UNITED STATES OF AMERICA
In the Matter of
RICHARD P. SCALZO, CPA,
|ORDER INSTITUTING PUBLICADMINISTRATIVE AND CEASE- AND-DESIST PROCEEDINGS PURSUANT TO SECTION 21C OF THE SECURITIES EXCHANGE ACT OF 1934 AND RULE 102(e) OF THE COMMISSION'S RULES OF PRACTICE, MAKING FINDINGS, AND IMPOSING REMEDIAL SANCTIONS AND A CEASE-AND-DESIST ORDER|
The Securities and Exchange Commission ("Commission") deems it appropriate that public administrative and cease-and-desist proceedings be, and hereby are, instituted against Richard P. Scalzo, CPA ("Respondent" or "Scalzo") pursuant to Section 21C of the Securities Exchange Act of 1934 ("Exchange Act") and Rule 102(e)(1)(ii) of the Commission's Rules of Practice.1
In anticipation of the institution of these proceedings, 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, Respondent consents to the entry of this Order Instituting Public Administrative and Cease-and-Desist Proceedings Pursuant to Section 21C of the Securities Exchange Act of 1934 and Rule 102(e) of the Commission's Rules of Practice, Making Findings, and Imposing Remedial Sanctions and a Cease-and-Desist Order ("Order"), as set forth below.
On the basis of this Order and Respondent's Offer, the Commission finds2 that:
Richard P. Scalzo was the PricewaterhouseCoopers LLP ("PwC") engagement partner for the audits of the financial statements of Tyco International Ltd. ("Tyco") for the company's fiscal years 1997 through 2001. In the course of those audits, Scalzo became aware of facts and events that provided him notice regarding the integrity of Tyco's senior management. By the end of the Tyco annual audit for its fiscal year ended September 30, 1998, if not before, those facts were sufficient to obligate Scalzo, pursuant to generally accepted auditing standards ("GAAS"), to reevaluate the risk assessment of the Tyco audits and to perform additional audit procedures, including further audit testing of certain items (most notably, certain executive benefits, executive compensation, and related party transactions). Scalzo did not take sufficient steps in these regards. Accordingly, Scalzo did not conduct those Tyco financial statement audits in accordance with GAAS. However, for each of the Tyco fiscal years from its fiscal year ended September 30, 1998, through its fiscal year ended September 30, 2001, PwC issued an audit report stating that PwC had conducted an audit of Tyco's financial statements "in accordance with auditing standards generally accepted in the United States of America." As the engagement partner for the PwC team auditing Tyco's financial statements, Scalzo was responsible for those statements, and, at the time those statements were made, Scalzo was reckless in not knowing that the Tyco audits had not been conducted in accordance with GAAS.
Richard P. Scalzo, age 46, was the PwC engagement partner for the firm's audits of the financial statements of Tyco, beginning with the Tyco fiscal year ended June 30, 1997, and continuing through Tyco's fiscal year ended September 30, 2002.3 He is currently licensed as a Certified Public Accountant by the Commonwealth of Massachusetts and has been so licensed since July of 1984. He resides in Massachusetts.
1. PricewaterhouseCoopers LLP is a limited liability partnership engaged in public accounting. It maintains its principal place of business in New York City. The firm was formed by the July 1, 1998, merger of Coopers & Lybrand, LLP and Price Waterhouse, LLP.
2. Tyco International Ltd. is a Bermuda corporation with its headquarters in Bermuda. Tyco is a manufacturing and service company involved in fire and safety systems, electronic security services, disposable medical products, packaging materials, flow control products, electrical and electronic components, and underwater telecommunications systems. The common stock of Tyco is registered with the Commission pursuant to Section 12(b) of the Exchange Act and is traded on the New York Stock Exchange.
3. L. Dennis Kozlowski was Tyco's Chairman of the Board, President, and Chief Executive Officer from 1997, and an Executive Officer of Tyco from 1992, until his resignation in June of 2002. Kozlowski had been affiliated with the company since 1975.
4. Mark H. Swartz was Tyco's Chief Financial Officer and an Executive Vice President from 1995 until September of 2002. Swartz was also a Tyco Director from 2001 until his resignation in August 2002. Swartz had been affiliated with the company since 1993
5. Frank E. Walsh, Jr. was an outside Director of Tyco from 1992 until February of 2002. In that capacity, Walsh served as the Chairman of the Board's Compensation Committee from 1998 through 2000 and as a member of the Board's Corporate Governance Committee and Lead Director in 2001.
