SECURITIES EXCHANGE ACT OF 1934
Release No. 43862 / January 19, 2001
ACCOUNTING AND AUDITING ENFORCEMENT
Release No. 1360 / January 19, 2001
Admin. Proc. File No. 3-9500
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In the Matter of KPMG PEAT MARWICK LLP c/o Michael Carroll, Esq. |
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OPINION OF THE COMMISSION
CEASE-AND-DESIST PROCEEDING
RULE 102(e) PROCEEDING
Accounting firm cannot be considered independent when it conducted audit of registrant's financial statements and issued audit report while loan from accounting firm to registrant's officer was outstanding and when accounting firm had the right to receivea fee contingent on the registrant's financial success. Accounting firm violated requirement that audit report accurately state that audit was made in accordance with Generally Accepted Auditing Standards. Accounting firm also caused registrant to violate reporting provisions, because the financial statements included as part of registrant's annual report, were not, as represented, audited by independent accountants. Held, it is in the public interest to order that accounting firm cease and desist from causing violations of Section 13(a) of the Securities Exchange Act of 1934 and Rule 13a-1 thereunder, or from committing violations of Rule 2-02(b) of Regulation S-X, by having any transactions, interests, or relationships that would impair its independence under Rule 2-01 of Regulation S-X or under Generally Accepted Auditing Standards. Because of the unique procedural posture of the proceeding, however, it cannot be concluded that accounting firm engaged in improper professional conduct within the meaning of Rule 102(e).
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Ground for Remedial Action
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Violation of Rules Governing Financial Statements
Causing Violations of Reporting Provisions
Ground for Remedial Action
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Improper Professional Conduct
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APPEARANCES:
Stephen J. Crimmins and Richard C. Sauer, for the Division of Enforcement and the Office of the Chief Accountant.
Michael P. Carroll and Joseph Warganz, of Davis Polk & Wardwell, Donald W. Rose, of KPMG LLP (of counsel), and Ronald S. Flagg, of Sidley & Austin (of counsel), for KPMG Peat Marwick LLP.
Appeal filed: February 11, 2000
Last brief filed: July 19, 2000
Oral argument held: September 28, 2000
I.
The Division of Enforcement and the Office of the Chief Accountant (together the "Division") appeal from the decision of an administrative law judge finding that KPMG Peat Marwick LLP ("Peat Marwick"), a Delaware limited liability partnership,1 failed to adhere to standards of auditor independence in connection with its audit of Porta Systems Corp.'s ("PORTA") financial statements. The law judge concluded that Peat Marwick violated Rule 2-02 of Regulation S-X2 and causedviolations of Section 13(a) of the Securities Exchange Act of 1934 and Rule 13a-1 thereunder.3 The law judge also concluded, however, that Peat Marwick did not engage in improper professional conduct within the meaning of Commission Rule of Practice 102(e).4 The law judge dismissed the proceeding insofar as it alleged that Peat Marwick engaged in improper professional conduct and denied the Division's request for entry of a cease-and-desist order against Peat Marwick pursuant to Section 21C of the Exchange Act.5 We base our findings on an independent review of the record.
II.
On September 29, 1994, L. Glenn Perry, a senior partner in Peat Marwick's Department of Professional Practice ("DPP"),6 met with staff members of the Commission's Office of the Chief Accountant ("OCA") for just over thirty minutes to discuss the contents of a "draft on an independence matter" he had sent to OCA via facsimile the previous afternoon.7 The draft described the creation of an entity -- KPMG Corporate Finance ("KPMGCF") - that would be involved in a "business relationship" with Peat Marwick and that would provide clients with financial advice and related services.8 The draft set forth, in very general terms, KPMGCF's proposed operations and briefly outlined the contours of the proposed relationship between Peat Marwick and KPMGCF. Accordingto the draft, Peat Marwick had concluded that it and KPMGCF would be "separate" entities and that the independence rules applicable to Peat Marwick would not constrain KPMGCF's activities. The draft solicited the staff's views on the matter.
During the meeting, Perry mentioned certain information addressed in the draft: 1) Peat Marwick would extend to KPMGCF a $5 million working capital loan; 2) Peat Marwick would license to KPMGCF the use of the "KPMG" initials; and 3) in return for the license Peat Marwick would receive a royalty from KPMGCF. Perry also responded to certain questions posed by OCA staff regarding the use of Peat Marwick's staff in KPMGCF engagements, another aspect of the proposed relationship mentioned in the draft. One of the items in the draft -- not discussed during the meeting --indicated that KPMGCF proposed to provide "services to troubled companies in the context of turnaround or bankruptcy."9 Perry was not prepared to discuss that point; he had "no specific understanding" as to its meaning, beyond what was said in the draft.
At the end of the meeting, the Deputy Chief Accountant, John Riley, advised Perry that he had not heard anything during the meeting that would cause the staff to raise questions about Peat Marwick's independence. Because the alliance was in the planning stages and details remained to be worked out, however, Riley anticipated that Peat Marwick would consult with OCA again as decisions about the contours of the alliance were refined and finalized. The staff also advised Perry that the activities of KPMGCF and its relationship with Peat Marwick raised a number of issues that Perry should discuss with staff of the Commission's Division of Market Regulation. The OCA staff advised Perry that another national accounting firm had previously abandoned a similar proposal when it became apparent that the Division of Market Regulation would view the accounting firm as acting in the capacity of a broker-dealer by virtue of the proposed affiliation.
Although Peat Marwick did not follow up with either OCA or the Division of Market Regulation, it nevertheless determined to proceed with the alliance. In January 1995, it entered into a license agreement with KPMG BayMark, LLC ("BayMark"), a Delaware limited liability company, and BayMark's two subsidiaries - KPMG BayMark Strategies, LLC ("Strategies"), a Delaware limited liability company, and KPMG BayMark Capital, LLC ("Capital"), a Delaware limited liability company (collectively the "BayMark parties"). The agreement described BayMark as "a newly formed limited liability company which [would] provide financial services" including "investment banking, corporate recovery, crisis management and other services under the direction of David Maughan, Mark Taffet, Edward Olson, and Dan Armel." Each of these persons were "Principals" of BayMark andeach held a 25% ownership interest in BayMark.10 BayMark was to conduct business through its subsidiaries. Strategies planned to engage in a corporate recovery, crisis management, and restructuring advisory business based in California and Virginia. Olson would serve as its Executive Managing Director.11 BayMark owned 51% of the interests in the Strategies limited liability company, and Olson and Armel each owned 24.5%. Capital, based in New York, New York, was to engage in investment banking and other brokerage activities. BayMark owned 51% of the Capital limited liability company interests, and Maughan and Taffet each owned 24.5%.
