UNITED STATES OF AMERICA
In the Matter of
ORDER INSTITUTING PROCEEDINGS
The Securities and Exchange Commission ("Commission") deems it appropriate that cease-and-desist proceedings be, and hereby are, instituted pursuant to Section 21C of the Securities Exchange Act of 1934 ("Exchange Act") against Firstmark Corp. ("Firstmark").
In anticipation of the institution of these proceedings, Firstmark has 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 to which Commission is a party, and without admitting or denying any of the findings contained herein, except those findings pertaining to the jurisdiction of the Commission over it and over the subject matter of these proceedings, which it admits, Firstmark consents to the entry of this Order instituting proceedings, making findings and issuing a cease-and-desist order ("Order").
On the basis of this Order and the Offer submitted by Firstmark, the Commission finds that:1
1. Firstmark is a Maine corporation which, at all relevant times, owned a registered broker-dealer and a registered investment adviser and made venture capital and other investments. The company's headquarters was in Waterville, Maine. Firstmark's stock is registered with the Commission pursuant to Section 12(g) of the Exchange Act. From December 1992 through April 1999, Firstmark's common stock was listed on the NASDAQ SmallCap Market.
B. Other Relevant Persons
1. Firstmark's former chief executive officer ("the former CEO") held that position from the early 1980s until January 1997. He was the chairman of Firstmark's board of directors until November 1998. At all relevant times, the former CEO was responsible for all aspects of Firstmark's operations.
2. Firstmark's former chief financial officer ("the former CFO") held that position, as well as serving as secretary and treasurer of the company, from the mid-1990s until January 1997. She served as a director of Firstmark until 1998. At all relevant times, the former CFO was responsible for maintaining Firstmark's books and records, recording its transactions and preparing its financial statements and periodic reports filed with the Commission.
For the periods ended September 30, 1994 through March 31, 1996, Firstmark filed materially false quarterly and annual reports by grossly inflating and improperly accounting for the value of its investments in two start-up companies. The first investment was in a company in the resale business (the "resale company"). For its fiscal year ended June 30, 1995 and the quarters ended December 31, 1994 through March 31, 1996, Firstmark improperly valued its investment in the resale company at cost. Because the resale company had become worthless, Firstmark should have written off the investment in the quarter ended December 31, 1994. The second investment consisted of restricted stock in a small technology company (the "technology company"). For its 1995 fiscal year, Firstmark recognized income on the appreciation in the value of the stock by reclassifying it as a trading security. Under generally accepted accounting principles ("GAAP"), Firstmark's recognition of income from its investment in the stock of the technology company was improper because Firstmark lacked a basis under Statement of Financial Accounting Standards No. 115 ("FAS 115") for transferring the securities into, and subsequently from, the "trading" category.
For the quarter ended September 30, 1994, Firstmark failed to disclose a portion of its investment in the resale company. For the quarter ended December 31, 1994, instead of net income before taxes of $144,471, Firstmark should have reported a loss of $880,529. For the quarter ended March 31, 1995, net income before taxes should have been reduced from $99,424 to $84,424. For the fiscal year ended June 30, 1995, instead of net income before taxes of $771,895, Firstmark should have reported a loss of $54,886. Throughout the period, Firstmark's assets were overstated from approximately ten to eighteen percent. Accordingly, Firstmark violated Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and Rules 10b-5, 12b-20, 13a-1 and 13a-13 thereunder.
2. Quarter Ended September 30, 1994
In November 1993, the former CEO began investing in the resale company, which was purportedly going to sell overstock merchandise from a cable television home shopping network. Firstmark's investments were in anticipation of the resale company's initial public offering ("IPO"), which was supposed to occur during the first half of calendar year 1994.2 At the end of calendar year 1993, Firstmark's investment in the resale company amounted to $315,000.