a. The Key Employee Loan Program Loans
September 30, 1997, was the first fiscal year-end for the new, larger Tyco that emerged from the mid-1997 merger of Tyco and ADT Limited, and Scalzo was the engagement partner for the audit of Tyco's September 30, 1997, financial statements. By the time of that audit, however, factual red flags had already begun to appear in the audit working papers compiled by the team working under Scalzo's direction. Perhaps the most significant red flag for that audit involved the Tyco Key Employee Loan Program ("KELP"). The KELP, established in 1983, was designed to encourage ownership of Tyco common shares by executives and other key employees. For each Tyco fiscal year from the fiscal year ended September 30, 1997, through the fiscal year ended September 30, 2001, the notes to Tyco's consolidated financial statements included in the company's annual report on Form 10-K, stated that loans under the KELP "are made . . . for the payment of taxes upon the vesting of shares granted under [the company's] Restricted Stock Ownership Plans."4 For the fiscal year 1997 audit, the working papers concerning that statement contain twenty-six-pages of reports prepared by the company, listing the activity in the various KELP accounts of Tyco employees. Three of those twenty-six pages set forth the KELP account activity for L. Dennis Kozlowski (then the company's Chief Executive Officer and Chairman) from February 1, 1987, through September 30, 1997. Most of the 1997 line items for the Kozlowski account also include a brief description for each such item, and eighteen carry descriptions that are immediately recognizable as not being for the payment of taxes on the vesting of restricted stock. For example, one item reads "WINE CELLAR," another reads "NEW ENG WINE," another "BMW REG/TAX," another "ANGIE KOZLOWS," and thirteen read either "WALDORF," "WALDORF RENT," "WALDORF EXPEN," "WALDORF RENT A," or WALDORF RENT S."5
For each of the Tyco fiscal years from its fiscal year ended September 30, 1998, through its fiscal year ended September 30, 2001, the PwC audit working papers continued to include schedules for the KELP accounts of Tyco employees. Although those schedules did not include Kozlowski activity line item descriptions, the schedules nevertheless continued to show Tyco's most senior officers utilizing the KELP with a frequency that is impossible to reconcile with the payment of taxes on the vesting of restricted stock. In fact, the rate of KELP activity for those officers was due to their use of the program as a revolving line of credit -- and should have led the PwC audit team to inquire further as to whether the loans could possibly be authorized.
Scalzo's own desk files contain at least one additional document that clearly reflects the KELP being used for purposes other than the payment of taxes on the vesting of restricted stock. The document, with marginalia in Scalzo's handwriting, relates to a series of transactions that took place over a three-day period in 1998 and involved an exercise of Tyco stock options by Kozlowski, Mark H. Swartz (then Tyco's Chief Financial Officer), and one other Tyco executive. The stock options were exercised by the executives borrowing, in the aggregate, in excess of $50 million from the KELP and then selling the shares received from their option exercise back to the company, through an off-shore subsidiary. The first two lines of the Scalzo desk file document states "17-Jul-98; LDK & MS & DB exercises [sic] options by borrowing cash from TYCO US; TYCO US forwards money to TIL."6 The document then lists the initial journal entries reflecting the transaction. The first three entries listed include debits to "Key Employee Loans [sic] DB"; "Key Employee Loan LDK"; and "Key Employee Loan MS."
These documents provided notice to Scalzo regarding the integrity of Tyco's most senior management. Specifically, the documents showed that his client was using the KELP for the improper benefit of its most senior officers, and, in any event, for purposes other than the only purpose stated in the notes to the company's financial statements -- the payment of taxes on the vesting of restricted stock.
b. Tyco's Refusal to Disclose Non-Interest-Bearing "Relocation" Loans
The consistent refusal of Tyco's management to disclose non-interest-bearing "relocation" loans granted to Tyco executives provided notice to Scalzo regarding the nature of Tyco's management. Scalzo was aware of tens of millions of dollars of these non-interest-bearing loans to Tyco's top two officers. By the time of the fiscal year 1999 audit, Scalzo knew, for example, that Kozlowski had $35.5 million, and that Swartz had $8 million, of such loans. The loans ostensibly were granted under Tyco's relocation loan program and were to be used to assist with the purchase of real estate by Tyco employees who were required to relocate to Tyco's offices in New York City and Boca Raton, Florida. These loans were recorded on the books and records of the company and were reviewed as part of the audit process.
Pursuant to the firm's standard audit procedures, the PwC audit team for the Tyco audits recommended that Tyco disclose in its periodic reports the existence of these non-interest-bearing loans. When Scalzo raised the issue with the principal beneficiaries of the loans (Kozlowski and Swartz), Swartz told Scalzo that disclosure was not needed because the loans were not material to Tyco's financial statements, and Swartz refused to make the disclosure. The resistance to such disclosure, together with other facts and events discussed herein, provided notice to Scalzo regarding the character and integrity of Tyco senior management.
c. Post-period Adjustments Off-setting Unanticipated Charges
Two separate incidents, and one ongoing practice, in which management utilized post-period adjustments to negate the impact of unanticipated charges discovered post-period provided notice to Scalzo regarding the integrity of Tyco management. Most of those adjustments involved reversals of accruals. PwC had objected in prior periods to most of the accruals, and Tyco had refused in those periods to record the adjustments requested by PwC.
(i) Fiscal Year 1998: Compensation Charge
As noted above, during the course of the audit of Tyco's financial statements for its fiscal year ended September 30, 1998, the PwC audit team noticed a series of transactions from July 1998 in which Kozlowski, Swartz, and one additional Tyco executive exercised Tyco stock options, by borrowing from the KELP, and then sold the shares realized from their options exercises back to the company the next business day, along with additional shares previously held by the executives, through an off-shore Tyco subsidiary. Tyco then wrote a check to the executives, representing a net settlement of the stock buybacks, the KELP loans used to exercise the options, interest on those loans, and other unrelated KELP loans owed by the executives.7 After consulting with PwC national partners, the PwC audit team came to the conclusion that Tyco should include a compensation charge of approximately $40 million.