Under its license agreement with the BayMark parties, Peat Marwick agreed to lend $100,000 to each of the four Principals on a non-recourse basis, to be used by the Principals as equity contributions to BayMark and its subsidiaries. Those equity interests in turn were pledged by the Principals to Peat Marwick as security for the loans. Thus, for example, Olson executed a promissory note and entered into a pledge agreement with Peat Marwick. Olson promised, among other things, to make a $99,000 capital contribution to Strategies and a $1,000 capital contribution to BayMark on receipt of the loan from Peat Marwick. He also pledged to Peat Marwick his equity interests in Strategies and BayMark as security for payment on the note.
Under the license agreement, Peat Marwick granted the BayMark parties rights to use "KPMG" as part of their names, provided, among other things, that the BayMark parties: (a) sought and received approval from Peat Marwick to use any advertising bearing the initials; (b) complied withcertain "professional and ethical policies and standards of practice" to which Peat Marwick adhered; and (c) used the phrase "A Strategic Alliance of KPMG Peat Marwick" in connection with the use of the "KPMG" initials.12 In return for the license, each BayMark party agreed to pay Peat Marwick a license fee ("royalty fee") of five percent of its quarterly consolidated fee income, excluding certain revenues received from another BayMark party less certain fees. The royalty fees were to be paid to Peat Marwick quarterly, within thirty days after the close of each quarter.
In addition, Peat Marwick agreed to enter into revolving credit agreements with the BayMark subsidiaries under which Peat Marwick would lend the subsidiaries up to $2.3 million each.13 In return, Peat Marwick took a security interest in Strategies' and Capital's accounts receivable, contracts, licenses, intangibles, proceeds, and other properties. Peat Marwick also agreed to provide, for an hourly fee, financial analysis and other services to the BayMark parties in support of their engagements. The BayMark parties in turn agreed to assist in developing Peat Marwick's financial analysis and support services business through their "sources."14
The financial and trade press published news of the Peat Marwick/BayMark alliance in late August or early September 1995. When Michael Sutton, then the Commission's Chief Accountant, became aware of these articles, he directed his staff to gather more information. On September 29, 1995, Perry responded to staff inquiries by sending a letter reiterating, almost verbatim, the information set forth in his 1994 draft memorandum, together with a brief description of the ownership of BayMark and the background of its owners. Thus, for example, the letter described Olson's background as follows: "Thirty years of operational expertise, including 15 years of corporate turnaround consulting. Most recently, Ed was president of his own consulting company."
On October 19, 1995, Perry and Chris Trattou, a senior manager in Peat Marwick's DPP, met with OCA staff, including Sutton.15 Jerry Sullivan, Executive Director of the Public Oversight Board ("POB"), also attended the meeting.16 The purpose of the meeting was to address the staff's concerns and questions about Peat Marwick's relationship with BayMark. Among other things, OCA expressed concern that Peat Marwick could be found to be lacking in independence if Peat Marwick controlled BayMark and BayMark provided services to registrants audited by Peat Marwick. Specifically, the staff expressed concern about BayMark's use of the "KPMG" initials, the royalty fee arrangement, and BayMark's financing.17 The staff also indicated that Peat Marwick's independence might be adversely affected by the services it would provide BayMark's clients as a subcontractor. Accordingly, the staff informed Perry and Trattou that OCA would "not say `at this . . . time' that . . . [it did] not object to the strategic alliance." According to Perry's notes, Sutton ended the meeting by cautioning Perry: "If you have a significant SEC client, we suggest you consult with us before you use BayMark." Perry asked Sutton what he meant by "significant" SEC client, and Sutton responded, "A client you do not want to embarrass."18 As Van Brunt put it:
[T]he meeting more or less ended with Mr. Sutton indicating that whatever BayMark was providing, it ought not to be provided to any of the audit clients of . . . [Peat Marwick] if they considered the client to be a client they wanted to retain. I don't remember the exact phraseology, but there was some indication that the auditing of a BayMark client by Peat Marwick would be a problem and that Mike would be particularly interested in that matter with respect to independence of the firm.
Despite this interchange, Perry and Trattou failed to indicate to OCA that just such a situation was about to occur. Between two and three weeks earlier, Strategies had submitted a letter agreement to PORTA under which Strategies would provide PORTA (a Syosset, New York telecommunications company that was experiencing losses from operations) with turnaround management services for fifteen months.19 PORTA had been Peat Marwick's audit client for a few years. Leonard Sturm, a partner in Peat Marwick's Long Island, New York office, was the engagement partner for PORTA's 1994 audit. Sometime in the early summer of 1995, in the course of a partners' meeting, Sturm learned that Peat Marwick had a strategic alliance with an entity called BayMark and that BayMark "provided turn-around services . . . and helped secure financing for companies." Later, when Sturm learned that PORTA's management was seeking assistance to turn the company around, Sturm contacted a colleague at Peat Marwick and, ultimately, Strategies was "introduced" to PORTA.20
Under the agreement between PORTA and Strategies, which was executed on November 3, 1995, Olson was to assume the title of Chief Operating Officer ("COO") of the company and direct itsturnaround effort in exchange for a management fee of $250,000 and certain percentages of PORTA's earnings, disposed inventory, and restructured debt ("success fee").21 Strategies, through Olson, was given authority to put in place a management team that would lead the turnaround effort, establish control of the company's cash flow, "take whatever actions are necessary to enable [PORTA] to survive," restructure the company's business, develop reward and compensation systems, and seek out opportunities for "profitable growth." The work was to be performed "with a view toward the development of specific short term and long term business strategies" for PORTA. On November 9, 1995, PORTA's Board of Directors elected Olson president and COO of the company.22
In October 1995, Sturm became aware that PORTA was going to engage BayMark (Strategies). Although he thought BayMark would provide only consulting services to PORTA, because he knew little about the alliance or BayMark, Sturm contacted the DPP to determine whether it was "okay for [BayMark] to provide services, consulting services, to an audit client." He was referred to Trattou, whom he understood to be "fielding questions on anything related to BayMark." Trattou let Sturm know that the situation was "okay" -- that "the way the alliance was set up . . . [BayMark] could provide services to an audit client." Trattou further stated that the alliance had been discussed with the "SEC" and it had no objection.
