UNITED STATES OF AMERICA Before the SECURITIES AND EXCHANGE COMMISSION SECURITIES EXCHANGE ACT OF l934 Release No. 40446 / September 17, 1998 ACCOUNTING AND AUDITING ENFORCEMENT Release No. 1076 / September 17, 1998 ADMINISTRATIVE PROCEEDING File No. 3-9707 __________________________________ : ORDER INSTITUTING In the Matter of : PROCEEDINGS PURSUANT TO : SECTION 8A OF THE AUDRE RECOGNITION SYSTEMS, INC., : SECURITIES ACT OF 1933 BEVERLY E. JOHNSTON, AND : AND SECTION 21C OF THE NICK R. AVILA, : SECURITIES EXCHANGE ACT : OF 1934, MAKING FINDINGS, Respondents : AND IMPOSING RELIEF : I. The Securities and Exchange Commission deems it appropriate and in the public interest to institute public administrative proceedings against the Respondents, Audre Recognition Systems, Inc. ("Audre"), Beverly E. Johnston ("Johnston"), and Nick R. Avila ("Avila") pursuant to Section 8A of the Securities Act of 1933 ("Securities Act") and Section 21C of the Securities Exchange Act of 1934 ("Exchange Act"). II. In anticipation of the institution of these administrative proceedings, Audre, Johnston, and Avila have submitted Offers of Settlement to the Commission, which the Commission has determined to accept. Without admitting or denying the facts and findings contained herein, except as to jurisdiction, which they admit, Audre, Johnston, and Avila have consented to the issuance of this Order Instituting Proceedings Pursuant to Section 8A of the Securities Act of 1933 and Section 21C of the Securities Exchange Act of 1934, Making Findings, and Imposing Relief ("Order"). ACCORDINGLY, IT IS ORDERED that proceedings pursuant to Section 8A of the Securities Act and Section 21C of the Exchange Act be, and hereby are, instituted. III. On the basis of this Order and the Respondents' Offers of Settlement, the Commission makes the following findings: A. RESPONDENTS 1. Audre, a Canadian corporation with headquarters in San Diego, California, develops and markets document-conversion software. Audre's securities are registered pursuant to Section 12(b) of the Exchange Act, but Audre has not filed periodic reports with the Commission since September 1995, when it filed for Chapter 11 bankruptcy reorganization. Audre's stock is quoted in the "pink sheets." Audre operated through Audre, Inc., its subsidiary. 2. Beverly E. Johnston served as executive vice president for administration at Audre, Inc., with responsibility for operations, shareholder relations, and SEC reporting. Johnston left Audre in April 1997. 3. Nick R. Avila was Audre's senior accountant and later served as Audre's manager of finance. He left Audre in December 1996. B. THE CEO Audre's CEO, who also served as the president and chairman of the board and Chief Financial Officer of Audre, obtained a large personal loan from Audre in August 1993 and concealed it from public disclosure. The CEO will be a defendant in a separate injunctive action to be filed in federal district court. C. SUMMARY Audre's CEO took an undisclosed personal loan of $908,000 from Audre in August 1993. The CEO directed his subordinates, executive vice president Johnston and senior accountant Avila, to withhold disclosure of the material transaction, create false records, and make material misstatements to Audre's auditors. One year later, after Audre had disclosed the loan and its repayment, the CEO directed that Johnston and Avila conceal the circumstances surrounding the earlier nondisclosure. D.FACTS 1.The CEO Borrows $908,000 From Audre In August 1993, the CEO told Johnston that he wanted to borrow more than $900,000 from Audre to pay off a margin call for Audre stock that he held in a personal brokerage account. Johnston, who had responsibility for Audre's operations, administration, and SEC reporting, asked the senior accountant, Avila, to look into the accounting treatment and disclosure consequences of the loan. Johnston contacted outside securities counsel, who advised that Audre would need to disclose the loan in its financial statements. Avila separately determined that Audre would have to disclose the loan. After the CEO learned that Johnston had contacted counsel, he instructed Johnston and Avila not to tell anyone about the loan. He also promised that he would pay back the loan before October 31, 1993, the end of the quarter. Johnston instructed Avila to carry out the loan transaction. The CEO directed Avila to transfer a total of $908,000 from Audre's money market account to his personal brokerage account. The CEO also told Avila not to record the loan. Avila, acting accordingly, did not prepare a promissory note or other documentation with respect to the loan. Moreover, there were no entries recorded on Audre's books and records on the days the funds were transferred. 