On October 15, 1998, when PwC first learned of the transactions, Tyco was within days of a scheduled October 22 earnings release and had already conditioned Wall Street analysts to expect earning numbers that did not include the previously unanticipated compensation charge. Taking an additional multi-million dollar compensation charge would have caused the company to report earnings per share that would have been several cents lower than those the Street was anticipating. Scalzo clearly knew the urgency of this issue at the time that he consulted with PwC's national partners. A Scalzo e-mail communication summarized the accounting issue for his partners and concluded by stating, "The potential impact to Tyco on this issue is significant."
Faced with the reality of having to book an unanticipated $40 million compensation charge, Tyco suddenly arrived at $40 million in additional, contemporaneous, post-period adjustments which had the effect of negating the impact of the $40 million charge. The entries are set forth in a memorandum dated October 20, 1998, from Tyco's corporate controller at the time.8 The Tyco entries negating the impact of the compensation charge were a series of credits to the selling, general and administrative expenses ("SG&A") line item on Tyco's income statement. The $40 million in credits raise significant issues -- each of which provided additional notice to Scalzo about the integrity of Tyco's management. Of those credits, $7.8 million resulted from Tyco reversing a previous "fourth quarter charge for restricted stock expense for certain executives no longer required." The rationale advanced for that reversal was that the executives had decided to forego the corresponding bonuses in the fourth quarter.9
One issue raised by the credits was the fact that $12.25 million of them resulted from Tyco's reversal of an "accrued restructuring reserve" into SG&A. That decrease of SG&A was accomplished by first reversing the accrued restructuring reserve against restructuring expense on the restructuring ledger and then debiting restructuring expense and crediting administrative expense on Tyco's general ledger. Scalzo was aware of the nature of these adjustments at the time they were made.10 Documents in Scalzo's handwriting show that Scalzo was also aware of an additional issue raised by the reversal of the restructuring reserve -- the fact that Tyco had suddenly decided that $12.25 million of the reserve would be reversed. Scalzo's notes made at the time that Tyco was attempting to resolve these issues contain a notation -- with the letters "SEC" printed to its left -- stating, "Why is this the right qtr to reverse restructuring vs prior periods." The Tyco controller's memorandum lists the justification for the reversal as the need "[t]o reverse certain restructuring items that have been resolved during the fourth quarter." Scalzo accepted this written representation from his client.
Of the remaining credits, several were the result of entries that PwC previously had advised Tyco to make, but which Tyco in the past had declined. Tyco, at least in part, followed previously rejected PwC recommendations in recording $19.2 million of the adjustments. Faced with a $40 million post-period crisis, however, Tyco changed its mind and made the previously rejected entries on its books. Any doubt as to whether Tyco would have taken these entries otherwise should be put to rest by the fact that Tyco was days away from its earnings release and had already conditioned analysts to expect earnings that did not include the impact of any these entries.11
Part of the $19.2 million in adjustments was a $2 million credit resulting from Tyco's partial reversal of its "corporate general reserve." In fact, during the previous fiscal year, PwC had noted on its Summary of Unadjusted Differences ("SUD") that the reserve was per se impermissible and should be reversed completely.12 At that time, Tyco had declined to reverse the reserve in any amount, and, at the time of the post-period adjustments off-setting the impact of the $40 million compensation charge, Tyco only reversed $2 million of that reserve -- leaving the remainder of the accrual available for future use.
The facts point to Scalzo's knowledge of the process whereby Tyco arrived at $40 million in adjustments to negate the impact of the compensation charge. The notes in Scalzo's handwriting, which make sense only if they date from some point in time prior to the final "resolution" of the matter, set forth, near the bottom of one page, three line items reading, "13M reverse restricted stock award; 14M reverse I/C hit; 13M restructuring reversal." The line items aggregate $40 million. Moreover, they closely resemble the types of post-period adjustments that eventually were made on Tyco's books.13 All of these issues provided further notice to Scalzo regarding the integrity of Tyco's management. Moreover, the very next fiscal year the post-close fire-drill reoccurred.
(ii) Fiscal Year 1999: Purchase Accounting Charges
During the annual audit for Tyco's fiscal year ended September 30, 1999, the PwC team auditing Tyco's Flow Control division came to the conclusion that $10.6 million in expenses at the division's Earth Tech subsidiary had been improperly charged against purchase accounting accruals.14 Scalzo, once informed of the findings, told the client that these errors were "black and white" and had to be reversed.