Sometime during the first few days of December, after Sturm became aware that Olson had assumed the positions of president and COO of PORTA and in anticipation of beginning an audit "down the road," Sturm again called Trattou to inquire about "a second potential independence question" - "[w]hether it was okay for Ed Olson to not only be performing consulting services . . . [but also to be] performing . . . COO-type functions at the company . . . [and to] ha[ve] the title[s] of COO and President."23 Trattou "indicated that he needed to take a look at [the situation] and get back" to Sturm.
On December 5, 1995, Trattou forwarded to Thomas Vasquez24 an e-mail Trattou had written concerning Sturm's inquiry. The forwarding header told Vasquez that Trattou would "try and work this out" with the partner in charge of the DPP, Michael Conway, and others "before [Vasquez] ha[d] to get involved." The forwarded message read:
We have been asked by a [Peat Marwick] office whether BayMark Strategies (Ed Olsen [sic]) may act as interim president, for 15 months ($10,000 a month), for a public audit client. The purpose is to turn around the companies [sic] financial condition and develop a new strategy. [Peat Marwick] will continue to be the auditors during the turn around period and the original Chairman/CEO and a new CFO from industry will continue their roles.
The e-mail continued:
Glenn [Perry] and Mike [Conway] believe this situation is not appropriate. They believe if there is ever an audit failure in this type of situation, where we are indirectly getting `representations' from KPMG BayMark, we will be extremely embarrassed as a firm. In THEORY, they believe the situation should be able to work if Strategies is truly independent and not controlled by [Peat Marwick], but the form is such that it does not work.
Trattou went on to state that he disagreed with Conway and Perry and believed that "this situation can work." He further opined that "[t]here must be a way to structure such engagements to make them work by using walls, proper representations and full disclosure concepts." He concluded:
If BayMark is `independent' then they must `always' be deemed independent from [Peat Marwick] in substance and form for all transactions. If we start identifying transactions that `look' like problems then we weaken our position that BayMark is truly an independent company, not controlled by [Peat Marwick]. A no answer has obvious impacts to the financial success of the strategic alliance with BayMark Strategies and spill over effects to BayMark Capital transactions with public audit clients.
Perry and Conway met with OCA staff and representatives of the POB on December 6, 1995, the day after this e-mail.25 They did not, however, mention anything about Strategies' PORTA engagement. Instead, the discussion focused on the same concerns raised in the October 19 meeting. Thus, Sutton reiterated OCA's concern that the relationship between BayMark and Peat Marwick (including Peat Marwick's loans to BayMark's subsidiaries and its Principals, Peat Marwick's contractual right to a royalty, and BayMark's use of the "KPMG" initials) might compromise Peat Marwick's independence from audit clients that would engage BayMark. The staff also expressed reservations about whether Peat Marwick could provide services to audit clients as a BayMark subcontractor and maintain its independence. Focusing again on Capital's business, the staff warned that broker-dealer activities were not compatible with audit functions and that those activities raised separate issues for the Division of Market Regulation. As Conway's notes reflect, the POB representatives "basically side[d]" with OCA with respect to these issues. The meeting ended without any resolution of OCA's concerns but with an understanding that dialogue would continue.
Before the meeting drew to a close, Sutton again warned Perry and Conway that, if BayMark and Peat Marwick were viewed as one entity, "any services provided to an audit client by BayMark would have to be viewed as services provided by the combined entity." Based on his "working assumption" that Peat Marwick controlled BayMark, Sutton indicated, in substance, that Peat Marwick "can't audit SEC registrants who use BayMark if BayMark's services . . . are precluded for auditor."26 As Burns' notes of the meeting state: "Problem if BM [BayMark] doing anything PM [Peat Marwick] can't do."
On December 8, 1995, Trattou called Sturm seeking information, to use in an upcoming meeting with OCA staff, about the services Sturm proposed to provide to PORTA.27 He did not answer Sturm's earlier independence questions. He asked about the amount of the fee Sturm proposed to charge for conducting the audit of PORTA's financial statements. Sturm replied that he proposed to charge $150,000. Trattou inquired whether Sturm had yet commenced any audit procedures. Sturm replied that he had not. Trattou also asked whether Peat Marwick had providedany services to PORTA as a BayMark subcontractor and whether it intended to do so in the future. Sturm told him "no, we had not, and we did not intend to." After Sturm answered the questions, Trattou told Sturm, in essence, "not to worry . . . unless [Sturm] heard back" from Trattou and that, "if [Sturm] didn't hear anything prospectively, then assume that things are okay; otherwise [Trattou] . . . would call [Sturm] back." During the hearing, Sturm recalled that he and Trattou had a number of follow-up conversations that Sturm did not consider to have further resolved the independence question.
On December 18, 1995, Conway met again with OCA staff and other Commission employees.28 The purpose of the meeting was to give Conway and Peat Marwick's attorneys the opportunity to demonstrate why the relationship between Peat Marwick and BayMark was not "a potentially independence impairing relationship." Although Conway and Harvey Pitt, an attorney representing Peat Marwick, argued at some length that the alliance did not raise independence concerns, those attending the meeting discussed no new issues.29 There were no discussions of particular BayMark engagements with Peat Marwick audit clients, such as PORTA, although there was some "generic" discussion that BayMark had some ongoing relationships with audit clients and "generically" what they involved.30 The focus was on Capital's business and Sutton's concern that certain aspects of the alliance would lead a "reasonably informed person . . . [to] consider [Peat Marwick to be] in [the] invest[ment] banking bus[iness] as well as auditing."