In July 1994, the former CEO increased the amount of Firstmark's investment in the resale company by providing an additional $360,000 (the "$360,000 payment") to the company, for a total investment of $675,000.3 In order to limit Firstmark's exposure from the investment, however, the former CEO planned to form and sell interests in a limited partnership investment fund, and then to use the investor funds he raised to reimburse Firstmark for the $360,000 payment.4
To conceal the extent of Firstmark's investment in the resale company, in the Form 10-QSB for the quarter ended September 30, 1994, the former CEO and the former CFO did not include the $360,000 payment within the line item on the balance sheet entitled "other investments," which contained the balance of Firstmark's investment in the resale company. Instead, they included the payment within the line item called "prepaid expenses and other current assets," which totaled $530,326. In a footnote that discussed the pending formation of the limited partnership investment fund, Firstmark disclosed that it had invested $360,000 in connection with forming the partnership. Firstmark did not disclose that it had provided the $360,000 payment to the resale company, thus increasing its exposure to the company. This information was material because the $360,000 payment increased Firstmark's investment in the resale company from five percent to ten percent of total assets. Accordingly, a reader of Firstmark's financial statements had no way of knowing that the explanatory footnote was referring to an amount included in the prepaid expenses and other current assets line item, or that the $360,000 purportedly invested in connection with the limited partnership had been invested in the resale company.
3. Quarter Ended December 31, 1994
From September 30, 1994 through December 31, 1994, Firstmark loaned an additional $175,000 to the resale company, for a total of $900,000, including the $360,000 payment. In Firstmark's Form 10-QSB for the quarter ended December 31, 1994, the former CEO and the former CFO valued the total resale investment at cost. Also in December 1994, the resale company granted stock to Firstmark as payment for consulting services and arranging loans. In its December Form 10-QSB, Firstmark recognized as revenue $125,000 in fee income based on this receipt of worthless stock from the resale company. In addition, Firstmark continued to report the $360,000 payment within the line item entitled prepaid expenses and other current assets and to carry it at cost, without disclosing that it increased Firstmark's exposure to the resale company.
By December 1994, the former CEO and the former CFO should have written off Firstmark's investment in the resale company, because they knew or were reckless in not knowing that the resale company was worthless. According to GAAP, a loss in value which is other than a temporary decline should be recognized. See Accounting Principles Board Opinion No. 18 ("APB 18"), ¶ 6. Evidence of a loss in value includes, among other things, absence of an ability to recover the carrying amount of the investment or inability of the entity that received the investment to sustain an earnings capacity which would justify the carrying amount of the investment. By December 1994, it was clear that the resale company was worthless and unable to sustain an earnings capacity which would justify carrying the investment at cost. The resale company's IPO had not occurred. Instead, it was experiencing severe financial distress. The resale company was no longer functioning and owed substantial sums to creditors, including the Internal Revenue Service. The situation grew so bad that, beginning in December 1994, Firstmark's former CEO directed the controller to wire funds from Firstmark to the personal bank accounts of the resale company's CEO and his wife.5 Funds were wired weekly to cover the resale company's expenses and were to personal bank accounts to prevent creditors from seizing the funds.
The former CEO and the former CFO also knew, or were reckless in not knowing, that it was improper to recognize as revenue $125,000 in fee income from the receipt of shares of the resale company for consulting services. During the quarter, Firstmark received 250,000 shares of stock in the resale company, which it arbitrarily valued at fifty cents per share. According to GAAP, to recognize revenue, there must be a completed exchange of goods or services for something of value. GAAP provides that revenue should be recognized in financial statements when it is realized or realizable and earned. Financial Accounting Standards Board Statement of Financial Accounting Concepts No. 5, ¶ 83 ("CON 5"). Revenue is realized when products (goods or services) are "exchanged for cash or claims to cash" and is "realizable when related assets received or held are readily convertible into known amounts of cash or claims to cash." CON 5, ¶ 83(a). Here, the valueless stock that Firstmark received from the resale company was not readily convertible into cash or a claim to cash, thus it was improper to recognize revenue based on its receipt.
If correct accounting treatment had been applied and Firstmark's investment in the resale company had been written off, Firstmark would have been required by GAAP to deduct the cost of the investment -- a total of approximately $1.025 million by December 31, 1994 -- from income. This would have erased Firstmark's net income before taxes for the quarter ended December 31, 1994 of $144,471 and resulted instead in a loss of $880,529. In addition, Firstmark's assets were overstated by approximately 17%.