Tyco, in fact, agreed to reverse the entries and allow the expenses to flow through Tyco's operating expense. By memorandum dated October 21, 1999, the Flow Control divisional controller informed the Tyco corporate controller that "[p]er our discussion, Tyco Flow Control will reverse $10.6 m of inappropriate Earth Tech purchase accounting spending" and that "Flow Control will reverse the following accruals to cover this inappropriate purchase accounting spending." 15 (emphasis added). The memorandum then listed three items, aggregating $10.6 million:
$2.1 m - Dog Leg Accruals (excess booked in post close in Boca)
$5.4 m - Flow Control Books (Account 021-0035)
$3.1 m - Corporate (Boca) General Reserve
Once again, suddenly faced with an unexpected charge, Tyco came up with additional post-period adjustments to off-set the impact of the unanticipated charge. In fact, the adjustments that "cover" the purchase accounting reversals were all items that had been slated by PwC for inclusion on the fiscal year 1999 SUD, although Tyco booked them selectively and only partially, as necessary to off-set the impact of the unexpected charges. The Flow Control memorandum leaves little doubt that Tyco would have declined to make the adjustments, barring the unanticipated post-period $10.6 million in additional expense. In fact, the $3.1 million reversal from the corporate general reserve is a reversal of the same corporate reserve utilized a year earlier when Tyco covered the effect of the $40 million compensation charge. Again, the very existence of that reserve had been noted on the PwC SUD annually, and annually Tyco had declined to reverse the accrual. The $2.1 million reversal of the excess "Dog Leg" accrual, moreover, bears no economic or business relation to the 1996 Earth Tech acquisition. "Dog Leg" was the Tyco transactional code name for its August 1999 disposition of The Mueller Company, another subsidiary within the Flow Control division.16
d. Continued Use of General Unallocated Reserves
Scalzo continued to witness Tyco's use of general unallocated reserves to off-set unexpected expenses throughout Tyco's fiscal years 1998-2001. For example, the PwC Discussion Outline for the Tyco fiscal quarter ended June 30, 2001, notes "[g]eneral reserves of $26m recorded through post-close entries; Increase is allocated to various Corporate accrual and reserve accounts, but intention is primarily to off-set possible (but unidentified) under accruals at a divisional level."
e. Improper Accounting Treatment for Certain Executive Bonuses
On three occasions over one calendar year, the company's treatment for certain executive bonuses provided notice to Scalzo regarding the integrity of Tyco senior management.
(i) The TyCom IPO
In July 2000, Tyco successfully completed an initial public offering ("IPO") of approximately fourteen percent of the outstanding common stock of its previously wholly-owned subsidiary, TyCom Ltd., which served as the holding company for Tyco's undersea fiber optic cable communications business. The TyCom IPO generated a one-time gain of approximately $1.76 billion on the books of Tyco. In early September 2000, Kozlowski decided to grant bonuses to fifty-one Tyco officers, managers, and employees, ostensibly for their contributions to the gain from the TyCom IPO. On November 30, 2000, Scalzo received a facsimile transmission of a memorandum purportedly written by Swartz and dated September 29, 2000. The memorandum noted the TyCom IPO bonuses and stated that selected employees would receive their bonuses in the form of cash, forgiveness of relocation loans, and/or Tyco stock under Tyco's restricted stock program. The memorandum also stated that the bonus payments are not in lieu of a normal year-end bonuses but instead represented an incremental payment to reward selected employees for the successful TyCom IPO.
The relocation loan forgiveness, and other components of the bonuses, aggregated $95,962,653, of which Kozlowski and Swartz received $49,586,754. According to a Tyco report on Form 8-K, filed with the Commission on September 10, 2002, an internal Tyco investigation found that Tyco had classified $44,642,065 of the $95.9 million as a TyCom offering expense, with the remainder charged against previous overaccruals of general and administrative expense and against an accrual for federal income taxes.
Scalzo first learned of the TyCom IPO bonuses in the course of PwC's year-end audit in October 2000. An October 19 draft Discussion Outline from Scalzo's desk files bears a notation in his handwriting that states "IPO; GAIN -- offsets need memo" and shows that Scalzo was aware of and focused on off-sets to the IPO. Scalzo subsequently discussed the TyCom IPO bonuses with Swartz, a primary beneficiary of the bonuses, and was told that the bonuses were not material. Management also represented to Scalzo that the bonuses were direct and incremental costs of the TyCom IPO.17
(ii) The ADT Automotive Divestiture
In October 2000, Tyco sold its ADT Automotive business for approximately $1 billion in cash, with a net gain on the sale of approximately $400 million. In November 2000, Kozlowski used the ADT Automotive divestiture as a vehicle for the payment of almost $56 million in bonuses to Tyco officers and managers, in the form of cash bonuses, relocation loan repayments, and grants of restricted stock.18 Although the bonus recipients were almost exclusively Tyco corporate headquarters personnel, Swartz directed that the $56 million in charges be netted against the gain on the divestiture, and that all but the restricted stock components be classified as "direct selling costs" associated with the ADT Automotive divestiture.
A January 15, 2001, draft of PwC's Discussion Outline for the Tyco quarter ended December 31, 2000, lists, as one of nine "Key Items," an issue relating to "[c]harges recorded against gain on sale of businesses."19 The "Corporate" section of the draft Discussion Outline cites the ADT Automotive issue more explicitly. Discussing a "$(410.4)m gain on disposal of businesses," the Outline states, "Calculation of gain nets a number of additional charges against the mechanical gain calculation (proceeds less net assets) of $548.1m, including: Management bonuses of $61.5m - documentation of these bonuses is that they are direct and incremental costs of the sale of ADT Automotive."20 The "Key Item" language and the "Corporate" language appear in identical form in another document from Scalzo's desk files, a document entitled "Audit Committee Discussion Outline - March 26, 2001." Scalzo received a representation from Swartz that the bonuses were direct and incremental costs of the transaction. 21 While Scalzo brought the bonuses to the attention of the audit committee, he did not disclose to the committee that Kozlowski and Swartz were recipients of the bonuses.