2.The Loan Is Falsely Recorded on Audre'sBooks, Records, and Financial Statements The CEO decided that Audre's books and records would reflect the loan as an "investment" on behalf of Audre. Accordingly, Avila instructed the accounting clerk to record a $908,000 credit to Audre's money market account and a corresponding debit to the company's investment account. The CEO instructed Johnston and Avila to conceal the loan for purposes of Audre's financial statements. In October 1993 the CEO informed Johnston and Avila that he did not have the funds to repay the loan by the end of the current quarter, but he assured them that he would repay the loan in the following quarter. Avila prepared financial statements that falsely reported the CEO's loan in Audre's cash and cash equivalents account in the Form 10-Q for the quarter ended October 31, 1993. Avila carried through with the CEO's plan although he knew that the nondisclosure of the loan would result in an incorrect balance sheet, cash flow statement, and footnotes in the Form 10- Q. Johnston reviewed the false Form 10-Q and the CEO signed it. In January 1994 the CEO informed Avila, who in turn informed Johnston, that he did not have the money to repay the loan. Avila continued to conceal the loan, but he advised Johnston that he would inform authorities if the CEO failed to repay it by April 30, Audre's year-end. Avila improperly reported the loan in the financial statements for that quarter's Form 10-Q, just as he had done in the previous quarter's filing. The CEO reviewed and signed the report. Johnston reviewed the report before it was filed with the Commission. 3. The CEO Repays the Loan The CEO repaid Audre a total of $925,000 in late April, before the fiscal year end. Avila instructed the accounting clerk to record $908,000 as debits to the cash account and credits to the investment account, and to record $17,000 as interest income in the investment account. The amount of the interest payment was limited to the amount that the CEO had been able to raise. This worked out to a rate of about 4%, roughly equivalent to the rate that U.S. Treasury bills were earning at the time. The CEO directed Avila and Johnston not to disclose his loan to Audre's auditors during their audit for the year ended April 30, 1994, and the auditors did not detect it. A management representation letter dated July 22 and signed by the CEO, Johnston, and Avila stated that all related-party transactions and amounts receivable or payable, including loans and transfers, had been properly recorded or disclosed in the financial statements. 4.Disclosure of the Loan The CEO filed for personal bankruptcy in April 1995, about one year after he repaid the loan. Audre's counsel learned of the loan through the bankruptcy proceeding and advised Audre to make the appropriate disclosure. In June 1995 Audre filed an amendment to its Form 10-K for the year ended April 30, 1994, which disclosed the CEO's loan and its repayment as related-party transactions. Following the 1995 disclosure, the CEO directed Johnston and Avila to conceal the circumstances surrounding Audre's nondisclosure of the loan. The CEO directed that, when questioned, Johnston and Avila assert that a miscommunication had caused Avila to assume wrongly that the transaction was an investment that the CEO would be managing on behalf of Audre. Avila followed the CEO's direction and conveyed the false story to Audre's auditors during the 1995 audit. The auditing firm resigned in July 1995, asserting that it could no longer rely on management's representations. Audre filed for bankruptcy in September 1995. E. FALSE FINANCIAL STATEMENTS AND DISCLOSURE DEFICIENCIES 1. Related-Party Transactions According to Generally Accepted Accounting Principles ("GAAP"), an issuer's financial statements are complete only when they contain all material information necessary to represent validly the underlying events and conditions. See Statement of Financial Accounting Concepts 2, 79. Financial statements must disclose the financial effects of transactions and events that already have happened. See Statement of Financial Accounting Concepts 1, 21. According to Statement of Financial Accounting Standards ("FAS") No. 57, financial statements are not complete and reliable unless they contain additional explanations of and information about related-party transactions. FAS 57 defines related parties to include the principal owner of an enterprise and its management, as well as their affiliates and members of their immediate families. Management includes members of the board of directors and the chief executive officer, among others. Section 210.4-08(k) of Regulation S-X states that related party transactions should be identified and the amounts stated on the face of the balance sheet, income statement, or statement of cash flows. Item 404(a) under Regulation S-K requires a description of transactions exceeding $60,000 between the registrant and any of its directors or executive officers or any member of their immediate families. Item 404(a) requires disclosure of the person and the person's relationship to the registrant, the nature of the person's interest in the transaction, and, if practicable, the amount of the person's interest in the transaction. 