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U.S. Securities and Exchange Commission

Washington, D.C.

Rel. No. 43235 / August 31, 2000

Rel. No. 1297 / August 31, 2000

Admin. Proc. File No. 3-8944

            In the Matter of             :
             RUSSELL PONCE               :



Grounds for Remedial Action

Violations of Antifraud, Reporting, and Recordkeeping Provisions


Grounds for Remedial Action

Improper Professional Conduct

Violations and Aiding and Abetting of Violations of Federal Securities Laws

Auditor assisted company that materially overstated its assets and understated its losses. Auditor thereby violated, and caused violations of, antifraud provisions and caused and aided and abetted reporting and recordkeeping violations. Auditor also failed to comply with Generally Accepted Auditing Standards. Held, it is in the public interest to bar auditor from practice before the Commission with a right to reapply after five years and to order that auditor cease and desist from violating or causing any violations or future violations of Sections 10(b), 13(a), and 13(b)(2) of the Securities Exchange Act of 1934 and Rules 10b-5, 12b-20, 13a-1, and 13a-13 thereunder.


Kenneth M. Christison, for Russell Ponce.

Karen Matteson, for the Division of Enforcement and Office of the Chief Accountant.

Appeal filed: December 24, 1996
Last brief received: April 28, 1997


The Division of Enforcement and the Office of the Chief Accountant (together the "Division") appeal from the decision of an administrative law judge dismissing this proceeding against Russell Ponce. Ponce formerly was the auditor of American Aircraft Corporation ("AAC"). 1 The Division alleges that Ponce violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. 2 The Division further alleges that Ponce willfully aided, abetted, and caused AAC's violations of Exchange Act Sections 13(a) and 13(b)(2) and Exchange Act Rules 12b-20, 13a-1, and 13a-13. 3

The Division also alleges that Ponce engaged in improper professional conduct within the meaning of Rule 102(e)(1)(ii) 4 of the Rules of Practice during his audits of AAC's financial statements in which he deviated from Generally Accepted Auditing Standards ("GAAS"). The Division further alleges that Ponce willfully violated or willfully aided and abetted violations of the federal securities laws and regulations thereunder and therefore is subject to discipline under Rule 102(e)(1)(iii). 5

The Division seeks a cease-and-desist order against Ponce. It also seeks permanently to deny Ponce the privilege of appearing or practicing before the Commission. We base our findings on an independent review of the record, except with respect to those findings below not challenged on appeal.


AAC was a public company that registered its common stock pursuant to Exchange Act Section 12(g). 6 AAC originally was formed to manufacture and sell ultralight aircraft. 7 Under Exchange Act Section 13(a)(2), AAC was required to file annual reports on Form 10-K including financial statements certified by an independent public auditor, as well as quarterly reports on Form 10-Q.

Russell Ponce, a certified public accountant, acted as AAC's auditor. 8 He audited AAC's annual financial statements for fiscal years 1988 through 1991 and issued opinions representing that his audits had been conducted in accordance with GAAS and that, with adjustments not relevant here, the financial statements accorded with Generally Accepted Accounting Principles ("GAAP"). During this period, Ponce prepared the cash flow statements for inclusion in AAC's quarterly reports filed on Form 10-Q. In addition, Poncereviewed AAC's Forms 10-Q for compliance with Commission requirements.

In 1993, in response to a request by the Commission's Division of Corporation Finance, AAC filed an amendment to its 1991 annual report on Form 10-K. In this amended report, Ponce reported that AAC had restated its financials to classify AAC as a "development stage company." 9 AAC changed its annual report to reflect that the aircraft designs had not progressed beyond research and development. AAC also wrote off $654,245 that previously had been recorded as "inventory, work-in-progress, and tooling" in prior reports. This restatement was described as "a correction to accounting methods that were not used at the combination date and for fiscal periods following the combination date to November 30, 1990," which was intended "so as to conform to generally accepted accounting principles and SEC accounting rules."

This proceeding examines the propriety of Ponce's opinions with respect to management's valuation of certain assets and Ponce's treatment of costs associated with the tooling and prototypes for certain aircraft. Also at issue is whether Ponce deviated from GAAS by: (1) failing to exercise due professional care; (2) failing to render an accurate audit report; and (3) failing to maintain independence.

A. The License.

In February 1988, two weeks before being acquired by Phalanx Organization, Inc. ("Phalanx"), a private development-stage company, 10 AAC purchased from William F. Moody, Jr., 11 AAC's President andChief Executive Officer, all rights and an exclusive license to manufacture certain aircraft, patent application files, copyrights, and design patents for aircraft and helicopters ("License") for 2.5 million shares of restricted AAC stock. 12 Moody had not produced or sold any product using the intangible assets covered by the License.

On March 4, 1988, AAC and Phalanx completed a transaction in which Moody, Phalanx's controlling shareholder, assumed control over AAC. The transaction was structured as a reverse acquisition in which AAC purchased all of Phalanx's assets, which AAC valued at $124,742. 13 AAC paid for the assets by issuing to Phalanx 28,673,440 shares of AAC common stock, or the equivalent of $.0044 a share. As a result of this transaction, Moody became Chairman of the Board, President, and Chief Executive Officer of AAC. Moody had no accounting background.

In his answer, Ponce admitted that he understood that the License comprised the major part of AAC's reported assets after its acquisition. 14 In certifying the financial statements for AAC's fiscal years ending November 30, 1988 through November 30, 1991,Ponce accepted management's valuation of the License as an asset worth $4,687,500. Management purported to establish this valuation by discounting by fifty percent the $3.75 per AAC share bid quoted on Nasdaq on the day AAC issued the 2.5 million restricted shares in exchange for the License. 15

Ponce admitted that he had reservations about management's $4,687,500 valuation and believed that AAC could not sell the License for that amount. He also testified that, while he valued the License on a cost basis (based on the value of the restricted shares), he thought the number of AAC shares issued for the License was "ridiculously high." Moreover, in February 1988, when it acquired the License, AAC was insolvent, it had a history of operating losses, and its stock was thinly traded. 16

None of the projects that employed designs or copyrights covered by the License progressed beyond research and development. The Phalanx Intra-Lift and Phalanx Hunter never advanced beyond paper drawings. While AAC completed the tooling and electronics for the Phalanx Dragon, it could not get an engine for it. AAC developed a prototype of the Phalanx Falcon and the Phalanx Hind, but they were never fully flight tested. The Phalanx Hind was superseded by another aircraft -- the Penetrator -- which was designed for a different market. As discussed below, while the Penetrator began flight testing in December 1991, it was never sold commercially. 17