(iii) The FLAG Telecom Transaction
On June 22, 2001, Tyco acquired 15 million shares of FLAG Telecom for $11,421,810 in cash and 5,580,647 shares of common stock in Tyco's subsidiary, TyCom Ltd.22 Tyco reported a $79,364,700 gain associated with its swap of TyCom shares for the FLAG Telecom equity. Kozlowski and Swartz directed bonuses to a handful of Tyco corporate headquarters officers and managers, again ostensibly to reward the officers and managers for their role in creating the $79 million gain. At the end of its fiscal third quarter ended June 30, 2001, when it was still not clear what form these bonuses might take, Tyco established a $15 million accrual for management bonuses and netted the accrual against the gain on the FLAG Telecom transaction. During its fiscal fourth quarter, Tyco management decided to take the bonuses in the form of accelerated vestings of restricted stock. The officers and managers sold those shares back to Tyco, through a Tyco off-shore subsidiary, and the proceeds were then wired to their personal accounts. The aggregate cost of those bonuses was $15,378,700, of which $12,329,475 went to Kozlowski and Swartz. Kozlowski and Swartz then awarded themselves a tax gross-up on their FLAG Telecom bonuses, in the form of approximately $9.6 million in additional restricted stock. The tax gross-up was charged against a corporate income tax account on Tyco's balance sheet. Accordingly, neither Kozlowski's and Swartz' initial FLAG Telecom bonuses nor their tax gross-up affected Tyco's operating expense.
The PwC audit team knew that, once again, Tyco management had classified executive bonuses so that the charges would not be included in operating expenses. The PwC audit team disagreed with that accounting treatment for the FLAG Telecom bonuses and included that item on its SUD, which was provided to the audit committee. The PwC Discussion Outline for the quarter ended June 30, 2001, lists as its first "Key Item" "$15m `bonuses' netted against gain on issuance of TyCom shares for FLAG equity purchase - netted against special charges." Under its "Corporate" section, the Discussion Outline again lists the item, and explicitly questions its classification, this time stating, "$15m `bonus' netted against gain on issuance of subsidiary shares - basis? Is this operating?" (emphasis added). A PwC outline for the fiscal third quarter report to the Tyco audit committee, dated August 8, 2001, continues to list the matter, noting under the header "Unusual Transactions," the item "[g]ain on sale of subsidiary shares -- for flag investment $64m."23 Scalzo also listed the $9.6 million tax item on the 2001 fiscal year SUD, although the listing did not tie the item to executive bonuses. These facts provided notice to Scalzo that Tyco management was aggressively attempting to classify executive bonuses in a manner that would keep the bonuses out of Tyco's operating expenses.24
f. The Frank E. Walsh, Jr. CIT Finder's Fee
Finally, in early December 2001, during the financial statement audit for Tyco's fiscal year 2001, Scalzo was informed by the PwC team auditing Tyco's Tyco Capital Corporation subsidiary that the team had noticed a $20 million finder's fee paid to Frank E. Walsh, Jr., then a Tyco outside Director, in connection with Tyco's 2001 acquisition of The CIT Group, Inc. (Tyco Capital Corporation, later renamed CIT Group Inc., was formed as a result of Tyco's acquisition of The CIT Group, Inc.) The Tyco Capital Corporation audit team especially wanted Scalzo to know that the $20 million fee consisted of a $10 million payment directly to Walsh and a $10 million contribution by Tyco to a charitable foundation chosen by Walsh.25 By the time that the Tyco Capital Corporation audit team informed Scalzo about the finder's fee, the PwC audit team under Scalzo had already interviewed Tyco management regarding the existence of related party transactions for Tyco's fiscal year 2001 and had been told that there were no such transactions to report.26 Therefore, Tyco management had given the audit team false information. Once again, Scalzo was faced with facts that raised serious questions about the integrity of Tyco management.
These facts and events -- repeated and consistent -- provided notice to Scalzo, by the end of the PwC audit for Tyco's fiscal year 1998, if not before, regarding the character and integrity of Tyco management. So informed, and as the engagement partner for the PwC Tyco audits, Scalzo faced certain obligations under GAAS.
a. The Requirements of GAAS
As an initial matter, in order for an audit to be conducted in accordance with GAAS, the auditor must plan the audit "to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud." AU § 316.01. The auditor's obligations regarding assurance, however, do not end there. The auditor is directed to also perform the audit in a manner calculated to obtain such assurances. AU § 316.01. Thus, "the assessment of the risk of material misstatement due to fraud is a cumulative process and one that should be ongoing throughout the audit." AU § 316.35. Because this process is a cumulative one, "[a]s the auditor performs planned procedures, the evidence obtained may cause him or her to modify the nature, timing, and extent of other planned procedures." AU § 316.33. Thus, "conditions may be identified during fieldwork that change or support a judgment regarding the [risk] assessment," including "[t]ransactions not recorded in a complete or timely manner or improperly recorded as to amount, accounting period, classification, or entity policy" or "[l]ast-minute adjustments by the entity that significantly affect financial results." AU § 316.25 (emphasis added). Statements on Auditing Standards make clear that one of the ways that "procedures may need to be modified" in response to facts uncovered during an audit is that "[t]he nature of audit procedures performed may need to be changed to obtain evidence that is more reliable or to obtain additional corroborative information." AU § 316.28.