2.False Forms 10-Q for the periods ended October 31, 1993 and January 31, 1994 The unaudited financial statements contained in Audre's Forms 10- Q for the quarters ended October 31, 1993 and January 31, 1994 failed to disclose the CEO's loan as a related-party transaction. GAAP required Audre to disclose in its quarterly financial statements that it had made a $908,000 loan to an officer, and to disclose the nature of the transaction. 3.False Financial Statements in Audre's Form 10-K for the year ended April 30, 1994 The audited financial statements contained in Audre's Form 10-K for the year ended April 30, 1994 failed to disclose the CEO's loan and repayment during the fiscal year. The loan was not required to be disclosed on Audre's consolidated balance sheet because it was paid off by the end of the fiscal year. FAS 57 nonetheless requires footnote disclosure of related-party transactions that occurred during the year. In addition, Audre's financial statements for the year ended April 30, 1994 did include a Consolidated Statement of Cash Flows. FAS 95, Statement of Cash Flows, states in part that the primary purpose of a cash flow statement is to provide relevant information about the cash receipts and cash payments of an enterprise during the period. Accordingly, the CEO's loan should have been identified in Audre's cash flow statement, along with the appropriate disclosures required by FAS 57 and Regulation S-X. 4.False Financial Statements in Audre's Registration Statement on Form S-1 Audre filed a Form S-1 registration statement for a $1.8 million offering that went effective in December 1994. The registration statement contained Audre's false financial statements for the year ended April 30, 1994, which failed to disclose the loan and its repayment. In a January 1995 letter to Audre's auditors in connection with the filing, the CEO, Johnston, and Avila confirmed their false representations that all related-party transactions had been properly disclosed in the 1994 financial statements. F. LEGAL DISCUSSION Section 10(b) of the Exchange Act and Rule 10b-5 proscribe the making of materially false and misleading statements in connection with the purchase or sale of any security. Section 17(a) of the Securities Act prohibits the making of false and misleading statements in connection with the offer or sale of securities. Violations of the antifraud provisions require proof of scienter. See Aaron v. SEC, 446 U.S. 680 (1980). In the case of a corporation, the scienter of officers and employees is imputed to the corporation. See SEC v. Manor Nursing Centers, Inc., 458 F.2d 1082 (2d. Cir. 1972); In the Matter of Ponder Industries, et al., Securities Exchange Act Release No. 38858, (July 22, 1997). Issuers must file accurate annual and quarterly reports with the Commission pursuant to Section 13(a) of the Exchange Act and Rules 13a-1 and 13a-13 thereunder. See SEC v. Savoy Industries Inc., 587 F.2d 1149 (D.C. Cir. 1978), cert. denied, 440 U.S. 913 (1979). Under Section 13(a), issuers must also comply with the disclosure requirements of Regulation S-K. Rule 12b-20 requires that statements and reports contain all information necessary to ensure that statements made in them are not materially misleading. Scienter is not necessary to establish a violation of Section 13(a). See SEC v. McNulty, Docket No. 97-6122, 1998 U.S. App. Lexis 4031 (2d Cir. Mar. 3, 1998). Under Section 13(b)(2)(A) of the Exchange Act, issuers must make and keep books, records, and accounts that accurately and fairly reflect the transactions and dispositions of their assets. Section 13(b)(2)(B) requires issuers to devise and maintain an adequate system of internal controls. Similarly, Section 13(b)(5) proscribes the circumvention of or the failure to implement an issuer's system of internal accounting controls, or the knowing falsification of any book, record, or account subject to Section 13(b)(2)(A). Rule 13b2-1 prohibits any person from falsifying or causing the falsification of any book, record, or account subject to Section 13(b)(2)(A). Rule 13b2-2 prohibits officers and directors from making materially false statements or omissions to accountants in connection with any audit or examination of financial statements, or in preparing any document or report filed with the Commission. 