B. Tooling and Prototype Costs.

Adolfo Batista, who had been the in-house accountant for Phalanx, became the in-house accountant for AAC after the acquisition. Batista was not a certified public accountant, and he testified that he was familiar with "only some" of GAAP. Batista prepared draft quarterly financial statements and submitted them to Ponce prior to AAC's filing its reports on Form 10-Q. Ponce prepared the cash flow statements for inclusion in AAC's quarterly reports. Batista relied on Ponce for compliance with Commission requirements. He further testified that he relied on Ponce's certifications of the accounting treatments in the Forms 10-K in preparing the Forms 10-Q. Each year's audited financial statements included a footnote that Ponce drafted stating: "Research and development costs are expensed when incurred."

1. Tooling costs.

Batista testified that he had treated tooling costs 18 for the Phalanx Dragon aircraft as expenditures before the reverse acquisition. Batista considered tooling costs to be research and development, which, under Research and Development Arrangements, Statement of Financial Accounting Standards No. 2 (Financial Accounting Standards Board 1982) ("FAS 2"), must be expensed when incurred. In each draft AAC financial statement after the reverse acquisition, Batista continued to treat tooling costs as expenditures. Each time, Ponce prepared adjusting journal entries to reclassify costs attributable to tools, molds, and dies as work in progress, which were capitalized.

Ponce testified that he discussed with management the treatment of the tooling costs. Moody insisted that the tools involved no new technology 19 and therefore should not be treated as research anddevelopment costs. Moody executed management representation letters with respect to AAC's 1989, 1990, and 1991 financial statements. In those letters, Moody represented that AAC had progressed beyond the research and development stage in developing certain aircraft and that tooling costs therefore were properly capitalized. In April 1989, the Board of Directors of AAC passed a resolution stating that the tools were an asset of the corporation. There was no other information in Ponce's work papers indicating that the tooling costs were not research and development.

Although Moody claimed that the tools involved no new technology, in its fiscal 1989 Form 10-K, AAC stated that:

The company acquired designs for certain new militarized versions of FAA certified aircraft described as the Phalanx Falcon and the Phalanx Hind Assault-Lift Gunship, as well as the Phalanx Dragon and the Patriot tilt-prop VTOL aircraft. Further, the company had to expend a significant amount of its capital in the research, development and tooling of these specific products (ie; the Phalanx Falcon, Hind and Patriot). 20

As described above, Moody testified that the Falcon and Hind were never flight tested. Ponce nonetheless treated AAC's tools as assets worth $1,435,575 in the annual report for 1989.

In its 1990 annual report, dated April 3, 1991, AAC stated that it had spent almost all of its resources completing the proof of concept model of the Penetrator, that the tools for the Penetrator were largely completed, 21 and that AAC anticipated a pre-production prototype flight to take place in April 1991. At this time, the Penetrator was the only aircraft that was actively in development. AAC reported that the company had written off tools for projects thatwere previously deferred in the amount of $508,889. 22 Ponce did not reevaluate whether AAC should classify the remaining tools as research and development even though AAC had written off or deferred certain projects and associated deferred tooling costs. Tools and molds were treated as assets worth $1,222,896 in the 1990 Form 10-K.

2. Prototype costs.

In its fiscal year 1991 Form 10-K, AAC disclosed that it had been developing the Penetrator helicopter -- work that required technological modification to the obsolete VH-1 Huey helicopter. Moody testified that he had originally designed this aircraft under the name Phalanx Hind. He had hoped to market the Phalanx Hind to the United States Army for use in training, but, when the Soviet Union collapsed, he renamed it and redesigned it under the Penetrator name for export to Taiwan. In its 1991 Form 10-K, the company further reported that it had produced a "proof of concept" version of the Penetrator that would be disassembled and analyzed at the completion of flight testing.

Ponce initially recorded the prototype costs for the Penetrator as research and development to be expensed when incurred. Moody believed, however, that the prototype costs were assets because, according to Moody, AAC was taking an existing certified helicopter, the Huey, and merely changing its outer appearance to make the Penetrator. Moody therefore argued that the Penetrator was not research and development, and, although the model would be disassembled after flight tests, prototype costs should be capitalized. At the hearing, Moody admitted that he had no familiarity with the GAAP definition of research and development. Ponce, nonetheless, acceded to Moody's views and adjusted AAC's books and records to capitalize the prototype costs as inventory for 1991. AAC reported the Penetrator prototype as an asset valued at $562,847 in the 1991 annual report on Form 10-K.

C. Fees AAC Owed to Ponce.

As of February 1989, AAC owed Ponce $17,769 for prior services rendered. As of February 1990, AAC owed Ponce $35,759. As of November 1990, AAC owed Ponce $31,000. As of March 1991, AAC owed Ponce $65,000.

Ponce testified that, during each year at issue, he had expressed concern to Moody regarding these unpaid fees. Ponce admitted telling Moody that, because AAC was delinquent in paying him, Ponce's independence might be questioned in such a way that the audits would be "unacceptable." By 1990, Ponce told Moody that AAC would have to pay Ponce some of the fees, or Ponce would have to disclaim independence. Moody and Ponce agreed to a payment schedule to be secured by a brokerage account with sufficient AAC shares or other "viable" Nasdaq-listed shares equal to the value of the unpaid balance. Nonetheless, in December 1991, AAC still owed Ponce $54,522 in cumulative audit fees. Ponce testified that, although he felt that he could maintain his independence despite the fees owed him, "when you're owed money there's an appearance, perhaps, of not being independent."


Under Exchange Act Section 13(a) and Exchange Act Rule 13a-1, AAC was required to file annual reports including, among other things, certain financial information. Pursuant to these requirements, AAC had to file financial statements that: 1) were prepared in conformity with GAAP; and 2) contained a report by an independent auditor certifying that the auditor had audited the company's financial statements, in accordance with GAAS, to determine whether the statements were prepared in conformity with GAAP. 23 Under Exchange Act Rule 13a-13, AAC also was required to file quarterly reports that were not misleading. Under Exchange Act Rule 12b-20, AAC had a duty to correct any misstatements or omissions in documents filed with the Commission. 24

For the reasons discussed below, Ponce willfully aided, abetted, and caused AAC's filing of misleading reports and caused it to fail to correct misleading reports in violation of Exchange Act Section 13(a) and Rules 12b-20 and 13a-1. 25 Ponce also willfully aided, abetted, and caused AAC's filing of false annual and quarterly reports that were misleading in violation of Rules 13a-1 and 13a-13.