Risk assessments, and, accordingly, any reevaluations of risk assessments, should be made with consideration of applicable risk factors. See AU § 316.12, .14. Thus, the auditor's response to a risk assessment "is influenced by the nature and significance of the risk factors identified as being present." AU § 316.26. One of the principal categories of "[r]isk factors that relate to misstatements arising from fraudulent financial reporting" is "[m]anagement's characteristics and influence over the control environment." AU § 316.16. Those factors "pertain to management's abilities, pressures, style, and attitude relating to internal control and the financial reporting process." AU § 316.16 (emphasis added).27 One of the examples of the risk factors from another principal category, that of risk factors relating to operating characteristics and financial stability, is "[s]ignificant related-party transactions not in the ordinary course of business" AU § 316.17 (emphasis added).
One of the cardinal principles of GAAS is that "[d]ue professional care is to be exercised in the planning and performance of the audit and the preparation of the [audit] report." AU § 230.04 (emphasis added). Statements on Auditing Standards note that "[d]ue professional care requires the auditor to exercise professional skepticism," AU § 230.07, and "[i]n exercising professional skepticism, the auditor should not be satisfied with less than persuasive evidence because of a belief that management is honest," AU § 230.09. In fact, one of the ways in which a reevaluation of risk assessment may affect the audit is in the increased application of professional skepticism. See AU § 316.27. "Some examples demonstrating the application of professional skepticism in response to the auditor's assessment of the risk of material misstatement due to fraud include (a) increased sensitivity in the selection of the nature and extent of documentation to be examined in support of material transactions, and (b) increased recognition of the need to corroborate management explanations or representations concerning material matters -- such as further analytical procedures, examination of documentation, or discussion with others within or outside the entity." AU § 316.27.
The auditor's obligation of ongoing risk assessment does not end once the fieldwork is complete. "At the completion of the audit, the auditor should consider whether the accumulated results of audit procedures and other observations [for example, conditions arising during fieldwork] affect the assessment of the risk of material misstatement due to fraud he or she made when planning the audit." AU § 316.33. "Such an accumulation may provide further insight into the risk of material misstatement due to fraud and whether there is a need for additional or different audit procedures to be performed." AU § 316.33. Moreover, "[w]hen audit test results identify misstatements in the financial statements, the auditor should consider whether such misstatements may be indicative of fraud." AU § 316.34.
In conducting such an analysis, even seemingly immaterial transactions may trigger the need to reevaluate the audit's risk assessment. See AU §§ 312.11, 316.34.28 Thus, "[i]f the auditor has determined that misstatements are or may be the result of fraud, but the effect of the misstatements is not material to the financial statements, the auditor nevertheless should evaluate the implications, especially those dealing with the organizational position of the person(s) involved." AU § 316.34 (emphasis added). This is true because, "when the matter involves higher level management, even though the amount itself is not material to the financial statements, it may be indicative of a more pervasive problem." AU § 316.34 (emphasis added).29
As noted, if risk assessment is reevaluated properly, GAAS may well lead an auditor to the conclusion that he or she is required to take additional audit steps. In addition, an auditor's identification of certain types of transactions or events may also trigger the need to take specific, additional actions. For example, during the course of an audit, the auditor may become aware of reportable conditions, that is, "matters coming to the auditor's attention that, in his judgment, should be communicated to the audit committee because they represent significant deficiencies in the design or operation of internal control, which could adversely affect the organization's ability to record, process, summarize, and report financial data consistent with the assertions of management in the financial statements." AU § 325.02. One example of a reportable condition is "[e]vidence of significant or extensive undisclosed related party transactions." AU § 325. Similarly, "[w]hen the auditor, as a result of the assessment of risk of material misstatement due to fraud, has identified risk factors that have continuing control implications (whether or not transactions or adjustments that could be the result of fraud have been detected), the auditor should consider whether these risk factors represent reportable conditions relating to the entity's internal control that should be communicated to senior management and the audit committee." AU § 316.39 (emphasis added). Additional matters encountered during the course of the audit may also need to be brought to the attention of the audit committee, AU § 380, including, for example, "audit adjustments," or proposed corrections "of the financial statements that, in the auditor's judgment, may not have been detected except through the auditing procedures performed." AU § 380.09.
b. Scalzo's Failure to Follow GAAS
In contrast to the requirements of GAAS, Scalzo conducted the financial statement audits for Tyco's fiscal years 1998, 1999, 2000, and 2001, under an assessment of risk that remained unchanged by facts and events that called into question the character and integrity of Tyco's most senior management. With regard to those facts and events, "the evidence obtained" did not cause him "to modify the nature, timing, and extent of other planned procedures." AU § 316.33. When it came to Tyco's most senior management, Scalzo did not reevaluate risk assessment as a result of conditions that arose during the course of fieldwork or as a result of audit test results. See AU § 316.25, .33. In fact, at no point during the course of his work as engagement partner for the Tyco audits did Scalzo reassess the level of audit risk with regard to executive compensation or related party transactions.30
A principal vehicle of executive compensation and related party transactions at Tyco was the KELP loans to its senior officers.31 Nevertheless, the PwC audit team did not pursue troublesome facts regarding KELP. The PwC working papers contained documents that contradicted the KELP financial statement footnote they were ostensibly intended to support. Scalzo knew, and documents contained in his own desk files showed, that KELP loans had been used to exercise tens of millions of dollars worth of stock options rather than to pay taxes on the vesting of restricted stock. Failing to reevaluate audit risk in this area, Scalzo took no further steps. He did not perform, nor did he direct PwC personnel to perform, any audit steps to determine whether KELP loans made to Tyco's top officers, in fact, were consistent with the program purpose stated in the financial statement footnote. He did not inform the audit committee of Tyco's Board of Directors that Tyco's most senior officers had used KELP loans for non-program purposes.