Sutton recalled that at this meeting he "definitely said" that, if BayMark was performing services that Peat Marwick could not itself perform, Peat Marwick's independence would be impaired. According to Burns' detailed notes, as the meeting drew to a close, Conway stated that, if OCA would "undertake to consider the[] issues" raised by suggestions as to ways in which the structure of the alliance might be modified, Conway would "undertake to place a moratorium" on BayMark performing services for Peat Marwick's public audit clients. Sutton responded by noting that the only alternative would be to consider the services provided to each client and to make a case-by-case assessment as to whether or not those services would impair Peat Marwick's independence from that client.
On December 26, 1995, Sutton and Conway met again. Sutton indicated that "in order to avoid staff objections to the structure" of the alliance, Peat Marwick needed to drop the "KPMG" initials from the BayMark parties' names, eliminate the royalty fee arrangement, and bring about the repayment of the $400,000 in loans made to the BayMark Principals.31 Sutton and Conway agreed to follow up this meeting with a telephone call to talk about "whatever was still pending." Accordingly, in a December 28, 1995 telephone call, Conway answered certain questions Sutton had posed on December 26 concerning Peat Marwick's revolving credit arrangements with BayMark's subsidiaries.32 In addition, the two men again discussed the ways in which Peat Marwick and BayMark's relationship needed to change. As a result of these conversations, Conway and Sutton came to an agreement that Peat Marwick would undertake negotiations with BayMark to end the BayMark parties' use of the "KPMG" initials, terminate the royalty fee arrangement, and have the BayMark Principals repay their loans.
During the course of these conversations, Sutton and Conway also discussed pending BayMark engagements.33 Conway let Sutton know that eighteen engagements were "on hold" since the October 19 meeting and would stay on hold until OCA's concerns were resolved.34 Conway then turned to other engagements that, as Sutton acknowledged he understood, were not on hold but rather "in progress." These engagements were dual engagements "contracted for [by] both BayMark and Peat Marwick" and had been identified because Conway had asked for such information and "someone" at Peat Marwick had gotten it for him. That person prepared a chart "identif[ying] six engagements where [Peat Marwick] w[as] auditor of record [and] . . . BayMark had contracts with . .. [and was] doing work for those particular clients."35 Conway "needed to know one way or the other fairly soon whether we had to stop those engagements or if they could proceed."36 He wanted, and we find that he sought, Sutton's "yea or nay as to whether or not [the six dual engagements] could go forward." 37
One of the six dual engagements involved Strategies' provision of turnaround management to PORTA.38 Conway knew that "someone" from Strategies was acting as president of PORTA and that the "someone" was "running" PORTA. But Conway testified that he may not have known that the person was a BayMark Principal or a person to whom Peat Marwick had lent $100,000.39 AsConway recognized, however, Peat Marwick "clearly" could not itself have provided the services he understood Strategies to be providing to PORTA because an audit firm cannot "have an audit client where [it] had someone in running the company."
According to Sutton's notes, Conway described the PORTA situation to Sutton as follows: "[S]trategies - assistance to troubled companies; work-out; top level management [KPMG could not do]" (second brackets in original).40 Conway did not identify PORTA by name, did not indicate that Olson was the person who would provide the top level management, and did not mention that the person who would manage PORTA (Olson) was a BayMark Principal or a person to whom Peat Marwick had loaned $100,000. Nor did Conway mention that Strategies would earn a success fee41 or discuss precisely when Peat Marwick would be performing audit work for PORTA.42 According to Conway, Sutton expressed some "concern" about the PORTA situation. Conway recalled that Sutton "must've said . . . is this something that [Peat Marwick] could . . . do, and I said to him that Peat Marwick could not do what BayMark Strategies is doing."
The Division and Peat Marwick generally agree that there was consensus during these conversations that Peat Marwick would resolve OCA's independence concerns if it proceeded to modify the alliance in the three respects specified by OCA. They disagree sharply, however, as to whether the six dual engagements could proceed to completion before the changes to the alliance were implemented. We find that Sutton neither told Conway that he approved or disapproved of the six dual engagements nor asked that Peat Marwick take steps to discontinue any of them. On the other hand, Conway testified that he believed that there was agreement with OCA that the six engagements could go ahead while the resolution of the issues posed by the alliance went forward. The law judge, who observed the demeanor of all the witnesses, found credible Conway's testimony as to his belief, and we find no basis to overturn that determination.
Sometime before December 27, 1995, Trattou called Sturm with an answer to Sturm's earlier independence inquiries. Trattou's answer professed to reflect accurately the content of Conway's dialogue with Sutton. According to Sturm, Trattou told him that the "SEC" was "aware of the PORTA situation," that PORTA had been mentioned to the "SEC" by name, and that Sturm "should proceed with the audit unless [he] heard otherwise and that even if there was an issue . . . because everybody knew about [the PORTA situation], it would be grandfathered." Indeed, Trattou implied that the situation had been described as he and Sturm had discussed -- that "Ed Olson had [been] hired, had those titles, and BayMark was performing some services there." Trattou also indicated that there would be some changes to the strategic alliance, but he mentioned only that the "KPMG" initials would be dropped from BayMark's name. Trattou did not, in the course of this conversation (or during those that took place earlier), inform Sturm about the concerns voiced by Commission staff about the structure of the alliance. Nor did Trattou or anyone else in the DPP tell Sturm that Peat Marwick hadloaned money to Olson or that the BayMark subsidiaries were obligated to pay a five percent royalty to Peat Marwick for use of the "KPMG" initials.