Moreover, Ponce willfully aided, abetted, and caused AAC's violation of Exchange Act Section 13(b)(2) resulting from AAC's failure to keep books, records, and accounts that accurately and fairly reflected the transactions and disposition of AAC's assets. 26 Ponce certified financial statements in which AAC carried, on anovervalued basis, the investment in the License. Ponce further instructed Batista to treat tooling and prototype costs as assets rather than as research and development costs. Because of these deviations from GAAP, AAC overstated its assets for each fiscal year between 1988 and 1991 by amounts ranging from $5,509,069 to $7,097,332 and materially understated its net losses by amounts ranging from $407,142 to $1,153,829.

A. Ponce Improperly Certified Financial Statements that Falsely Overvalued the License.

In all four annual reports on Form 10-K and in the intervening quarterly reports on Form 10-Q, AAC listed the License as an asset valued at $4,687,500 based on the adjusted bid price of AAC stock. 27 The valuation of the License was clearly inflated. As noted, two weeks after Moody sold the License for 2.5 million shares of AAC stock, purported to be worth $4,687,500, Phalanx, which Moody controlled, sold assets worth $124,742 for 28,673,440 shares of AAC stock. AAC's valuation of the License necessarily implied either: (1) that in the space of two weeks the per share value of AAC common stock fell a stunning 99.8%, from $1.875 to $.0044; or (2) that Moody, who controlled Phalanx, orchestrated a transaction that had the effect of diluting almost to nothing the value of the shares he received for the License.

The record does not support either scenario. AAC suffered no economic reverses between its purchase of the License and its sale to Phalanx. As to the second scenario, had the common stock Moody received for selling the License really been worth $4,687,500, its value would have plummeted to $11,000 (2,500,000 x .0044) as a result of the AAC-Phalanx transaction. There is no indication that Moody sought to accomplish such a personally damaging result. 28 Poncewas fully aware of the transaction with Phalanx, but its unmistakable implications did not affect his opinion.

Moreover, Ponce was aware that AAC had operating losses and that the stock was thinly traded. Ponce admits that there was no justification for the value of the License as shown in AAC's financial statements. Despite AAC's erroneous valuation, Ponce certified that the financial statements were prepared in conformity with GAAP.

Ponce compounded his failure in subsequent audits. Ponce should have considered whether AAC's inflated valuation of the License declined over time. 29 The Company was required to account for any changes in the useful economic life of its assets. 30 When AAC wrote off or suspended projects involving aircraft designs, patent applications, patents, and copyrights that were included in the License, however, AAC did not adjust the value of the License or correct its reports. Ponce had evidence that AAC was not developing the designs covered by the License. Nonetheless, Ponce did not withdraw or qualify his opinion to reflect the evidence of the declining value of the License or otherwise make footnote disclosure.

Ponce asserts that he prepared footnotes to AAC's financial statements that adequately disclosed the method by which AAC initially valued the License such that no investor or shareholder could have been misled. The footnotes state that the company's use of a discounted bid price was "an attempt to account for the reduced market value of these shares" because the shares were restricted. That footnote, however, does not disclose the factors that made the valuation suspect: the subsequent price paid by Phalanx for AACstock; Ponce's belief that the License was not worth the value assigned; the lack of reliability of AAC's bid quotation given the Company's insolvency and financial condition; the low volume of trading in its stock; and, in subsequent years, the suspension of projects associated with the License. Thus, potential investors or shareholders were not given accurate information in the financial statements.

Ponce also claims that the valuation of the License was proper because the License had "alternative future uses." In his brief, Ponce does not explain what those uses might be, nor are they documented in the financial statements or his work papers. Rather, during the period at issue, many of the projects that were based on designs in the License were discontinued or suspended. 31

B. Ponce Improperly Certified Financial Statements that Falsely Capitalized Tooling and Prototype Costs.

Ponce also improperly treated tooling and prototype costs as assets. As research and development costs, they should have been expensed under FAS 2, which states: "All research and development costs encompassed by this Statement shall be charged to expense when incurred." AAC's in-house accountant, Batista, initially recorded AAC's tooling costs as expenditures in his trial balance sheets for AAC's quarterly reports on Form 10-Q. Batista provided the trial balances to Ponce. For every quarter for four years, Ponce changed Batista's entries to capitalize tooling costs. Batista then included Ponce's changes in the Forms 10-Q filed with the Commission. Ponce testified that AAC's Board of Directors had resolved to treat tooling costs as assets because the tooling would be used for the manufacture of the aircraft.

Ponce himself initially treated prototype costs for the Penetrator as expenses but subsequently included the Penetrator in inventory when Moody pressured him to do so. In its 1991 annual report on Form 10-K, AAC reported that it had produced a single "proof of concept" version of the Penetrator that would be disassembled and analyzed at the completion of flight testing,expected to be in August 1992. 32 Moody testified that flight tests on the Penetrator did not begin until December 1991. The prototype was never sold.

These tooling and prototype costs fell within the types of matters considered to be research and development. FAS 2 defines research and development as follows:

Research is planned search or critical investigation aimed at discovery of new knowledge with the hope that such knowledge will be useful in developing a new product or service . . . or a new process or technique . . . or in bringing about a significant improvement to an existing product or process.

Development is that translation of research findings or other knowledge into a plan or design for a new product or process or for a significant improvement to an existing product or process. . . . It includes the conceptual formulation, design, and testing of product alternatives, construction of prototypes, and operation of pilot plants. It does not include routine or periodic alterations to existing products, production lines, manufacturing processes, and other on-going operations even though those alterations may represent improvements . . . .

FAS 2, Paragraph 9 also provides examples of activities that typically would be included in research and development. Among these examples are:

d. Testing in search for or evaluation of product or process alternatives.

e. Modification of the formulation or design of a product or process.

f. Design, construction, and testing of preproduction prototypes and models.

g. Design of tools, jigs, molds and dies involving new technology.

