: Okay. And was a flying version of the Patriot ever completed? A: No. Q: Okay. Going to the next item, the Phalanx Hind Helicopter, how far was this design developed? A: We acquired, we the company acquired Hewey Helicopters from which we cannibalized all the mechanical equipment, including the engines, the controls and devices in electronics, and all the elements other than the fuselage. We then fabricated, we designed and fabricated the Hind superstructure, we manufactured its tools, and we built the fuselage and were ready to assemble, at which time there was a change in international geo-political status. Q: Was the aircraft ever completed assembled? A: It was superseded by another aircraft which was completed. Q: And what aircraft was that? A: The Penetrator. Q: The Penetrator Helicopter? A: Yes. Q: And the Penetrator is not on this list? A: No, because it didn't exist at the time. Q: Okay. But, the Hind was never -- there was no flying prototype ever made because it was superseded -- A: We were designing for a specific customer, which is the Army, the Army Aviation, and also Taiwan. We were dealing directly with General Woodmansee at the Pentagon, which had all conventional weapons, and he ==========================================START OF PAGE 25====== had asked this vehicle for a target aggressor, and we were specifically working at his request. When the Soviet Union fell apart, disintegrated, there was no longer a need for aggressor trainers, and so we then turned to export and were dealing with General Ma and General Ho in Taiwan on the acquisition, and they did not want a Soviet look-a-like, they wanted an American look, not a Soviet look. So, I redesigned it and called it the Penetrator, but everything was the same except I did cosmetic surgery. Q: Okay. But, the Hind itself was never built? A: The Hind was built, but it was never installed. We had it done but we just -- Q: When you say never installed, what do you mean? A: In other words, we had all the elements, we had the fuselage, we had the engine, we had everything put together. Q: But it wasn't -- A: But we didn't bring it together because the world changed a lot. Q: So, you never had a flying version of it? A: No. Well, we have an amended flying version because it was superseded by the Penetrator. Q: Well, I'm not asking that. A: No, the Hind never flew. Q: With this particular design it never flew? A: No. Q: With regard to the Phalanx Hunter Helicopter, how far did that design progress? A: That was on hold. Q: When you say on hold, how long was it on hold? A: It was on hold until we completed the other projects. We could only do so much at one time. Q: Right. So, it never developed off of paper then? A: It never went past that stage. Q: And with regard to the Phalanx Falcon, the last item on this list? A: That was developed. Q: How far was it built? A: We built, I think, three of those through test results. Q: And when was that? A: That was in, I think, 1989 or 1990, I believe. Q: And were those prototypes? A: Yes, they're experimental. Q: And they weren't ever sold to anybody? A: They could not be sold at that stage. Q: Why not? A: Because they hadn't been fully tested, flight tested. Q: And a prototype is a testing vehicle, is that correct? ==========================================START OF PAGE 26====== A: It's a flight vehicle. Q: And what were you intending to do with the prototypes? A: We were flight testing it with the intent of, again the Army was interested in it, and also other foreign countries, and Egypt, and we had a lot of requests for orders -- strike that -- we had requests and queries for orders, but it was subject to our completing the flight testing. (Tr. 30-34.) On cross examination, Moody accurately characterized the Penetrator work as "routine on-going efforts to refine, enrich, or otherwise improve upon the qualities of an existing product." (Tr. 73-75.) I conclude that the tooling, molds, construction, and testing were also properly characterized as assets with "alternative future uses" in the filings, consistent with Financial Accounting Standard No. 2, at paragraphs 10 and 11a: 10. The following are examples of activities that typically would be excluded from research and development in accordance with paragraph 8: a. Engineering follow-through in an early phase of commercial production. b. Quality control during commercial production including routine testing of products. c. Trouble-shooting in connection with breakdowns during commercial production. d. Routine, on-going efforts to refine, enrich, or otherwise improve upon the qualities of an existing product. e. Adaptation of an existing capability of a particular requirement or customer's need as part of a continuing commercial activity. f. Seasonal or other periodic design changes to existing products. g. Routine design of tools, jigs, molds, and dies. h. Activity, including design and construction engineering, related to the construction, relocation, rearrangement, or start-up of facilities or equipment other than (1) pilot plants (see paragraph 9(h)), and (2) facilities or equipment whose sole use is for a particular research and development project (see paragraph 11(a)). i. Legal work in connection with patent applications or litigation, and the sale or licensing of patents. . . . . ==========================================START OF PAGE 27====== 11. Elements of costs shall be identified with research and development activities as follows: a. Materials, equipment, and facilities. The costs of materials (whether from the enterprise's normal inventory or acquired specially for research and development activities) and equipment