1. Audre's Violations a. Antifraud Provisions Audre failed to disclose the CEO's loan in the Forms 10-Q that it filed in October 1993 and January 1994, the Form 10-K that it filed in April 1994, and the Form S-1 registration statement that it filed in December 1994. Audre had assets of only about $8,800,000 when it lent the $908,000 to the CEO. The loan therefore represented more than 10% of Audre's total assets. In view of the size of the loan, the nondisclosure satisfies the materiality requirement of the antifraud provisions of the federal securities laws. The CEO knew that Audre was required to disclose his loan. He nonetheless directed his subordinates not to record the loan and not to disclose it to the public or to Audre's auditors. The CEO's scienter is imputed to Audre for the purpose of establishing Audre's violations. Accordingly, Audre's deliberate nondisclosure of the loan transaction violated Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act, and Rule 10b-5. b. Reporting Violations Under GAAP, the CEO's loan was a material related-party transaction that Audre should have reported in the Statement of Cash Flows and disclosed in the notes to the financial statements contained in its Form 10-K for fiscal 1994. Item 404(a) of Regulation S-K and 210.4-08(k) of Regulation S-X further required a description of the loan as a related-party transaction. The disclosure was required even though the amount was loaned and repaid within the same fiscal year and there was no effect on the balance sheet at year end. The financial statements in Audre's Forms 10-Q for the periods ended October 31, 1993 and January 31, 1994 contained material misstatements. The large loan to the CEO was improperly included as cash and was not identified as a related-party transaction. Accordingly, Audre violated Section 13(a) of the Securities Act and Rules 12b-20, 13a-1, and 13a-13. c. Books and Records Violations Audre's books and records falsely recorded the loan as an investment. The CEO's repayment was credited to the investment account and the interest on his personal loan was reflected as interest income to the investment account. By maintaining false and misleading books, records, and accounts, Audre violated Section 13(b)(2)(A) of the Exchange Act. Audre further failed to devise and maintain an adequate system of internal accounting controls to maintain accountability for assets and to permit preparation of financial statements in accordance with GAAP. Audre's internal accounting system did not provide for the segregation of duties with respect to reconciling the investment account and making disbursements. The absence of internal accounting controls enabled the concealment of the CEO's loan. Accordingly, Audre violated Section 13(b)(2)(B) of the Exchange Act. 2. Violations of Individuals The CEO took the loan for his own personal financial reasons, and Johnston and Avila had no financial stake in the loan or its nondisclosure. Johnston and Avila were at all times subordinate to the CEO, followed his directions with respect to the nondisclosure, and reasonably believed they would be fired if they did not follow his directions. None of these factors, however, excuses their misconduct. The integrity of the disclosure process requires that each person in the disclosure chain act with integrity. "Following orders" or being a "good soldier" provides no defense for failure to do so. See In re Collins Industries, Inc. et al., Securities Exchange Act Release No. 34934 (November 3, 1994); In the Matter of Thomas C. Runge, Securities Exchange Act Release No. 23006 (March 26, 1986). Accordingly, the imposition of administrative cease-and-desist orders against Johnston and Avila is fully warranted in this matter. a. Johnston As Audre's executive vice president, Johnston reported directly to the CEO. Johnston supervised Avila and had responsibility for accounting, administration, operations, and SEC reporting. She also had signing authority over Audre's bank accounts. Johnston knew that the loan was recorded improperly as an "investment" in Audre's books and records, and she knowingly participated in the scheme to record the loan improperly in Audre's books, records, and periodic reports. Johnston knew that Audre's Form 10-K for the fiscal year ended April 1994 and its Forms 10-Q for the periods ended October 1993 and January 1994 failed to disclose the loan as a related-party transaction. In addition, Johnston knew that Audre had not accurately reflected the loan and repayment in financial statements that were included in the December 1994 Form S-1 registration statement. Johnston made