* * *

i. Engineering activity required to advance the design of a product to the point that it meets specific functional and economic requirements and is ready for manufacture.

The tools and molds for the aircraft exteriors should have been treated as research and development costs under FAS 2 Paragraph 9.g. None of AAC's aircraft included in the License, for which tooling was developed, advanced beyond the research and development stage.

The prototype of the Penetrator, an aircraft not included in the License, involved a unique new exterior that was replacing that of an old aircraft. The Penetrator would have had to undergo flight testing before it could be commercially manufactured. Moody's assertion that no "new" technology was involved because he was simply making cosmetic changes to an existing aircraft is not persuasive. 33 The work on the prototype did not constitute "routine or on-going efforts to improve an existing product" under FAS Paragraph 10.d. A prototype that must be changed because it does not meet commercial marketability expectations is considered research and development. 34 Here, the prototype was originally designed to meet the needs of the United States Army and configured to resemble a Soviet aircraft. AAC had to reconfigure the prototype to resemble a United States aircraft design for potential export to Taiwan and to complete flight testing.

Our conclusion is confirmed by AAC's 1991 annual report on Form 10-K, which states that after "engineering modifications

. . . the Company will be in a position to manufacture . . . upon receipt of a firm contract. There can be no assurance of the ability of the Company to successfully complete the engineering process or to commence production of the prototype." Clearly, the aircraft was still in development. The prototype was not, as Ponce suggests, properly classified as inventory. It was not "held for sale in the ordinary course of business or . . . in process of production for such sale." 35

Ponce also argues that the tools and prototype had "alternative future uses," and were therefore not research and development. 36 These potential uses are not documented in the work papers. 37 Moreover, it is not enough to argue that the tools might have been usable in the future, if the aircraft designs ever were developed sufficiently to be commercially produced. 38 While all research and development arguably would have such an alternative future use in production if the product were commercially developed, this potential does not satisfy

FAS 2. 39 In any event, the prototype clearly did not have an "alternative future use" because AAC planned to disassemble it after flight testing. Preproduction prototype costs for the Penetrator fall squarely into FAS 2, Paragraph 9.f.


Auditors violate Exchange Act Section 10(b) and Rule 10b-5 whenthey prepare and certify publicly-filed financial statements that they know, or are reckless in not knowing, are false. 40 Ponce prepared and certified financial statements included in AAC's public filings that he knew, or was at least reckless in not recognizing, would mislead public investors who could be expected to rely on the reports. 41

Ponce falsely represented that he audited AAC's financial statements in accordance with GAAS. He also falsely represented that AAC's financial statements were presented in conformity with GAAP. His opinion misrepresented that the value of the License -- which was AAC's chief asset -- complied with GAAP and failed to disclose the material information discussed in Section III.A above that called that valuation into question. He changed entries on AAC's books and records to capitalize tooling costs and recorded the Penetrator prototype as inventory at Moody's direction after Batista properly expensed these costs. Ponce stated in notes to the financial statements in AAC's Forms 10-K that research and development costs were expensed when incurred, when, in fact, he treated research and development costs as assets. As a result, AAC appeared to be worth millions of dollars when, in fact, it was insolvent.

The law judge concluded that these misstatements were not material. We disagree. AAC's overstatement of its assets, which for fiscal years 1988-91 ranged from 88 to 95%, coupled with the fact that AAC's treatment did not, contrary to Ponce's representation, comply with GAAP, would have been material to a reasonableinvestor.42

In subsequent years, Ponce exacerbated his initial failings. He certified the propriety of the $4,687,500 valuation in succeeding Forms 10-K when he knew that the License was impaired because design projects that involved aircraft covered by the License were abandoned or suspended. 43 At the very least, Ponce was recklessly indifferent to the consequences of his actions for members of the investing public. We accordingly find that Ponce willfully violated Section 10(b) of the Exchange Act and Rule 10b-5 thereunder.


The Division seeks permanently to bar Ponce from appearing before the Commission under Rules 102(e)(1)(ii) and (iii) of the Commission's Rules of Practice. As relevant here, a professional may be barred or suspended from appearing before the Commission if he: (1) engaged in unethical or improper professional conduct; or (2) willfully violated or aided and abetted violations of any Federal securities laws or rules and regulations thereunder.

We have found above that Ponce willfully violated Exchange Act Section 10(b) and Rule 10b-5 and willfully aided, abetted, and caused AAC's violations of Exchange Act Sections 13(a) and 13(b)(2) and Rules 12b-20 and 13a-1. Therefore, Ponce is subject to discipline under Rule 102(e)(1)(iii).

We further conclude that Ponce engaged in improper professional conduct under Rule 102(e)(1)(ii). Ponce did not comply with at least three of the ten general standards of GAAS: he did not act with due professional care, he falsely stated that his audit was conducted in accordance with GAAP, and he was not independent.

A. Ponce did not act with due professional care in performing his audit. Ponce performed no investigation to corroborate whether or not the management representation letters were accurate in stating that certain aircraft designs had progressed beyond research and development and that tooling costs therefore were properly capitalized. According to Montgomery's Auditing, 12th Ed. John Wiley & Sons, 1990 at 47, "due care is not exercised if the auditor fails to corroborate representations of client management that are significant to the financial statements. . . ." 44 Ponce recklessly adopted Moody's view that the tooling and prototype costs were not research and development costs although, as discussed above, he had access to information that should have caused him to question these representations. An auditor cannot rely solely on management representations. The purpose for requiring an independent auditor is to test management's judgment of how the company's financials should be presented. 45

Ponce claims that his "acquiescence in the valuation of the designs" was reasonable given the overall "audit environment." We understand this to be a reference to discussions Ponce had with management relating to his treatment of the License. However, the "audit environment" refers to an auditor's duty toconsider the risks and issues associated with a particular audit when determining how thoroughly to investigate the company's transactions. 46 Here, Ponce knew that the License was a critical asset to the company. He was at least reckless in failing to recognize that the Company's valuation of the License was grossly inflated. In subsequent years, he knew that development of certain aircraft under the License had been suspended. Nonetheless, Ponce did not critically evaluate the circumstances surrounding his audit. 47

B. Ponce falsely certified that AAC's financial statements were presented in conformity with GAAP, subject to certain adjustments not at issue here. Ponce claims that he "initiated extensive, sometimes heated, discussions about the proper treatment of [AAC's] R&D expenses before agreeing to accept management's position." However, Ponce's obligation was to comply with GAAS and to determine whether management's financial statements complied with GAAP. If the financial statements did not comply with GAAP and management refused to make the required adjustments, Ponce had an obligation to decline to certify AAC's financial statements. 48 Even Ponce conceded in his testimony before the law judge that, because AAC "did not actually get into full scale operations" by commercially producing any aircraft, he should have either removed himself from the engagement or told AAC that he could render only an adverse opinion.