4. Quarter Ended March 31, 1995
Between January 1, 1995 and March 31, 1995, the former CEO loaned the resale company an additional $15,000 of Firstmark's funds. These funds were again wired to the personal bank accounts of the resale company's CEO and his wife to prevent creditors from seizing them. In early 1995, the former CEO began negotiating with the principals of the resale company to "exchange" Firstmark's investment for an interest in various, other, yet-to-be-financed companies. Notwithstanding the obvious collapse of the resale company, the former CEO and the former CFO prepared, signed and filed a Form 10-QSB for the quarter ended March 31, 1995 that reported Firstmark's $1.04 million investment in the resale company at cost. Further, the additional $15,000 provided to the resale company during the quarter should have been written off, thus reducing Firstmark's net income before taxes from $99,424 to $84,424 for the quarter. The $360,000 payment continued to be carried at cost within the prepaid expenses and current assets line item, without disclosure that it was an investment in the resale company. Assets as of March 31, 1995 were overstated by approximately 18%.
5. Fiscal Year Ended June 30, 1995
The former CEO and former CFO prepared, signed and filed a Form 10-KSB for the fiscal year ended June 30, 1995 that overstated Firstmark's net income by $826,781 and overstated assets by 13%. Instead of net income before taxes of $771,895, Firstmark should have reported a loss of $54,886. The overstatement occurred because Firstmark failed to write off the worthless resale company investment and because it improperly reclassified its technology company stock as a trading security. The former CEO was motivated to overstate Firstmark's net income because he wanted to apply to list Firstmark's stock on the NASDAQ National Market System or the American Stock Exchange, which required at least $750,000 in pretax income for eligibility.
a. The Resale Company
As of June 30, 1995, the former CEO and CFO improperly reported Firstmark's investment in the resale company at cost. For the year ended June 30, 1995, they improperly recognized as revenue $125,000 in fee income for services provided in exchange for stock from the resale company. Firstmark should have written off the entire investment, totaling $680,000, because the investment had become worthless.6
b. The Technology Company
For the fiscal year ended June 30, 1995, Firstmark improperly recorded and reported income from unrealized gains on restricted stock in the technology company, which Firstmark had purchased in a private sale in May 1995. Under FAS 115, which Firstmark implemented in fiscal 1995, securities must be classified in one of three categories upon acquisition: (1) trading; (2) available-for-sale; or (3) held-to-maturity. Under FAS 115, equity securities must be classified as either available-for-sale or trading, since they have no stated maturity date. According to FAS 115, trading generally reflects active and frequent buying and selling. Trading securities are bought and held principally for the purpose of selling them in the near term and are used to generate profits on short-term differences in price. Available-for-sale securities are any securities not intended to be traded and not intended to be held to maturity. FAS 115 provides that, if securities are classified as trading securities, unrealized gains or losses resulting from increases or decreases in their value are included in income. If securities are classified as available-for-sale, unrealized gains and losses are excluded from income and are reported in a separate component of shareholders' equity until realized.
During the preparation of Firstmark's fiscal 1995 financial statements, the former CEO improperly reclassified the restricted stock held by Firstmark in the technology company as a trading security as of June 30, 1995 so that he could record and report income. In May 1995, upon purchase, Firstmark's controller classified the stock as available-for-sale. However, in August 1995, when preparing Firstmark's fiscal 1995 financial statements, the former CEO instructed the controller to reclassify the stock from the available-for-sale category into the trading category as of June 30, 1995. Shortly thereafter, the former CEO instructed the controller to change the classification back to the available-for-sale category for the period beginning July 1, 1995.
Firstmark's recording of income based on its holdings of the technology stock was improper because Firstmark lacked an appropriate basis under FAS 115 for transferring the securities into, and subsequently from, the trading category. According to paragraph 15 of FAS 115, transfers into or from the trading category should be rare; the decision to classify a security as trading should occur at acquisition.7 The former CEO's abrupt reclassification of the technology stock to the trading category at June 30, 1995 and back to the available-for-sale category for the next reporting period indicates that the reclassification was performed solely to manage earnings by recording gains associated with trading securities in current income. By including this unrealized gain in income, the former CEO increased Firstmark's 1995 pretax income by 23%.