On December 29, 1995, Conway directed an e-mail to Vasquez and copied it to Perry, among others. The message -- which updated Vasquez on "where we stand with our latest discussions with Mike Sutton" -- summarized the structural changes to the strategic alliance that Conway had agreed to discuss with BayMark and noted that Sutton "again indicated that it was important that we resolve any problems" that the Division of Market Regulation might have with the alliance because certain of their determinations might affect OCA's conclusions about independence. The e-mail continued:
Mr. Sutton said that he was going to try to get the matter resolved on the basis that we discussed and that, if resolved quickly, he thought that Baymark would be able to complete the engagements in process without jeopardizing our independence with respect to our SEC audit clients. Mr. Sutton needed to discuss the matter with others before he came to a final conclusion . . . .43
On January 3, 1996, Conway contacted Sutton to inform him that Peat Marwick was ready to begin negotiating the changes to the alliance but that Conway wanted to be sure that OCA was "satisfied before putting the lawyers to work." Sutton told Conway that OCA would get back to him. On January 5, Burns called Conway to say that "OCA was comfortable with the proposals he had made but . . . could not give him any approval or clearance until the Market Regulation issues were resolved." Conway understood this to mean that Peat Marwick's counsel was to begin discussions with the Division of Market Regulation and that the changes to the alliance could not be made until Market Regulation resolved its concerns about the alliance.
Sutton and Conway then exchanged letters purporting to reflect the outcome of their discussions. In a letter dated January 29, 1996, Conway summarized the proposed modifications to the structure of the strategic alliance and then stated that OCA had informed Peat Marwick "that the implementation of the foregoing revisions (which . . . remain subject to negotiation with BayMark) would resolve all issues that might be said to arise as a result of the strategic alliance under applicable independence rules." Two days later, Sutton replied in a letter correcting Conway's statement about the resolution of independence issues: Sutton's letter stated that all "independence issues raised by the OCA are, and will remain, open until all issues raised by the Division of Market Regulation have been resolved." On February 14, 1996, Conway replied to Sutton's letter and acknowledged that "[o]urrespective recollections [as to the discussions] are generally consistent." Nowhere in these letters is there a reference to the six ongoing dual engagements.
Again, the parties agree that "independence issues" remained open pending further action by the Division of Market Regulation. But the Division contends, in essence, that the "independence issues" included whether the six engagements could proceed, while Peat Marwick argues, in essence, that it was understood that the six engagements could proceed while the "independence issues" as to the overall structure of the alliance were being resolved. We believe that the December 29 e-mail and the subsequent correspondence can fairly be read as being consistent with either view. Accordingly, they do not lead us to overturn the law judge's determination to credit Conway's testimony concerning his belief that Peat Marwick and the BayMark subsidiaries were free to go forward with the pending engagements.
In the meantime, however, on December 27, 1995, PORTA signed Peat Marwick's engagement letter. Field work began sometime in January 1996. The audit team did not interact with Olson. Indeed, Olson deliberately stayed clear of the auditors. He was mindful that, at the outset of his dealings with Peat Marwick, Vasquez had told him that Peat Marwick wanted to maintain its independence from BayMark.44
On the other hand, as PORTA's president, Olson signed the management representation letter on which the audit team relied in conducting the audit. As a consequence, Olson, along with the other officers and the director who signed the letter, took responsibility for "the fair presentation" in consolidated financial statements of PORTA's financial position, results of operations, and cash flows in conformity with generally accepted accounting principles ("GAAP"). Moreover, the fact that Olson, a person associated with Strategies, was managing PORTA was certainly not lost on the audit team. As Peat Marwick's workpapers reflect, the audit engagement team considered whether it "needed to reevaluate" its relationship with PORTA "due to man[agement] turnover." In determining not to do so, the team considered, among other things, that the "new COO, Ed Olson, is with BayMark Strategies [and] came highly recommended by [Peat Marwick's] corporate finance personnel."
On January 5, 1996, Catherine McGuire, Chief Counsel of the Division of Market Regulation, met with Burns of OCA to discuss the Peat Marwick/BayMark alliance. She had become concerned that the resolution of the auditor independence issues raised by the BayMark venture ought to be better coordinated with the resolution of the broker-dealer registration issues. She was optimistic, however, that the broker-dealer issues might be resolved quickly given Conway's demonstrated willingness toundertake structural modifications to the alliance. Accordingly, on January 17, 1996, counsel for Peat Marwick and BayMark met with staff of the Division of Market Regulation, including McGuire. McGuire expressed concern, in light of Peat Marwick's failure to initiate dialogue with Market Regulation, that Peat Marwick seemed to be ignoring the broker-dealer issues arising from its relationship with BayMark and Capital. McGuire wanted Peat Marwick to understand that those issues were "extremely difficult and . . . important" and had been "the show stopper" with respect to another accounting firm's attempt to establish an affiliation similar to that of Peat Marwick and the BayMark parties. Accordingly, while McGuire invited Peat Marwick to submit a formal no-action request with respect to whether Peat Marwick could provide certain services to Capital's clients without broker or dealer registration, she stated that the staff had "said no . . . [to] the last account[ing] firm that wanted to do this."
On February 12, 1996, McGuire again conferred with attorneys representing Peat Marwick and provided detailed guidance on how the firm might seek no-action relief. First, McGuire identified those aspects of the license agreement that raised concerns about whether Peat Marwick controlled BayMark. Next, McGuire specified the sorts of representations Peat Marwick should make concerning the services it intended to supply to Capital's customers. Two months later, on April 12, 1996, Peat Marwick submitted a discussion draft of a no-action request. In McGuire's view, the draft failed to make the "simple representations" that might warrant no-action relief. McGuire explained that, instead of addressing relevant issues, the letter argued that the services that Peat Marwick would provide BayMark (Capital) were proper accounting functions and therefore were not broker-dealer functions. After it submitted a revised June 13 draft, Peat Marwick did not proceed further with the request.
Before Peat Marwick submitted the first draft no-action request -- and before it had effected any structural changes to the alliance - Sturm and the rest of the audit team concluded the audit of PORTA's 1995 year-end financial statements and Peat Marwick issued its "Independent Auditors' Report." PORTA's consolidated statements of operations reported a net loss of over $31 million for 1995 and the audit report, dated March 22, 1996, expressed substantial doubt about PORTA's ability to continue as a going concern. PORTA included the report as part of its 1995 annual report on Form 10-K, filed with the Commission on April 1, 1996. The annual report listed Olson as the company's president and COO and noted that Olson "is also one of the principals of KPMG BayMark Strategies LLC." The report also stated that "Mr. Olson continues in this position while serving as President and Chief Operating Officer of the Company."45 Olson signed the annual report as "President" of PORTA.