C. Ponce did not comply with the independence requirement of GAAS. GAAS requires that auditors not only be independent, but that they appear independent. Auditors are to avoid situations that may lead outsiders to doubt their independence. Unpaid fees for previous audits affect both the independence of an auditor and the public's perception of that auditor. We have stated that: "Generally, prior year audit and other unpaid fees should be paid before a current audit engagement is commenced in order for the accountant to be deemed independent with respect to the currentaudit." 49

Ponce was owed money for services rendered throughout the period he was preparing statements for AAC. In 1989, he was owed $17,769 for services rendered in prior periods. By 1991, Ponce was owed $65,000 for services rendered in prior periods. 50 Ponce's1990 agreement with Moody to secure payment of Ponce's fees with a brokerage account established in Ponce's name is further evidence of Ponce's lack of independence. AAC was to deposit into Ponce's account AAC shares or other Nasdaq-listed shares with a market value equal to the unpaid fees. The AICPA Code of Professional Conduct expressly prohibited Ponce from owning AAC stock during the time of the audit. An auditor's "[i]ndependence shall be considered to be impaired if . . . during the period of professional engagement, or at the time of expressing an opinion, a member or a member's firm . . . [h]ad or was committed to acquire any direct or material indirect financial interest in the enterprise." 51 While a deposit of AAC shares never actually occurred, Ponce's agreement to receive such shares further demonstrates his disregard of the requirement that he be independent. 52


Although Ponce never raised the issue before the law judge or the Commission, certain of Ponce's conduct at issue occurred more than five years before these proceedings were instituted on February 13, 1996. While these proceedings were pending, the United States Court of Appeals for the District of Columbia Circuit held that the general federal statute of limitations, 28 U.S.C. § 2462, prohibited the imposition of a censure and supervisory suspension in an administrative proceeding under Exchange Act Section 15(b) that had been instituted more than five years after the conduct at issue in those proceedings had occurred.

It is well established that "'[r]eliance on a statute of limitations is an affirmative defense and is waived if a party does not raise it in a timely fashion.'" 53 Ponce's failure to raise the statute of limitations in this case constitutes a waiver of that claim. 54

Ponce, moreover, engaged in conduct within the five-year period. Ponce audited financial statements for two annual reports that AAC filed with the Commission and prepared cash flow statements included in several quarterly reports. These financial reports contained the above-discussed misstatements during the five-year period preceding the initiation of these proceedings.

We previously have stated that we may consider conduct outside the limitations period to determine motive, intent, or course ofconduct. 55 Therefore, even Ponce's conduct outside of the limitations period can inform our decision.


A cease and desist order may be issued when a person is found to have violated or caused violations of the Exchange Act. Ponce willfully violated Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. Ponce also willfully aided, abetted, and caused AAC's violations of Exchange Act Section 13(a) and Rules 13a-1, 13a-13, and 12b-20, as well as Exchange Act Section 13(b)(2). Ponce's conduct continued over four years in the face of several indications that the valuation assigned to the License and his treatment of the tooling and prototypes costs were in error. While Ponce has not renewed his CPA license, he could still participate in the review of or preparation of a company's books or its periodic filings. 56 A cease and desist order under Section 21C of the Exchange Act is therefore appropriate.

Ponce's audits did not comply with GAAS and, contrary to his representations, the financial statements deviated from GAAP. Ponce also willfully violated and aided and abetted violations of antifraud, issuer reporting, and issuer books and records provisions of the Exchange Act. Ponce's conduct demonstrates a reckless disregard of his duties as an independent auditor. 57 We thereforeimpose a bar with a right to reapply in five years.

An appropriate order will issue. 58

By the Commission (Chairman LEVITT and Commissioners HUNT, CAREY, and UNGER); Commissioner JOHNSON, dissenting in part and concurring in part in result.

Jonathan G. Katz

Commission JOHNSON, dissenting in part and concurring in part in result.

I dissent from the Commission's decision to reverse the ALJ's dismissal of the Rule 102(e) charges in respondent's favor. As I have stated in detail elsewhere, I believe the Commission lacks theauthority even to promulgate Rule 102(e). 59

As to the remaining charges, I concur in result only.

Washington, D.C.

Rel. No. 43235 / August 31, 2000

Rel. No. 1297 / August 31, 2000

Admin. Proc. File No. 3-8944

            In the Matter of             :
             RUSSELL PONCE               :


On the basis of the Commission's opinion issued this day, it is

ORDERED that Russell Ponce cease and desist from committing or causing any violation of the antifraud, company reporting and books and records provisions of Sections 10(b), 13(a), and 13(b)(2) of the Securities Exchange Act of 1934 and Rules 10b-5, 12b-20, 13a-1 and 13a-13 thereunder; and it is further

ORDERED that Russell Ponce be, and he hereby is, barred from practice before the Commission with the proviso that, after five years, he may reapply to so practice.

By the Commission.

Jonathan G. Katz


1In a separate proceeding, AAC's President and Chief Executive Officer, William F. Moody, Jr., without admitting or denying the findings, was ordered to cease and desist from violating or causing violations of Exchange Act Sections 10(b), 13(a), and 13(b)(2) and Rules 10b-5, 12b-20, 13a-1, and 13a-13 thereunder, pursuant to his offer of settlement. In the Matter of William F. Moody, Jr., Securities Exchange Act Rel. No. 36700 (January 11, 1996), 61 SEC Docket 88. AAC also was ordered to cease and desist from violating the same provisions. In the Matter of American Aircraft Corporation, Securities Exchange Act Rel. No. 36855 (February 16, 1996), 61 SEC Docket 948. Our findings with respect to Moody and AAC, who are not parties to this proceeding, are solely for the purpose of this proceeding.

2 15 U.S.C. § 78j and 17 C.F.R. § 240.10b-5.