The former CEO stated in an August 30, 1995 letter to Firstmark's outside auditors that he did not intend to sell any of the technology company stock until the next year. It should be noted that even if Firstmark's management had indicated, as of June 30, 1995, its intention to sell its technology stock within a year, the stock still should have remained in the available-for-sale category. Paragraph 81 of FAS 115 indicates that available-for-sale securities should not automatically be transferred to the trading category because management decides to sell the securities within one year.8
6. Quarters Ended September 30, 1995; December 31, 1995 and March 31, 1996
For the quarters ended September 30, 1995; December 31, 1995 and March 31, 1996, Firstmark continued to carry its $680,000 investment in the worthless resale company at cost. As a result, during these periods, Firstmark's assets were overstated by approximately ten percent.9
7. Lack of Internal Controls
The former CEO and the former CFO were able to misstate Firstmark's operating results because they had complete control over Firstmark's books and records and financial statements. Until March 1996, Firstmark had inadequate internal controls, no audit committee and no outside directors.
1. The Antifraud Provisions
Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder make it unlawful to make any untrue statements or omissions of material fact in the offer, purchase, or sale of securities. To establish a claim under Section 17(a)(1) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, the Commission must prove scienter. See Aaron v. SEC, 446 U.S. 680 (1980).10 The Supreme Court has defined the term "scienter" as a "mental state embracing intent to deceive, manipulate or defraud." Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 n.12 (1976). To demonstrate materiality, the Commission must prove that there is a substantial likelihood that a reasonable investor would consider an omitted fact or misstatement to be important in making his or her investment decision. Basic, Inc. v. Levinson, 485 U.S. 224 (1988). False statements in periodic reports are in the offer and sale of securities, as required by Section 17(a) of the Securities Act, if the issuer sells its stock during the period. Such false statements meet the in-connection-with requirement of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder if trading in the issuer's securities ensues. SEC v. Benson, 657 F. Supp. 1122, 1131 (S.D.N.Y. 1987); see also SEC v. Rana Research, Inc., 8 F.3d 1358 (9th Cir. 1993) (false statements in press releases).
Firstmark violated the antifraud provisions of the Securities Act and the Exchange Act, because its former CEO and former CFO filed materially false Forms 10-QSB for the periods ended September 30, 1994 through March 31, 1996 and a materially false Form 10-KSB for the fiscal year ended June 30, 1995. For the periods ended December 31, 1994 and June 30, 1995, Firstmark recognized income based on its receipt of stock from the worthless resale company, and it failed to write down its investment in the company. For the periods ended September 30, 1994 through March 31, 1995, Firstmark concealed that it had made an additional $360,000 advance to the resale company. Firstmark also fraudulently recognized income based on its valuation of stock in the technology company by claiming that that restricted stock was a trading security which had appreciated in value. As a result, Firstmark falsely reported net income for its fiscal year ended June 30, 1995 of $771,895, when it should have reported a loss of $54,886. During the relevant period, Firstmark's stock was publicly traded. Therefore, Firstmark's misstatements were in connection with the purchase or sale of securities. Firstmark's overstatement of income was material because it masked a loss. A reasonable investor would have viewed such a large overstatement as significantly altering the total mix of information made available.
Firstmark acted with scienter because the mental state of its former senior officers can be imputed to it. SEC v. Manor Nursing Centers, Inc., 458 F.2d 1082, 1096 n.16 (2d Cir. 1972). The former CEO knew at least as early as late 1994 that Firstmark's investment in the resale company was worthless and should have been written off. The former CFO knew, or was reckless in not knowing, that Firstmark's investment in the resale company was worthless. Likewise, the former CEO knew that classifying Firstmark's restricted, illiquid technology company stock as a trading security as of June 30, 1995, and recognizing income from an unrealized gain in the stock, did not conform with GAAP. The former CEO also acted with scienter because he overstated Firstmark's pretax income in order to make Firstmark eligible for listing on the NASDAQ National Market System or the American Stock Exchange. Accordingly, Firstmark violated Section 10(b) of the Exchange Act and Rule 10b-5 thereunder.