Another principal area of Tyco executive compensation and related party transactions was that of non-interest-bearing loans extended to Tyco's senior management. Here, also, the audit team failed to respond to troublesome facts and events. Scalzo was aware of tens of millions of dollars in non-interest-bearing loans to Tyco's top two officers. For each of the Tyco fiscal years 1999-2001, PwC's recommendation that these loans be disclosed was rejected. Scalzo raised the issue with the principal beneficiaries of the loans: Kozlowski and Swartz. Swartz told Scalzo that disclosure was not needed because the loans were not material to Tyco's financial statements. Scalzo considered that statement and the impact of non-disclosure on the financial statements.32 Scalzo did not reevaluate audit risk in this area, and he took no additional audit steps regarding the propriety and disclosure of the loans or their authorization, other than to review and consider management's draft financial statements. He did not review the PwC working papers on the use of the loans. He did not insist on separate disclosure of the loans in Tyco's financial statements, and he did not inform the audit committee of the existence of the non-interest-bearing loans.
The facts and events that should have led Scalzo to reevaluate audit risk at Tyco continued to accumulate with his exposure to post-period adjustments made to cover the impact of unanticipated charges. The fiscal year 1998 and fiscal year 1999 post-period episodes informed Scalzo that his client, when faced with unexpected charges, made adjustments that the client had previously declined to make despite being advised that adjustments were required by generally accepted accounting principles ("GAAP"). At least for the fiscal year 1998 incident, Scalzo knew that the unanticipated charges were significant for Tyco and, if not off-set, would decrease Tyco's expected earnings per share by several cents. Scalzo knew that Tyco maintained a corporate general reserve, which was unallocated and which Tyco had been told was impermissible under GAAP and should be reversed in its entirety. Scalzo knew that the client utilized a portion of this reserve to negate part of the impact of the unexpected compensation charge for its fiscal year 1998. His own handwritten notes show that he was aware, prior to the resolution of the matter, that Tyco was attempting to find additional adjustments to cover the impact of the post-period charge. Scalzo came to know that Tyco used the unallocated reserve to off-set unexpected expenses during its fiscal years 1998-2001. Nevertheless, witnessing "last-minute adjustments by the entity that significantly affect financial results" did not lead Scalzo to reevaluate the relevant audit risk. AU § 316.25. Nor did the client's continued use of an impermissible reserve. This in spite of the fact that the corporate general reserve had repeatedly been placed on the PwC SUD and brought to the attention of Tyco management, without result. Scalzo did not bring the last-minute post-period adjustments or the use of a general unallocated reserve to the attention of the audit committee, nor did he insist that Tyco management cease using the reserve to off-set expenses.33
Scalzo also failed to reevaluate audit risk when confronted with the issues raised by the bonuses granted in connection with the TyCom IPO, the ADT Automotive divestiture, and the FLAG Telecom transaction. Scalzo discussed the TyCom IPO bonuses with Swartz, a primary beneficiary of the bonuses, and was told that the bonuses were not material. Scalzo considered Swartz' representation and accepted the lack of disclosure of the bonuses in the context of the financial statements. Scalzo accepted management's representation that the bonuses were direct and incremental costs of the TyCom IPO. He did not reevaluate audit risk. He did not insist that the bonuses be separately disclosed in the financial statements, and he did not report to the audit committee that Kozlowski and Swartz received the bonuses.
Faced with the accounting treatment for the ADT Automotive executive bonuses, Scalzo again accepted a management representation that the bonuses were direct and incremental costs of the transaction and allowed the accounting treatment to stand. He listed the bonuses on the audit committee Discussion Outline along with a notation that there was documentation that the bonuses were direct and incremental costs of the sale. More important for the violations discussed herein, he did not reevaluate audit risk. Accordingly, he undertook no additional audit procedures or testing. He did not direct the audit team to ascertain whether the bonuses were authorized by Tyco's Board of Directors. Although he discussed the bonuses with the audit committee, he did not identify the recipients of the bonuses to the audit committee and did not require the bonuses to be separately disclosed in the financial statements.
In response to Tyco's accounting treatment for the FLAG Telecom executive bonuses, Scalzo posted the amount of the bonuses on the SUD and discussed it with management (the beneficiaries of the bonuses). Although Scalzo explicitly questioned the accounting classification, he did not insist that the accounting treatment be changed, because he did not believe that it was material. Scalzo also listed the tax gross-up component on the SUD, although less explicitly. He did not point out that the tax item was another component of the FLAG Telecom executive bonuses. As above, he did not insist on its accounting treatment being changed. Again, faced with his client's acts and his client's response to his advice, he did not reevaluate audit risk. Accordingly, he undertook no additional audit procedures or testing. When faced with problematic facts regarding executive bonuses, Scalzo's analysis did not heed the cautionary statement, set forth in SAS, that, "when the matter involves higher level management, even though the amount itself is not material to the financial statements, it may be indicative of a more pervasive problem." AU § 316.34 .34
Moreover, during the fiscal year 2001 audit, Scalzo learned that Tyco management had not voluntarily informed the PwC audit team about the Walsh CIT finder's fee, and in fact had told the audit team that there were no related party transactions to report for that fiscal year. After another PwC audit team found, and informed Scalzo of, the fee, Scalzo discussed it with Tyco management and was told that the fee was not material for purposes of separate financial statement disclosure. Although his client had given the audit team false information regarding related party transactions, Scalzo did not reevaluate audit risk for such transactions. Accordingly, he did not perform, or direct PwC personnel to perform, any additional audit steps. Moreover, without the benefit of any such additional steps, Scalzo reached a determination that the payment was not material for purposes of separate financial statement disclosure. Scalzo did not inform the audit committee about the fee.