3 15 U.S.C. §§ 78m(a), and 78m(b)(2), and 17 C.F.R. §§ 240.12b-20, 240.13a-1, and 240.13a-13.

4 17 C.F.R. § 201.102(e)(1)(ii).

5 17 C.F.R. § 201.102(e)(1)(iii).

6 15 U.S.C. § 78l(g).

7 AAC was quoted on Nasdaq until April 1993, when AAC was delisted for failure to meet asset, equity, and bid price requirements. On December 20, 1994, AAC filed for bankruptcy under Chapter 11. On August 14, 1995, AAC converted its Chapter 11 reorganization to liquidation under Chapter 7.

8 Ponce let his accounting license lapse in 1994.

9 A development-stage enterprise is defined by Statement of Financial Accounting Standards No. 7 as a business devoting substantially all of its efforts to establishing a new business in which either: (1) planned principal operations have not commenced, or (2) there have been no significant revenues therefrom.

10 At the time of the merger, Phalanx was a research and development company dedicated to creating vertical aircraft. A footnote to Phalanx's financial statements as of January 31, 1988, stated that Phalanx had "engaged in activities related to organization, research and development activities, initial capitalization and further financing of its proposed business;however, it had not incurred or entered into any transactions of an operating nature that generated revenues or expenses. . . ."

11 Moody purported to do business as Moody Aircraft Design Bureau, an unincorporated sole proprietorship.

12 The design patents included the following aircraft and helicopters: Phalanx Intra-Lift, Phalanx Hunter, Phalanx Dragon, Phalanx Hind, and Phalanx Falcon.

13 In a reverse acquisition, a corporation acquires substantially all of the assets of a second corporation in exchange for the stock of the first corporation. After the transaction, the stockholders of the second corporation, through that ownership, own more than 50% of the fair market value of the outstanding stock of the first corporation. Treasury Regulation § 1.1502-75(d)(3) (as amended in 1973).

14 AAC's Form 10-Q for May 1988 reported assets of approximately $9 million, including the $4.6 million investment in the License.

15 Moody testified that he had no records that reflected his costs in creating the designs and that he could not produce records to substantiate a value. Moody testified that he therefore told Ponce to attribute zero value to the License even though he believed the License had a value as intellectual property.

16 APB Opinion No. 16, Paragraph 23 states that "a quoted market price may not always be a reliable indicator of fair value of consideration received because the number of shares issued is relatively large, the market for the security is thin, the stock price is volatile, or other uncertainties influence the quoted price."

17 The law judge credited Moody's testimony about the status of these various projects. We do not see any reason to disturb the law judge's assessment of Moody's demeanor. We conclude from Moody's description of the status of these projects thatthey never progressed beyond research and development. See Section III.B. infra.

18 These costs covered the materials, labor, and overhead to create molds for construction of aircraft and helicopter exteriors.

19 Under FAS 2, Paragraph 9.g., the design of tools involving new technology is considered research and development. Under FAS2, Paragraph 10.g., routine design of tools is not considered research and development.

20 The Patriot was not part of the License but was acquired by AAC from another aeronautical company.

21 The 1989 annual report stated that the tools for the Penetrator would be completed by April 20, 1990.

22 In 1990 and 1991, the tools for the Phalanx Hind were destroyed.

23 Regulation S-X, 17 C.F.R. § 210.4 et seq. A violation of Section 13(a) is established if a quarterly or annual report contains materially false statements or fails to state material information necessary to make the statements in it not misleading. Meris Laboratories, Inc., 51 S.E.C. 1305, 1314 (1994) (settled proceeding); SEC v. Kalvex, Inc., 425 F. Supp. 310, 315 (S.D.N.Y. 1975). See also SEC v. Beisinger Industries Corp., 421 F. Supp. 691, 694 (D. Mass. 1976) (Section 13(a) reporting requirements designed to insure that investors have adequate information upon which to base their investment decisions).

24 See SEC v. Falstaff Brewing Corp., 629 F.2d 62, 72 (D.C. Cir.) (company violated Rule 12b-20 by failing to update Form 10-Kthat did not disclose certain material facts related to litigation), cert. denied, 449 U.S. 1012 (1980); SEC v. World-Wide Coin Investments, Ltd., 567 F. Supp. 724, 758-59 (N.D. Ga. 1983) (failure to correct reports containing numerous misrepresentations and omissions resulted in liability for company director for aiding and abetting company's violation of Rule 12b-20).

25 The three elements necessary to find aiding and abetting here are: (1) securities law violations by AAC; (2) Ponce's general awareness or knowledge that his actions were part of an overall course of conduct that was illegal or improper; and (3) Ponce's knowing or reckless substantial assistance in the conduct constituting those violations. Sharon M. Graham, Securities Exchange Act Rel. No. 40727 (November 30, 1998), 68 SEC Docket 2056, 2066, aff'd, 2000 U.S. App. LEXIS 20938 (D.C. Cir. Aug. 18, 2000); Donald T. Sheldon, 51 S.E.C. 59, 66 (1992), aff'd, 45 F.3d 1515 (11th Cir. 1995), and cases cited therein. To establish that Ponce was a cause of AAC's violation, the record must show that Ponce knew or should have known that his actions would contribute to AAC's violation of the securities laws. Section 21C of the Exchange Act.

26 Exchange Act Section 13(b)(2) requires that an issuer keep books and records which, in reasonable detail, accurately and fairly reflect its transactions and disposition of its assets. See William D. Kyle, Securities Exchange Act Rel. No. 38876 (July 28, 1997), 65 SEC Docket 124 (where manager of company caused company to recognize revenue on orders that were not actually shipped during the fiscal year, manager violated13(b)(2)) (settled proceeding).

27 The Division also alleges that, for a number of reasons, the License should have been valued at zero. Given our analysis of the value used for the License, we do not reach this issue.

28 Moreover, GAAS states that if an auditor encounters matters that may require special knowledge, including valuation of restricted securities, he should consider consulting a specialist. Codification of Statements on Auditing Standards §336. Ponce never consulted a specialist to assess the value of the AAC stock.

29 AAC did not begin amortizing the License until 1990 although amortization should have begun in 1989. APB Opinion 17.

30 APB Opinion 17, paragraph 31 states that "a company should evaluate the periods of amortization continually to determine whether later events and circumstances warrant revised estimates of useful lives." See also AICPA Issue Paper, "Accounting for the Inability to Recover the Carrying Amount of Long Lived Assets," July 15, 1980 (discussing impairment of value of long lived assets).