materially false statements to the auditors in connection with the 1994 year-end audit. Johnston signed a management representation letter to the auditors falsely stating that all related-party transactions had been properly recorded or disclosed in the financial statements. She also confirmed the false representations in a January 1995 letter to the auditors in connection with the filing of the S-1 registration statement. Accordingly, Johnston violated Section 17(a) of the Securities Act, Sections 10(b) and 13(b)(5) of the Exchange Act, and Rules 10b-5, 13b2-1, and 13b2-2. b. Avila Avila carried out the scheme to conceal the CEO's loan. He directed a clerk in Audre's accounting department to record the loan on Audre's books and records as an investment, and he also falsified internal accounting records to conceal the true nature of the $908,000 transfer in anticipation of the year-end audit. Avila, along with the CEO and Johnston, signed the July 1994 and January 1995 management representation letters to the auditors falsely stating that related-party transactions had been disclosed in the 1994 financial statements. Avila understood that Audre would consequently file periodic reports containing financial statements that had not been prepared in accordance with GAAP. After Audre disclosed the loan in June 1995, Avila, acting at the CEO's direction, falsely told the auditors and others that a simple miscommunication had caused the disclosure failure. Accordingly, Avila violated Section 17(a) of the Securities Act, Sections 10(b) and 13(b)(5) of the Exchange Act, and Rules 10b-5 and 13b2-1. IV. FINDINGS On the basis of this Order and the Offers of Settlement submitted by the Respondents, the Commission finds that: A. Audre violated Section 17(a) of the Securities Act, 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; B.Johnston violated Section 17(a) of the Securities Act, Sections 10(b) and 13(b)(5) of the Exchange Act, and Rules 10b-5, 13b2-1 and 13b2-2; and C.Avila violated Section 17(a) of the Securities Act, Sections 10(b) and 13(b)(5) of the Exchange Act, and Rules 10b-5 and 13b2- 1. V. ORDER Based on the foregoing, the Commission deems it appropriate and in the public interest to accept the Offers of Settlement submitted by the Respondents and accordingly, IT IS HEREBY ORDERED, pursuant to Section 8A of the Securities Act and Section 21C of the Exchange Act, that: A.Audre cease and desist from committing or causing any violation or future violation of Section 17(a) of the Securities Act, 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; B.Johnston cease and desist from committing or causing any violation or future violation of Section 17(a) of the Securities Act, Sections 10(b) and 13(b)(5) of the Exchange Act, and Rules 10b-5, 13b2-1 and 13b2-2; and C.Avila cease and desist from committing or causing any violation or future violation of Section 17(a) of the Securities Act, Sections 10(b) and 13(b)(5) of the Exchange Act, and Rules 10b-5 and 13b2-1. By the Commission. Jonathan G. Katz Secretary SERVICE LIST Rule 23 of the Commission's Rules of Practice provide s that all amendments to moving papers, all answers, all motions or applications made in the course of a proceeding (unless made orally during a hearing), all proposed findings and conclusions, all petitions for review of any initial decision, and all briefs shall be filed with the Commission and shall be served upon all parties to the proceedings, including the interested division of the Commission. The attached Order Instituting Proceedings has been sent to the following parties and other persons entitled to notice: ------------------------------------------------------------------- Honorable Brenda P. Murray Ms. Beverly Johnston Chief Administrative Law 2105 Miller Avenue Judge Securities and Exchange Escondido, CA 92025-5914 Commission, Mail Stop 11-6 J. Mark Dunbar, Esq. 450 Fifth Street, N.W. Dunbar & Associates Washington, DC 20549 1205 Prospect Street, Suite 400 Securities and Exchange La Jolla, California 92037 Commission (attorney for Johnston) Division of Enforcement Attn: Jerry Isenberg Mr. Nick Avila Mail Stop 7-7 45315 Silverado Lane 450 5th Street, N.W. Temecula, CA 92592 Washington, D.C. 20549 Audre Recognition Systems, Robert D. Rose, Esq. Inc. Lorenz, Alhadeff, Cannon & c/o Thomas F. Casey, Rose President 550 West C Street - Suite 11021 Via Frontera 1900 San Diego, CA 92121-1706 San Diego, CA 92101 (attorney for Avila) Claudia A. Lewis, Esq. Farella Braun & Martel LLP 235 Montgomery Street San Francisco, CA 94104 (attorney for Audre Recognition Systems, Inc.) ------------------------------------------------------------------- -------------------------------------------------------------------