UNITED STATES OF AMERICA
In the Matter of
| ORDER INSTITUTING CEASE-AND- |
DESIST PROCEEDINGS PURSUANT
TO SECTION 21C OF THE SECURITIES
EXCHANGE ACT OF 1934, MAKING
FINDINGS AND IMPOSING A
: CEASE-AND-DESIST ORDER
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 Michael Marchese ("Marchese")("Respondent").
In anticipation of the institution of these proceedings, the Respondent has submitted an Offer of Settlement (the "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 the Commission is a party, and without admitting or denying the findings herein, except as to the Commission's jurisdiction over him and the subject matter of these proceedings, which Respondent admits, the Respondent by his Offer of Settlement consents to the entry of this Order Instituting Cease-and-Desist Proceedings Pursuant to Section 21C of the Securities Exchange Act of 1934, Making Findings and Imposing a Cease-and-Desist Order, as set forth below.
On the basis of this Order and the Respondent's Offer of Settlement, the Commission finds1 that:
A. Respondent and Related Party
Michael Marchese, 52, of Trumbull, Connecticut, was a director of Chancellor Corporation ("Chancellor") from December 1996 to June 1999. He has had no affiliation with Chancellor since 1999 and currently works as a bank loan officer.
2. Related Party
Chancellor Corp. (File No. 0-11663), incorporated in Massachusetts, maintained its principal place of business in Boston, Massachusetts. From 1983 to 2001, Chancellor's common stock was registered with the Commission pursuant to Section 12(b) of the Exchange Act. On March 9, 2001, Chancellor filed a Form 15 terminating its Commission registration because it had fewer than 300 shareholders.
Summary of Respondent's Conduct
Respondent Marchese served as an outside director of Chancellor at a time when Chancellor's CEO was orchestrating a fraudulent financial reporting scheme. Marchese failed to perform his duties as a director. He recklessly ignored signs pointing to improper accounting treatment, thereby allowing management's fraud to continue. He acted recklessly in signing Chancellor's Form 10-KSB for 1998, which contained materially misleading statements.
Due to its management's fraud, Chancellor materially overstated its assets, revenue and income in its 1998 and 1999 periodic filings. Its CEO, Brian Adley, caused Chancellor's 1998 revenue to be overstated by improperly consolidating revenue from a subsidiary over which Chancellor did not acquire actual control until 1999 and directing fabrication of documents to support his claim of control during 1998. After Chancellor's independent auditors advised Adley that the premature consolidation did not comport with generally accepted accounting principles ("GAAP"), he fired them. Marchese approved the firing although he knew that it was at least partly due to the auditors' disagreement with Adley. In addition, in connection with Chancellor's acquisition of this subsidiary, Adley caused Chancellor improperly to record payables totaling several million dollars to entities he controlled. The payment obligations were purportedly for acquisition consulting services but in fact minimal, if any, services were rendered. Adley directed an employee to fabricate documents in order to make it appear that Chancellor had approved payment of the fee to Adley's entities. Compounding the fraud, Adley capitalized thefee payables rather than reporting them as expenses. Marchese knew that in the previous year Chancellor had written off $1.14 million in related-party payments, but he did nothing to check whether there was adequate support for the millions of dollars in payments to Adley's entities recorded in 1998.
Marchese recklessly signed Chancellor's Form 10-KSB for 1998 without taking any steps to ensure that it did not contain materially misleading statements. He knew that Chancellor's original auditors would not approve the 1998 consolidation date, but took no steps to determine whether Chancellor's insistence on a 1998 date was correct. When successor auditors approved the 1998 date, he made no inquiry into the reasons why the new auditors came to a different conclusion than the former auditors or whether there was a factual basis for it. Further, he took no steps to determine whether Chancellor had in fact authorized payments to Adley's entities, whether the purported services for these payments had in fact been rendered, or whether the payments were adequately disclosed in the Form 10-KSB which he signed.