31 While the Penetrator's design derived, in part, from the Phalanx Hind, nothing in the financial statements or work papers demonstrates that the Penetrator relied on any of the designs, patents, patent applications, or copyrights conveyed to the Company by the License.

32 Ponce testified before the law judge that after the acquisition he met with Moody to discuss how to classify the Penetrator. "It certainly wasn't tooling or any form of fixed asset that you might record on the books. And Mr. Moody insisted it was saleable and he wanted this to be an inventory item, and that he intended to sell it . . . ."

33 David J. Checkosky, 50 S.E.C. 1180, 1192-93 (1992), remanded on other grounds, 23 F.3d 452 (D.C. Cir. 1994) (Commission rejected argument that development of a copier was a "reconfiguration [that] did not involve research and development, but simply routine engineering."). See also, Checkosky v. SEC, 23 F.3d at 456 (no argument that auditors failed to conduct audits in accordance with GAAP) (Silberman, J.), 476 ("[r]esearch designed to improve or refine what already exists, like research aimed at creating new technology, may lead to a dead end.") (Randolph, J.). On appeal of the remanded case, the Court of Appeals dismissed this proceeding because it found that the Commission failed to articulate a clear interpretation of Rule 102(e)(1)(ii), and because it could not discern whether the Commission's finding of liability was based on intentional, reckless, or negligent misconduct. Checkosky v. SEC, 139 F.3d 221, 223-24 (D.C. Cir. 1998).

The administrative law judge found credible Moody's and Ponce's testimony that AAC was a manufacturing enterprise with ready buyers and that it was not a research and development company. Whether activity constitutes research and development, however, is a mixed question of fact and law. While we do not questionthe law judge's finding as to these witnesses' demeanor, we find no evidence in the record that AAC manufactured any aircraft for commercial sale. Nor is there evidence in the record of any contracts or letters of intent to purchase any aircraft.

34 Checkosky, 23 F.3d at 477.

35 1 Matthew Bender, Applying GAAP and GAAS §8.04.

36 FAS 2, paragraph 11(a) states that costs of materials and equipment or facilities acquired or constructed for research and development activities that have "alternative future uses" can be capitalized as assets.

37 Such evidence might include contracts, engineering studies, electronic designs or models, marketing presentations, letters of intent, or financial commitment letters. The record contains only a March 1991 letter from an individual whorepresents that he has been in "the aircraft and helicopter marketing business for twenty years." He estimated the value of "pre-production aircraft once construction is completed and the flight testing validated." He speculated that the flight-tested aircraft could have value to foreign buyers replacing Hueys or for the movie business. The Penetrator was not flight-tested until December 1991, and this individual does not discuss the impact of disassembly on such a vehicle. There is no evidence that AAC had commitments to use the prototype for either of these suggested purposes.

38 Checkosky, 23 F.3d at 477 (research and development continues until product meets specific functional and economic requirements and is ready for manufacturing to begin).

39 The Division's expert testified before the law judge that FAS 2 was adopted to make consistent the manner in which companies were accounting for research and development. Many companies had been reflecting costs as assets when the product or design had no future benefit. The accounting profession's Financial Accounting Standards Board, in promulgating this standard, concluded that, although all research and development outlays are made with the expectation of future benefit, an objective determination of when such outlays had resulted in a technologically or economically feasible product was not possible. Appendix B to Statement of Financial Accounting Standards No. 2 (October 1974). Examples of assets having alternative future uses include multiple-use buildings, machinery, and salable patents on products or processes.

40 Russell G. Davy, 48 S.E.C. 138, 142-43 (1985), aff'd, 792 F.2d 1418 (9th Cir. 1986).

41 "By certifying the public reports that collectively depict a corporation's financial status, the independent auditor assumes a public responsibility . . . [and] owes ultimate allegiance to the corporation's creditors and stockholders, as well as to [the] investing public. This 'public watchdog' function . . . requires complete fidelity to the public trust. . . . [T]he independent auditor's obligation to serve the public interest assures that the integrity of the securities markets will be preserved." United States v. Arthur Young & Company, 465 U.S. 805, 817-18 (1984).

42 Staff Accounting Bulletin No. 99, 17 C.F.R. § 211 (August 12, 1999) (the omission or misstatement of an item in a financial report is material if, in the light of the surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item) (citing FAS 2). See also Regulation S-X, 17 C.F.R. § 210.4-01(a)(1) (financial statements filed with the Commission that are not prepared in accordance with GAAP are presumed to be misleading or inaccurate despite footnote or other disclosures).

43 As the years went by, Ponce was owed increasing fees for his work, which may have motivated his willingness to persist in this conduct. The Division did not allege that the failure to disclose the fees owed to Ponce was evidence of antifraud violations. Here, we note only that AAC's indebtedness to Ponce may have influenced his conduct.

44 See also Russell G. Davy, 48 S.E.C. at 140 (auditor cannot rely on comptroller's journal entries as to ownership of real estate and mineral rights without verification); Ronald P. Harrington, 48 S.E.C. 457, 460-61 (where auditor based audit primarily on information supplied by management during conversations with them and in documents he received from them, auditor violated GAAS). Because we find that Ponce willfully violated Section 10(b) of the Exchange Act and 10b-5 thereunder, he clearly did not act with due professional care.

45 See Codification of Statements on Auditing Standards ("AU") § 333 ("representations from management are part of the evidential matter the independent auditor obtains, but they are not a substitute for the application of those auditing procedures necessary to afford a reasonable basis for his opinion on the financial statements.").

46 See Ernst & Ernst, 46 S.E.C. 1234, 1262 (1978).

47 Ernst & Ernst, 46 S.E.C. at 1262 ("inquisitiveness" and "healthy skepticism" are the hallmark of due professional care).

48 U.S. v. Arthur Young & Co., 465 U.S. at 818 n.13 and accompanying text.

49 Financial Reporting Codification § 602.02.b.v. See also AICPA Ethics Ruling 52 (ET § 191.103-.104) (independence may be impaired if more than one year's fees are unpaid when the member issues a report on the client's financial statements for the current year).