As Sturm was reviewing the draft Form 10-K, he noticed that it described BayMark (Strategies) as "KPMG BayMark." Because he had been told that the "KPMG" initials would be dropped from BayMark's name pursuant to Peat Marwick's agreement with OCA, he called Conway to inquire specifically about whether the name BayMark Strategies, LLC should appear in the Form 10-K with the "KPMG" initials and generally to "reconfirm that there were no independence issues." He (or another member of the audit team) also discussed the matter with Vasquez. Ultimately, Conway and Vasquez "reconfirmed that the SEC was aware that BayMark was performing the work at PORTA, our independence has not been impaired, and that, due to the SEC review, we should not accept any subcontracted work from BayMark . . .".46
On May 6, 1996, OCA learned of the PORTA audit after Van Brunt and others in OCA ran a search on the Commission's Electronic Data Gathering and Retrieval System ("EDGAR") for filings in which the initials "KPMG" and the name "BayMark" appeared. The search disclosed that Peat Marwick had performed an audit of the financial statements of a public audit client, PORTA, while BayMark was providing, through its subsidiary, Strategies, and a BayMark Principal, Olson, management services to that client. Van Brunt and others told Sutton about the situation. Sutton directed them to talk with Peat Marwick and get the facts about the PORTA audit.
Approximately one week later, Burns mentioned to Conway that the staff was "looking at PORTA" and on May 20, 1996, Burns47 informed Conway that, in the staff's view, Peat Marwick was not independent from PORTA for "at least two reasons." First, because the structural changes to the strategic alliance had not been implemented, the staff considered Peat Marwick and BayMark to have been one entity for independence purposes and "[o]ne entity cannot be both management and auditor of a registrant's financial statements." Second, loans to a company (BayMark) owned by Olson "would constitute a loan from the auditor to a member of management and violate the fact and appearance of Peat's audit independence." Burns also told Conway that OCA would not "take action" on this determination until Sutton returned to the office.
At Conway's request, Conway met with Sutton and other members of the OCA staff on June 20, 1996.48 Counsel for Peat Marwick also attended the meeting. During the meeting, Sutton advised Conway that OCA did not consider Peat Marwick to have been independent from PORTA. Sutton further advised Conway that he had "difficulty" understanding how Peat Marwick "could cometo [the] conclusion" that it was "indep[endent] of [a] co[mpany] BM [BayMark] was managing . . . in view of our [1995] discussions." Although Conway insisted that he had "mentioned P/S [PORTA] as [a] man[agement] relationship," Sutton indicated that he had no recollection of that discussion.
By letter dated June 21, 1996, Sutton advised the Chairman of PORTA's Board of Directors, Warren Esanu, that "the existence of financial, operating, and other relationships among Mr. Olson, KPMG BayMark and KPMG Peat Marwick, adversely impacts KPMG Peat Marwick's independence with respect to Porta Systems." For that reason, the letter advised Esanu, the financial statements PORTA had included in its 1995 annual report would be considered unaudited and not in compliance with the federal securities laws. The letter also advised Esanu that PORTA should arrange for the immediate audit of its financial statements by an independent certified public accountant and should consider whether and how to notify public investors and others who might be relying on the then-current financial statements.49
III.
The capital formation process depends, in large part, on the availability of accurate and reliable financial information. As we have stated, "[a]n investor's willingness to commit his capital to an impersonal market is dependent on the availability of accurate, material and timely information regarding the corporations in which he has invested or proposes to invest."50
The investing public must be able to rely on reports by "independent" public accountants concerning the financial statements included in filings with the Commission. These reports provide the assurance that outside experts have examined a filer's financial statements and have arrived at objective opinions about whether the filer's financial position, results of operations, and cash flows are presented fairly in conformity with GAAP. Independent audits thus improve the reliability of financial statements and enhance their credibility.
Although the independence of auditors does not alone assure reliable and credible financial reporting, its absence would certainly undermine public confidence in that reporting, and thereby harm the securities markets.51 Accountants and their firms must be -- and must reasonably be perceived to be -- free from influences that would impair objective, unbiased examinations, even when the results are contrary to management's interests. As we have consistently recognized, if an auditor "is predisposed, or even appears predisposed, to blindly validate management's work rather than subjecting it to careful scrutiny, the ultimate result will be a diminution of public confidence in the profession and the integrity of the securities markets."52
In enacting the federal securities laws, Congress underscored the crucial function of independent auditors by requiring, or permitting the Commission to require, that "independent" public accountants certify financial statements filed with the Commission by public companies and others.53 As the United States Supreme Court recognized in United States v. Arthur Young & Co., 465 U.S. 805, 817-818 (1984), these requirements place a special responsibility on accountants who audit the financial statements of public companies:
By certifying the public reports that collectively depict a corporation's financial status, the independent auditor assumes a public responsibility transcending any employment relationship with the client. The independent public accountant performing this special function owes ultimate allegiance to the corporation's creditors and stockholders, as well as to the investing public. This "public watchdog" function demands that the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust.54
Congress did not define "independent;" instead it authorized the Commission to define "accounting, technical and trade" terms used in the federal securities laws.55 We have adopted Rule 2-01 of Regulation S-X,56 which provided, at all relevant times, in subsection (b) that the Commission "will not recognize any certified public accountant or public accountant as independentwho is not in fact independent." Based on the recognition that certain relationships between an auditor and a client are so likely to compromise an auditor's objectivity as to preclude a finding that an auditor is independent,57 the rule gave examples of situations that gave rise to an accountant being "considered not independent."58 The rule also stressed that, in determining whether an accountant is independent with respect to a particular person, the Commission would "give appropriate consideration to all relevant circumstances, including evidence bearing on all relationships between the accountant and that person or any affiliate thereof."59
In our adjudicatory capacity, we have issued decisions over the last six decades finding impaired independence in a variety of factual situations.60 Various releases in which we have proposed and adopted amendments to disclosure items and to Rule 2-01 itself also contain in-depthdiscussions of auditor independence issues.61 We also have issued extensive interpretations specifically designed to assist registrants and auditors in recognizing and evaluating independence questions.62
In addition, Rule 2-02(b)(1) of Regulation S-X requires an auditor's report to state "whether the audit was made in accordance with generally accepted auditing standards [GAAS]." GAAS, in turn, requires that "[i]n all matters relating to the assignment, an independence in mental attitude is to be maintained by the auditor or auditors."63 In keeping with this standard, the senior technical body of the American Institute of Certified Public Accountants ("AICPA")64 issued Statement on Auditing Standards ("SAS") No.1, Section 220, providing that: "[i]t is of utmost importance to the profession that the general public maintain confidence in the independence of independent auditors."65
The AICPA has developed a body of independence standards, set out in its Code of Professional Conduct, that applies to audits performed by its members.66 Auditors look to thesestandards (and to the interpretations and ethics rulings concerning these standards) to determine whether they are independent for purposes of GAAS.67 Ultimately, at least insofar as audits of financial statements of Commission registrants are concerned, however, the Commission retains the responsibility to ensure the development of an independence framework that serves the public interest and protects investors.