Marchese's dereliction of his duty as an outside director is more broadly reflected in his complete failure ever to review Chancellor's accounting procedures or internal controls, or even to become aware that he was an audit committee member, and his total deference to CEO Adley. Marchese completely failed to exercise any oversight over Chancellor's financial reporting, exercising no care to ensure that the company had appropriate internal controls and that its financial records were accurate. He acquiesced in Adley's complete control of accounting decisions, including those relating to payments to Adley's own companies.
By signing Chancellor's 1998 Form 10-KSB with reckless disregard for its truth or falsity, Respondent Marchese violated and caused Chancellor to violate Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, which prohibit untrue statements or omissions of material fact. Marchese's failure to perform his duty to oversee Chancellor's accounting processes and internal controls caused Chancellor's violations of Section 13(a) of the Exchange Act and Rules 12b-20 and 13a-1 thereunder, which require accurate filings, and its violations of Sections 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act, which require issuers to maintain accurate books and records and to maintain adequate internal controls.
Respondent Marchese became an outside director of Chancellor in December 1996. He was an acquaintance of Brian Adley, who was Chancellor's controlling shareholder, chairman and chief executive officer. Chancellor reported in public filings that Marchese was a member of the company's audit committee from 1996 to May 1999. Marchese never reviewed Chancellor's accounting procedures or internal controls. He generally deferred to Adley when board action was required.
1. Chancellor Prematurely Consolidated an Acquired Subsidiary's Revenue
On August 10, 1998, Chancellor entered into a letter of intent to acquire MRB, a seller of used trucks. A final closing took place on January 29, 1999. When preparing its financial reports for 1998, Chancellor improperly designated August 1, 1998, as the MRB acquisition datefor accounting purposes. Chancellor designated that date based on its claim that a preexisting written agreement between Chancellor and MRB gave Chancellor effective control of MRB's operations as of August 1, 1998. When Chancellor's auditors began the audit of Chancellor's year-end 1998 financial statements, they reviewed the agreement and informed Chancellor's management that it did not give Chancellor sufficient control of MRB during 1998 to justify consolidating the two companies' financial statements for accounting purposes. The auditors sent a memorandum to Adley and Marchese in February 1999 setting forth their position that GAAP required a 1999 consolidation date.
During February 1999, Adley directed Chancellor's acting CFO to create and backdate to August 1998 a purported amended management agreement with MRB to provide additional support to justify an August 1, 1998 acquisition date for accounting purposes. This document, however, did not cause the auditors to change their position with respect to the correct acquisition date.
On February 25, 1999, Adley dismissed Chancellor's auditors. Adley did not identify the difference of opinion about the accounting date for the MRB acquisition as a reason for the dismissal. As a director, Respondent Marchese approved the decision to dismiss Chancellor's auditors. He was aware of the disagreement between Chancellor's management and the auditors regarding the appropriate MRB acquisition date for accounting purposes. He knew that the disagreement formed part of the reason for the auditors' dismissal.
After dismissing its prior auditors, Chancellor engaged Metcalf, Rice, Fricke and Davis (now BKR Metcalf Davis)("Metcalf Davis") to conduct the independent audit of its 1998 financial statements. Respondent Marchese approved the engagement. During spring 1999, in connection with the Metcalf Davis audit, Chancellor's CEO Adley caused Chancellor's president and acting CFO to fabricate documents in order to support the 1998 acquisition date. The fabricated documents included letters and memoranda designed to demonstrate Chancellor's control of MRB during 1998. These documents were provided to Metcalf Davis.
In April 1999, after conducting its audit, Metcalf Davis personnel met with Marchese, another outside director, and Chancellor's top management. In the meeting, Metcalf Davis indicated that it would provide an unqualified audit report for Chancellor's 1998 year-end financial statements. For accounting purposes, Metcalf Davis approved an August 1998 acquisition date for MRB.