The Division also argued that Ponce was not independent because of his role in preparing the financial statements, specifically by changing Batista's accounting method. The Division contends that Ponce therefore was auditing some of his own work. See Thomas P. Reynolds Securities, Ltd., 50 S.E.C. 721, 724 (1991) (once an accounting firm prepares books of account and financial statements, it has become identified with management and may not perform an audit). This conduct was not charged in the Order Instituting Proceedings, however, and we do not consider it in assessing Ponce's conduct or the appropriate sanctions.

50 Ponce suggests that the Division did not demonstrate that the arrearage in his fees was material, and the law judge credited his testimony that he "maintained his independence." We believe that Ponce's actions as described above, particularly his willingness to accept management's directions, belie Ponce's testimony. As noted above, our view is that, in general, any arrearage can affect independence. Ponce, moreover, conceded before the law judge that the arrearage gave the appearance of lack of independence. Ponce did not present any evidence to rebut the presumption that his independence was impaired by being owed more than one year's fees. Ponce did not present any evidence that his financial position was secure enough that the amount of the arrearage did not affect him. Compare Anderson v. City of Bessemer, 470 U.S. 564, 575 (1985) ("[F]actors other than demeanor and inflection go into a decision whether or not to believe a witness. Documents or objective evidence may contradict the witness' story; or the story itself may be so internally inconsistent or implausible on its face that a reasonable fact finder would not creditit").

51 AICPA Professional Standards, ET § 101.02 (Jan. 12, 1988).

52 In October 1998, the Commission issued a final rule amendment to Rule 102(e) to clarify the standard for determining what constitutes "improper professional conduct." Amendment to Rule 102(e) of the Commission's Rules of Practice, Securities Act Rel. No. 7593 (Oct. 19, 1998), 68 SEC Docket 707. As noted in that release at note 34, we have long held that we have the authority to bring proceedings for knowing, reckless, or intentional conduct under Rule 102(e). Ponce's misconduct was reckless. The amendment merely codified the Commission's longstanding use of this standard. We are not considering the amendment in connection with our determination of Ponce's mental state.

53 Harris v. Department of Veterans Affairs, 126 F.3d 339, 343 (D.C. Cir. 1997) (citing Banks v. Chesapeake & Potomac Telephone Co., 802 F.2d 1416, 1427 (D.C. Cir. 1986)). See also Zipes v. Trans World Airlines, Inc., 455 U.S. 385, 393 (1982) ("filing a timely charge of discrimination with the EEOC is not a jurisdictional prerequisite to suit in federal court, but a requirement that, like a statute of limitations, is subject to waiver, estoppel, and equitable tolling"); Aceveo-Ramos v. United States, 961 F.2d 305, 307 (1st Cir.) (rejecting limitations defense in criminal context and noting that "every circuit that has addressed it has held that the statute of limitations is a waivable affirmative defense rather than a jurisdictional bar"), cert. denied, 506 U.S. 905 (1992); Wade v. Orange County Sheriff's Office, 844 F.2d 951, 955 (2d Cir. 1988) (statute of limitations is an affirmative defense that is waived if not raised).

54 Laurie Jones Canady, Securities Exchange Act Rel. No. 41250 (Apr. 5, 1999), 69 SEC Docket 1468, 1492 n.53, appeal pending, No. 99-1407 (D.C. Cir.). See 17 C.F.R. §§ 201.16(d), 201.17(b) (contentions not raised by a party before a law judge or the Commission on appeal may be deemed waived or abandoned). Similarly, Rule 8(c) of the Federal Rules of Civil Procedure (which do not apply to these proceedings) provides, under the heading "Affirmative Defenses," that "a party shall set forth affirmatively [in its pleading] . . . statute of limitations . . . and any other matter constituting an avoidance or affirmative defense."

55 See e.g., Sharon R. Graham, 68 SEC Docket at 2076 n.47. Statutes of limitation do not act as an evidentiary bar. Therefore courts may admit evidence of misconduct outside of an applicable limitations period. See, e.g., United States v. Gavin, 565 F.2d 519, 523 (8th Cir. 1977) (evidence of events extending beyond statute of limitations admissible to show motive, intent, a continuing scheme, and lack of inadvertent action).

56 In September 1999, Ponce's license was revoked. It can be reinstated only by the accountancy board. California Business and Professions Code § 5070.6-5070.7.

57 An administrative law judge recently granted partial summary disposition to an accountant in a Rule 102(e)(1)(ii) proceedings based on Checkosky v. SEC, 139 F.3d 221, 223 (D.C. Cir. 1998), which the law judge interpreted as invalidating Rule 102(e)(1)(ii). The Commission reversed the law judge,finding that Checkosky did not call into question the Commission's authority to bring cases under Rule 102(e)(1)(ii). Albert Glenn Yesner, Securities Exchange Act Rel. No. 42030 (Oct. 19, 1999), 70 SEC Docket 2743. Rather, the circuit court dismissed a Rule 102(e)(1)(ii) proceeding against accountants because the court held that it was not clear what standard of scienter the Commission was attempting to prove was violated.

We find that Ponce's conduct was reckless. This standard is not novel and has been used in proceedings that predate both Checkosky and Ponce's conduct here. See Potts v. SEC, 151 F.3d 810, 812 (8th Cir. 1998) (concluding Potts was reckless and sustaining Commission discipline under Rule 102(e)), cert. denied, 119 S. Ct. 1128 (March 1, 1999).

58 All of the contentions advanced by the parties have been considered. They are rejected or sustained to the extent that they are inconsistent or in accord with the views expressed herein.

59 See Albert Glenn Yesner, Exchange Act Rel. No. 42030, 70 SEC Docket 2743 (Oct. 19, 1999); Amendment to Rule 102(e) of the Commission's Rules of Practice, 63 Fed. Reg. 57164, 57172 (Oct. 26, 1998) (Johnson, Comm'r, dissenting); Norman S. Johnson & Ross A. Albert, Deja Vu All Over Again: The SEC Once More Attempts to Regulate the Accounting Profession Through Rule 102(e) of Its Rules of Practice, 1999 Utah L. Rev. 553; see also, Norman S. Johnson, The Dynamics of SEC Rule 2(e): A Crisis for the Bar, 1975 Utah L. Rev. 629; Norman S. Johnson, The Expanding Responsibilities of Attorneys in Practice Before the SEC: Disciplinary Proceedings Under Rule 2(e) of the Commission's Rules of Practice, 25 Mercer L. Rev. 637 (1974).