Independence traditionally has been understood by the profession to be a state of mind and a matter of character - subjective attributes of integrity, honesty, and objectivity.68 Thus, an individual auditor is said to be "independent in fact" when he or she possesses a mental attitude giving rise to an ability to act with objectivity and integrity.69 As we have recognized, however, "[s]ince objectivity exists only as a state of mind, [and] independence in fact, or the absence of it, is rarely susceptible to demonstrable proof . . . both the appearance and the fact of independence are equally important" under the securities laws.70 In addition, because it is vital that audits not only produce more reliablefinancial information but also that investors believe that they do, it is critical that auditors appear free of biases and prejudices that may impair their objectivity.71 Indeed, as SAS No.1, Section 220,72states:
Public confidence would be impaired by evidence that independence was actually lacking, and it might also be impaired by the existence of circumstances which reasonable people might believe likely to influence independence. To be independent, the auditor must be intellectually honest; to be recognized as independent, [the auditor] must be free from any obligation to or interest in the client, its management, or its owners.
As a consequence, both we and the AICPA have identified relationships and other circumstances so inherently compromising that they are judged necessarily to impugn independence. When, as a factual matter, such relationships are present, independence "shall be considered to be impaired" under GAAS,73 and an accountant would "be considered not independent" under ourformer Rule 2-01.74 Such relationships must be scrupulously avoided in order to preserve the credibility of audits.75
The questions we address today turn on whether, on the basis of the record before us, there were any such relationships among Peat Marwick, Strategies, Strategies' owner, Olson, and Peat Marwick's audit client, PORTA. As discussed below, we conclude that there were at least two relationships that compromised Peat Marwick's independence. We discuss only relationships that were not the subject of discussion between Peat Marwick and OCA. We need not reach other relationships that are asserted to give rise to independence impairments, because even without reaching them, we conclude that Peat Marwick should be ordered to cease and desist from violating the securities laws.76
IV.
A.
The first relationship we consider is Peat Marwick's debtor/creditor relationship with Olson. Peat Marwick's loan to Olson remained outstanding while Olson was PORTA's president and COO and Peat Marwick was auditing PORTA's financial statements and when Peat Marwick issued its audit report. Peat Marwick concedes that, as a result of this relationship, it was not independent from PORTA.
Former rule 2-01 required auditors and their firms to avoid direct and material indirect business relationships with officers of clients, including borrowing or lending.77 We have stated that these relationships engender a "mutuality or identity of interests with the client [that] would cause the accountant to lose the appearance of objectivity and impartiality . . . ".78 This is so because a reasonable person, knowing that an auditor or his or her firm has a financial stake in the repayment of the loan and knowing that the repayment might be dependent, at least to some extent, on the audit client's continued operation and solvency, would harbor serious doubt about whether the auditor will objectively assess the client's financial condition.79
GAAS is to the same effect. The AICPA Code of Professional Conduct, Interpretation 101-1, states that "[i]ndependence shall be considered to be impaired if, . . . [d]uring the period of a professional engagement or at the time of expressing an opinion," an auditor or his firm "[h]ad any loan to or from" an audit client, or any of its officers, directors or principal shareholders.80 Thisinterpretation establishes what we have called an "absolute prohibition of loans."81 Peat Marwick's loan to Olson violated that prohibition.
Peat Marwick's witnesses admitted -- and on review Peat Marwick admits -- that the loan to Olson impaired Peat Marwick's independence under GAAS. Indeed, one of Peat Marwick's expert witnesses testified that in 25 years of auditing he had "not seen an audit up until this one where the audit firm had a loan to the client."82 Peat Marwick nevertheless attempts to minimize what one witness correctly characterized as "an absolute blatant out-and-out violation of the AICPA Code of Professional Conduct" by characterizing it as a "mistake."83 We agree, but we stress that the "mistake" was serious and arose from Peat Marwick's failure to exercise ordinary care to maintain its independence.
B.
Another set of relationships between and among Peat Marwick, Strategies, and PORTA gave Peat Marwick the right to a fee attributable, in part, to PORTA's financial success. We also conclude that these relationships prevented Peat Marwick from being recognized as independent. As set out above, PORTA's turnaround agreement with Strategies required PORTA to pay Strategies a "success fee" of specified percentages of PORTA's quarterly earnings, disposed inventory, and restructured debt. The portion of the success fee attributable to earnings (five percent of the company's quarterly "earnings before interest taxes") was to be paid "at the end of each quarter during [the] engagement" and for three years thereafter. Strategies, in turn, was obligated to pay to Peat Marwick, on a fiscal quarterly basis in arrears, a royalty fee of five percent of its quarterly consolidated fee income.