Marchese knew that Chancellor's prior auditors had disagreed with Chancellor's management and had stated that a 1998 acquisition date did not comport with GAAP. Marchese, however, made no inquiry into the reasons for Metcalf Davis's contrary view. Nor did he determine whether there was any factual support for the 1998 acquisition date.
2. Chancellor Improperly Recorded a $3.3 Million Fee
In connection with Chancellor's acquisition of MRB, Adley caused Chancellor to record $3.3 million in fees to Vestex Capital Corporation ("Vestex"), a private entity he owned. The fees were purportedly for consulting services including identifying, negotiating and closing theMRB acquisition. In fact, no significant consulting services were rendered to Chancellor by Vestex in connection with the acquisition. In order to substantiate the fees to Vestex, Adley directed Chancellor personnel to fabricate numerous documents and provide them to Metcalf Davis while the firm was conducting its audit of Chancellor's 1998 financial results. In addition, at Adley's direction, Chancellor recorded as an asset on its balance sheet the $3.3 million in unsupported Vestex fees rather than recording them as an expense on its income statement. This was inconsistent with GAAP, which provides that costs payable to an outside consultant in business combinations may be capitalized only if the consultant has no affiliation with the companies involved in the acquisition.
The year before, in connection with the preparation of Chancellor's year-end results for 1997, Chancellor's auditors had required the company to write off $1.14 million in related party payments to Adley-controlled entities because there was no substantiation for the payments. Although Marchese knew of the 1997 write-off of payments to Adley's entities, he took no steps to determine whether the $3.3 million MRB acquisition fee to Vestex recorded in 1998 was substantiated. He did not ask Metcalf Davis or Adley any questions about related party transactions.
3. Marchese Signed a Misleading Form 10-KSB
Filed By Chancellor
On April 16, 1999, Chancellor filed a Form 10-KSB for the year ended December 31, 1998. Adley, Chancellor's president, Chancellor's controller, Marchese and another outside director signed the Form 10-KSB. The Form 10-KSB was materially misleading in several respects.
First, in the financial statements included in its 1998 Form10-KSB, Chancellor accounted for its acquisition of MRB as of August 1, 1998, and consolidated its financial results with those of MRB. As a result, Chancellor reported annual revenues of $29,639,000, 177% higher than the $10,708,000 revenue figure for Chancellor without the MRB consolidation. It also reported assets of $29,569,000 rather than $8,186,000 (261% higher). The accounting treatment did not comply with GAAP because during 1998 Chancellor did not have the effective control of MRB needed to justify accounting for MRB's acquisition.
Chancellor's Form 10-KSB also falsely represented that Adley's Vestex entity had handled the acquisition of MRB and provided consulting, financing and other services in connection with the acquisition, earning a fee payable of $3.3 million. The fee, for which no significant services in fact had been rendered, was improperly capitalized rather than reported as an expense. As a result, Chancellor reported net income of $850,000 rather than the $2.45 million loss which would have been reported had the fee been expensed, and its assets were overstated by 12%.
Marchese did not seek re-election as a director in 1999. He ceased to be a director of Chancellor on June 25, 1999. In August 1999, Marchese wrote a letter to the Commission staff expressing concern about Chancellor's financial reporting.
1. Marchese Violated and Caused Chancellor's Violation of Section 10(b) of the Exchange Act and Rule 10b-5 Thereunder
Marchese violated and caused Chancellor's violation of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder when he signed Chancellor's 1998 Form 10-KSB. He was reckless in not knowing that it contained materially misleading statements. Marchese knew that the Form 10-KSB reflected a 1998 MRB acquisition date. He also knew that Chancellor's original audit firm had been fired, with his approval, due in part to its disagreement with the 1998 date. Nevertheless, he recklessly failed to make any inquiry into the circumstances leading to the new audit firm's approval of a 1998 MRB acquisition date, or whether it was correct. In addition, Marchese knew that in the previous year Chancellor had written off $1.14 million in related-party fees to Adley entities. However, he recklessly failed to make any inquiry into the basis for the reported $3.3 million in fees payable to an entity owned by Chancellor's CEO which were included in Chancellor's 1998 Firm 10-KSB. Marchese failed to make any inquiry into the existence of documents substantiating the services for which the fees were purportedly due.