In sum, it is important to note that Scalzo was exposed to all of these facts and events -- not just those of a single fiscal year and not just those of a single type of transaction. Nevertheless, at no point during the course of his work as engagement partner for the Tyco audits did Scalzo reassess the level of audit risk with regard to executive compensation or related party transactions. For Scalzo, it was only exposure to these facts, and not the assessment of audit risk that was "a cumulative process."
Because of these repeated failures, PwC, under Scalzo's direction, for each of Tyco's fiscal years ended September 30, 1998; September 30, 1999; September 30, 2000; and September 30, 2001, failed to conduct an audit of Tyco's financial statements in accordance with GAAS. Nevertheless, for each of those fiscal years, PwC issued an audit report falsely stating that the firm had conducted its audit of Tyco's financial statements "in accordance with auditing standards generally accepted in the United States of America." Scalzo, as the PwC engagement partner for those Tyco audits, was responsible for the false statements. At the time those statements were made, Scalzo was reckless in not knowing that the Tyco audits had not been conducted in accordance with GAAS, and, therefore, that the statements were false.
Scalzo recklessly allowed PwC to issue an audit report containing the false statement in Tyco's annual report on Form 10-K for each of its fiscal years ended September 30, 1998; September 30, 1999; September 30, 2000; and September 30, 2001. Accordingly, as a result of the false statement contained in the PwC audit reports, Tyco filed with the Commission, and distributed to investors, false and misleading annual reports that misrepresented whether Tyco's financial statements had, in fact, been submitted to an audit in accordance with GAAS.
Section 10(b) of the Exchange Act of 1934 and Exchange Act Rule 10b-5 prohibit a person, in connection with the purchase or sale of a security, from making an untrue statement of a material fact or from omitting to state a material fact necessary to make statements made, in light of the circumstances under which they were made, not misleading. "[T]o fulfill the materiality requirement [of these provisions] `there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the "total mix" of information made available.'" Basic Inc. v. Levinson, 485 U.S. 224, 231-32 (1988) (citation omitted). Few matters could be more important to investors than that of whether an issuer's financial statements, contained in its filings with the Commission, had, in fact, been subjected to an annual audit conducted in accordance with GAAS in all material respects. To violate Section 10(b) or Rule 10b-5, a defendant must act with scienter, Aaron v. SEC, 446 U.S. 680, 695, 701-02 (1980), which the Supreme Court has defined as "a mental state embracing intent to deceive, manipulate, or defraud," Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 n.12 (1976). Such scienter encompasses knowing or intentional misconduct, or recklessness. See, e.g., IIT v. Cornfeld, 619 F.2d 909, 923 (2d Cir. 1980); Lanza v. Drexel & Co., 479 F.2d 1277, 1306 (2d Cir. 1973) (en banc). By means of the conduct set forth above, Scalzo violated Section 10(b) and Rule 10b-5.
Rule 102(e)(1)(ii) of the Commission's Rules of Practice allows the Commission to deny, temporarily or permanently, the privilege of appearing or practicing before it to any accountant who the Commission finds has engaged in improper professional conduct. According to the records of the Massachusetts Board of Public Accountancy, Scalzo is currently licensed by Massachusetts as a Certified Public Accountant and has been so licensed since July 1984. Rule 102(e)(1)(iv) provides, in relevant part, that "[w]ith respect to persons licensed to practice as accountants, `improper professional conduct' under [Rule 102(e)(1)(ii)] means: (A) Intentional or knowing conduct, including reckless conduct, that results in a violation of applicable professional standards."
The Commission has recently noted that it adopted the recklessness standard set forth in Rule 102(e)(1)(ii)(A) "to highlight that reckless conduct is not merely a heightened form of ordinary negligence, but rather a lesser form of intent." Michael J. Marrie, CPA, and Brian L. Berry, CPA, Exchange Act Release No. 48246 (July 29, 2003). "The question is not whether an accountant recklessly intended to aid in the fraud committed by the audit client, but rather whether the accountant recklessly violated applicable professional standards." Marrie and Berry. Scalzo's conduct set forth above constitutes reckless violations of applicable professional standards, and, accordingly, Scalzo engaged in improper professional conduct. "An auditor who skips procedures designed to test a company's reports or looks the other way despite suspicions is a threat to the Commission's processes." Marrie and Berry.
Based on the foregoing, the Commission finds that Scalzo committed and caused violations of Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder.
Based on the foregoing, the Commission finds that Scalzo engaged in improper professional conduct pursuant to Rule 102(e)(1)(ii) of the Commission's Rules of Practice.
In view of the foregoing, the Commission deems it appropriate to impose the sanctions agreed to in Respondent Scalzo's Offer.
Accordingly, it is hereby ORDERED, effective immediately, that:
Scalzo 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.
Scalzo is denied the privilege of appearing or practicing before the Commission as an accountant.
By the Commission.
|Jonathan G. Katz
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