or facilities that are acquired or constructed for research and development activities and that have alternative future uses (in research and development projects or otherwise) shall be capitalized as tangible assets when acquired or constructed. The cost of such materials consumed in research and development activities and the depreciation of such equipment or facilities used in those activities are research and development costs. However, the costs of materials, equipment or facilities that are acquired or constructed for a particular research and development project and that have no alternative future uses (in other research and development projects or otherwise) and therefore no separate economic values are research and development costs at the time the costs are incurred. (Div. Ex. 7-17.) ==========================================START OF PAGE 28====== The Auditing Fees Finally, the Division contends that Ponce was not independent because "he was owed material amounts of fees associated with the audit work that he had performed during the preceding years . . . ." (Tr. 313-14.) From 1988 through 1991, Ponce was due fees for past audit work. (Tr. 316.) Indeed by the completion of the 1990 audit, Ponce was owed $65,000 by AAC. (Div. Ex. 47-94.) However, the Division has failed to prove that the amount was significant enough to be material. The record does not establish Ponce's net worth, his gross or net income, the number of clients he serviced during the relevant time frame, or how much AAC had actually paid to him. Thus, I do not credit the opinion of the expert, because it is not corroborated by other facts. Instead, I credit the testimony of Ponce, who asserted that he had maintained his independence and did not believe AAC had greatly harmed him. Likewise, any defects in planning the audit or in the underlying paperwork are the result of the sole proprietorship nature of Ponce's work. Nothing that the Division criticizes in this context rises to the level of negligence: At the time a member issues a report on a client's financial statement, the client should not be indebted to the member for more than one year's fees. Accordingly, unless the amounts involved are clearly insignificant to both the client and the member, independence is considered to be impaired if fees for all professional services rendered for prior years are not collected before the issuance of the member's report for the current year. Montgomery's Auditing, at 81. The Division has not established that AAC owed more than one year's fees to Ponce. It has not established that the amounts were significant to Ponce, and it has not proved by a preponderance of the evidence that Ponce was not independent. Moody testified that, "We were always paying him, but we were always behind . . . ." (Tr. 82.) SUMMARY In Checkosky v. SEC, 23 F.3d 452, 478 (D.C. Cir. 1994), the court evaluated the evidence where the Commission found that accountants at the Savin company had not complied with GAAS regarding the deferral of costs: Among the time-honored descriptions of 'substantial evidence' is 'enough to justify, if the trial were to a jury, a refusal to direct a verdict when the conclusion sought to be drawn from it is one ==========================================START OF PAGE 29====== of fact for the jury' (Consolo v. FMC, 383 U.S. 607, 620, 16 L. Ed. 2d 131, 86 S. Ct. 1018 (1966)), which leaves open the possibility of sustaining the agency's findings even though one might draw 'two inconsistent inferences' from the evidence (NLRB v. Nevada Consol. Copper Corp., 316 U.S. 105, 106, 86 L. Ed. 1305, 62 S. Ct. 960 (1942)). . . . . The question, however, is not whether they believed Savin could surmount those and other problems with the photocopier. It is whether they tested management's representations, obtained adequate evidence to confirm those representations, and then conducted their own analysis to determine whether the costs Savin was expending in the effort to solve the problems constituted research and development. On that score, the Commission's decision that Checkosky and Aldrich fell short, and thus failed to act in accordance with GAAS, is sufficiently supported by the record . . . . I conclude that Ponce, unlike the accountants in Checkosky, tested the representations of AAC, obtained adequate evidence to confirm them, and then conducted his own analysis to determine whether the allocations in the financial statements were appropriate. The law prevents me from requiring more of the Respondent. In assessing Ponce's culpability, I am clearly unable to use proceedings as to other AAC employees or owners to draw inferences. Parklane Hosiery Co. v. Shore, 439 U.S. 322, 327 (1979); Goldberg v. Kelly, 397 U.S. 254, 266 (1970). Ponce did not violate Section 10(b) of the Exchange Act or Rule 10b-5 thereunder or other related sections of the securities laws. Nor did he cause AAC to violate the securities laws or rules. I find that the Division has not proved that the Respondent violated any section of the securities laws or regulations or Rule 102(e), and accordingly the case must be dismissed. ORDER IT IS ORDERED that the proceeding against Respondent Russell Ponce be, and it hereby 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 (1996). 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 ==========================================START OF PAGE 30====== has not filed a petition for review pursuant to Rule 360(d)(1) within twenty-one days after service of the initial decision upon the 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. __________________________________ Lillian A. McEwen Administrative Law Judge