2. Reporting, Books and Records and Internal Controls Provisions
Section 13(a) of the Exchange Act and Rules 13a-1 and 13a-13 require every issuer of securities registered with the Commission pursuant to Section 12 of the Exchange Act to file annual and quarterly reports with the Commission. Rule 12b-20 of the Exchange Act requires that, in addition to the information expressly required to be included in reports, further information must be added if necessary to make the required statements not misleading. Courts interpreting Section 13 of the Exchange Act have held that "the reporting provisions of the Exchange Act are clear and unequivocal, and they are satisfied only by the filing of complete, accurate and timely reports." Sky Scientific, Initial Dec. Rel. No. 137, 1999 SEC LEXIS 475, at *109 (citing SEC v. Savoy Industries, Inc., 587 F.2d 1149, 1165 (D.C. Cir. 1978)). Scienter is not required to establish a violation of Section 13(a) because it is a reporting provision, as opposed to an antifraud provision, of the securities laws. SEC v. Wills, 472 F. Supp. 1250, 1268 (D.D.C. 1978); SEC v. Aydin Corp., [1979-80 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 97,111, at 96,174 (D.D.C. Sept. 14, 1979); SEC v. Savoy Industries, Inc., 587 F.2d 1149, 1167 (D.C. Cir. 1978). Firstmark violated Section 13(a) of the Exchange Act and Rules 13a-1, 13a-13 and 12b-20 thereunder by filing false quarterly and annual reports for the periods ended September 30, 1994 through March 31, 1996.
Section 13(b)(2)(A) of the Exchange Act requires reporting companies to make and keep books, records and accounts which, in reasonable detail, accurately and fairly reflect the transactions and disposition of the assets of the issuer. This section was enacted to "promote the reliability and completeness of financial information that issuers are required to file with the Commission or to disseminate to investors pursuant to the Exchange Act." SEC v. World-Wide Coin Investments, Ltd., 567 F. Supp. 724, 747 (N.D. Ga. 1983). Section 13(b)(2)(B) of the Exchange Act requires issuers to devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances that financial statements are prepared in conformity with GAAP. Firstmark violated Sections 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act by failing to maintain accurate books and records and by failing to devise and maintain a system of internal controls.
On the basis of this Order and the Offer of Settlement that Firstmark has submitted, the Commission finds that Firstmark committed violations of Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and Rules 10b-5, 12b-20, 13a-1 and 13a-13 thereunder.
In view of the foregoing, the Commission deems it appropriate to accept the Offer and to issue the cease-and-desist order set forth therein.
Accordingly, IT IS HEREBY ORDERED, pursuant to Section 21C of the Exchange Act that:
A. Firstmark shall cease and desist from committing or causing any violation and any future violation of Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and Rules 10b-5, 12b-20, 13a-1 and 13a-13 thereunder.
By the Commission.
Jonathan G. Katz
1 The findings herein are made pursuant to Firstmark's Offer of Settlement and are not binding on any other person or entity in this or any other proceeding.
2 Throughout this period, the former CEO, through Firstmark's broker-dealer subsidiary, purchased and sold Firstmark's common stock.
3 In September 1994, Firstmark invested an additional $50,000 for a total investment as of September 30, 1994 of $725,000.
4 In late 1994, the former CEO filed a registration statement with the state of Maine to sell interests in the limited partnership. In February 1995, he began selling the interests, raising approximately $900,000 by September 1995.
5 These payments were included in the amount of Firstmark's investment.
6 In Firstmark's report on Form 10-KSB for the fiscal year ended June 30, 1995, the former CEO and the former CFO removed the $360,000 payment from the prepaid expense and current assets category and reclassified it as an advance to a related party. By June 30, 1995, the former CEO had begun to sell interests in the limited partnership investment fund, to which he intended to transfer the $360,000 payment. Accordingly, for the first time, funds were available to reimburse Firstmark for the $360,000 payment. The risk exposure for that portion of the investment in the resale company had thus been transferred to the limited partner investors.
7 See also Question 35 of the FASB Staff Implementation Guide for FAS 115, issued November 1995.
8 See also Question 36 of the FASB Staff Implementation Guide for FAS 115, issued November 1995.
9 In June 1996, new management and a larger, reconstituted board assumed control of Firstmark's operations. As of June 30, 1996, Firstmark wrote off its entire investment in the resale company.
10 Scienter is not a necessary element of a Section 17(a)(2) or (3) violation. See Aaron, 446 U.S. at 695-96.http://www.sec.gov/litigation/admin/34-42909.htm
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