2. Marchese Caused Chancellor's Violations of
Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act
and Rules 12b-20 and 13a-1 Thereunder
Marchese caused Chancellor's violations of Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and Rules 12b-20 and 13a-1 thereunder. Section 13(a) of the Exchange Act and Rule 13a-1 require issuers of registered securities to file annual reports with the Commission. The information provided in those reports must be accurate. See United States v. Bilzerian, 926 F.2d 1285, 1298 (2d Cir.), cert. denied, 502 U.S. 813 (1991); SEC v. Kalvex, Inc., 425 F. Supp. 310, 316 (S.D.N.Y. 1975). Regulation S-X requires that financial statements filed with the Commission pursuant to Section 13(a) of the Exchange Act be prepared in accordance with GAAP or such statements will be presumed to be misleading or inaccurate. In addition, Exchange Act Rule 12b-20 requires that these periodic reports contain all information necessary to ensure that statements made in them are not materially misleading. These issuer reporting provisions are violated when false and misleading reports are filed. SEC v. Falstaff Brewing Corp., 629 F.2d 62, 67 (D.C. Cir. 1980). No showing of scienter is necessary to establish a violation of Section 13(a) or Rules 12b-20 or 13a-1. See SEC v. McNulty, 137 F.3d 732, 740-41 (2d Cir. 1998); SEC v. Savoy Industries, Inc., 587 F.2d 1149, 1167 (D.C. Cir. 1978); SEC v. Wills, 472 F. Supp. 1250, 1268 (D.D.C. 1978).
Section 13(b)(2)(A) of the Exchange Act requires every reporting company to make and keep books, records and accounts that accurately and fairly reflect the issuer's transactions. Section 13(b)(2)(B) requires a company to devise and maintain a system of internal controls sufficient to provide reasonable assurances that transactions are recorded as necessary to permit the preparation of financial statements in conformity with GAAP. These provisions require an issuer to employ and supervise reliable personnel, to maintain reasonable assurances thattransactions are executed as authorized and to properly record transactions on an issuer's books. SEC v. World-Wide Coin Investments, Ltd., 567 F. Supp. 724, 750 (N.D.Ga. 1983). A violation of Section 13(b)(2)(A) or 13(b)(2)(B) does not require a showing of scienter. Id. at 751.
Marchese's conduct caused Chancellor's violations of Sections 13(a) and 13(b)(2)(A) and Rules 12b-20 and 13a-1. He was reckless in not knowing that Chancellor's Form 10-KSB for 1998 contained materially misleading statements. Further, he signed Chancellor's Form 10-KSB for 1998 without making any inquiry into the basis for the reported fees payable to Adley's company or the basis for the new audit firm's approval of a 1998 MRB acquisition date.
Marchese also caused Chancellor's violations of Section 13(b)(2)(B) of the Exchange Act. He never attempted to determine the reason for Chancellor's varying accounting treatments of the MRB acquisition and related fees to Vestex, and whether these demonstrated a lack of internal controls to ensure accurate financial reporting and prevent improper transfers to related parties. Marchese never reviewed Chancellor's accounting procedures or determined whether in fact there were any internal controls.
In view of the foregoing, the Commission deems it appropriate to impose the sanctions agreed to in the Offer submitted by Respondent Marchese.
ACCORDINGLY, IT IS ORDERED:
Pursuant to Section 21C of the Exchange Act, that Respondent Marchese shall cease and desist from committing or causing any violations and any future violations of Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder, and from causing any violations and any future violations of Sections 13(a), 13(b)(2)(A) and 13(B)(2)(B) of the Exchange Act and Rules 12b-20 and 13a-1 promulgated thereunder.
By the Commission.
Jonathan G. Katz
|1||The findings herein are not binding on anyone other than Respondent.|
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