Rule 302 of the AICPA's Code of Professional Conduct84 prohibits arrangements under which an auditor has the right to receive a fee that is contingent on the financial success of an audit client. The rule flatly prohibits an auditor from "perfor[ming] for a contingent fee any professional services for, or receiv[ing] such a fee" from a client for whom the auditor performs an audit or review of a financial statement. Peat Marwick ran afoul of that prohibition by "receiving" such a fee within the meaning of the Rule.85
Peat Marwick insists that it did not accept any royalties "once OCA raised a question" about the royalty fee arrangement, and that the success fee/royalty fee arrangements therefore do not support a finding of lack of independence. But, as Peat Marwick's own evidence shows, royalty fees due Peat Marwick for quarters ending after September 30, 1995, were deposited by BayMark in a "separate segregated account" established by BayMark, and the BayMark parties stood ready to make all required payments due under the terms of the license agreement once independence issues were resolved. In any event, whether Peat Marwick chose to avail itself of its right to share in the success fee is beside the point. Under AICPA Rule 302, as interpreted by ethics ruling 17, a contingent fee is deemed received when "the performance of the related services is complete and the fee . . . is determined."86 Thus, it was the relationships between and among Peat Marwick, Strategies, andPORTA permitting Peat Marwick to receive a determinable fee, not the actual receipt of funds, that created the danger of clouding objectivity and impartiality in the audit.
C.
In the respects described above, Peat Marwick established and maintained relationships that impaired independence from its audit client, PORTA. By virtue of its debtor/creditor relationship with Olson, Peat Marwick cannot be recognized as independent from PORTA under former Rule 2-01. We also conclude that the loan to Olson and Peat Marwick's right to share in Strategies' success fee ran afoul of AICPA Code rules aimed at safeguarding independence. Accordingly, these relationships, whether considered individually or collectively, impaired Peat Marwick's independence under GAAS.
Concerning our findings under former Rule 2-01, Peat Marwick argues that the record shows that the audit team was independent "in fact" as evinced by, among other things, the quality of the audit report, the issuance of the going concern qualification, and the fact that the audit team itself had no knowledge of the loan to Olson or of the other features of the alliance structure.87 Peat Marwick's argument misreads former Rule 2-01. Its argument essentially is that independence "in fact" -- the auditor's state of mind -- is to be determined by the outcome of the audit, and not by reference to those circumstances that have been designated by the Commission as inconsistent with independence. If the audit was properly performed, the argument goes, it must follow that the persons who performed it were independent.
This argument, in effect, calls upon us to replace the independence requirement with a "good audit" requirement. The argument assumes that, if the outcome of an audit was acceptable, it followsthat the auditors were objective. Of course, the absence of bias is not demonstrated by an adequate audit, just as an inadequate audit does not demonstrate that the auditor was biased. Rather, the independence requirement is designed to give investors the assurance that the persons examining a registrant's financial statements are capable of exercising objective and unbiased judgment. This assurance is at the core of the independence requirement, since investors are rarely in a position to judge whether, when financial statements are filed with the Commission, they have been subject to rigorous review and are accurate.88
Peat Marwick's argument fails for an additional reason. The circumstances identified in former Rule 2-01(b) as impairing independence were those involving the accountant, "his firm, or a member of his firm." This phrase appeared in subsections (b)(1) and (2), which gave examples of situations in which an accountant would be "considered not independent." Indeed, the situation described in subsection (b)(1) was one in which the accountant's "firm had . . . any direct financial interest or any material indirect financial interest" in an audit client or its affiliates. The rule plainly did not make the question of whether an auditor's independence is impaired because of a relationship between the firm and the audit client depend on an inquiry into what each auditor in the firm knew.89
Finally, it is apparent that some of the circumstances of the alliance did, in fact, have a significant effect on the audit at issue. As we have noted, the fact that Olson and Strategies would provide management services to PORTA was not lost on the audit team: in spite of significant management turnover, they decided not to reevaluate the audit relationship with PORTA, in part because Olson, the new COO, was "with BayMark Strategies" and "came highly recommended" by Peat Marwick's corporate finance personnel.
In another argument pertaining to former Rule 2-01, Peat Marwick contends that findings that its relationships adversely affected its independence would impose on it, without notice, new rules of conduct.90 We disagree. Due process requires only that laws give a "person of ordinary intelligence a reasonable opportunity to know what is prohibited."91 The degree of required noticevaries according to the circumstances.92 In cases such as this one, regulations satisfy due process so long as they are sufficiently specific that a regulated entity "acting in good faith would be able to identify, with ascertainable certainty, the standards with which the agency expects" it to conform "by reviewing the regulations and other public statements issued by the agency."93
We conclude that a reasonably prudent accounting firm would have had fair warning from the face of former Rule 2-01 that we would deem independence impaired when, during the period of an audit engagement, the firm maintained a debtor/creditor relationship with an officer of an audit client. Any doubt could have been resolved by recourse to, among other sources, our published decisions and our codification of financial reporting policies. In sum, our finding that Peat Marwick's relationship with Olson impaired its independence imposes no new rules of conduct.94
We therefore conclude that, by virtue of its lack of independence from PORTA, Peat Marwick violated our Rule 2-02(b)(1)95 by issuing an audit report stating that the audit was conducted in accordance with GAAS, when it was not.96 We also conclude that, because Peat Marwick lacked independence (gauged both by GAAS and former Rule 2-01), PORTA violated Section 13(a) of the Exchange Act and Rule 13a-1, since the financial statements included as part of PORTA's 1995 annual report, were not, as represented, audited by independent accountants.97 We note that each impairment we have found, considered on its own, compromised Peat Marwick's independence and each is sufficient, on its own, to support our finding of violations of Section 13(a) and Rule 13a-1. Similarly, each impairment is sufficient, standing alone, to compromise independence under GAAS and to support our finding of violation of Rule 2-02(b)(1).
V.
We now address whether Peat Marwick should be sanctioned for the conduct we have found. Under Exchange Act Section 21C(a), we may order a person to cease and desist from certain conduct if the person "is violating, has violated, or is about to violate" any provision of the Exchange Act, or anyrule or regulation thereunder.98 The section also authorizes us to order a person to cease and desist from certain conduct if the person "is, was or would be a cause of [a] violation [of the Exchange Act or the rules and regulations thereunder], due to an act or omission the person knew or should have known would contribute to such violation." As we conclude below, Peat Marwick acted negligently, and its conduct resulted both in its primary violation of Rule 2-02 and in its being the "cause" of PORTA's violations of Section 13(a) of the Exchange Act and Rule 13a-1. Because of the unique procedural posture of this case, however, negligence is not sufficient to warrant a conclusion that Peat Marwick engaged in "improper professional conduct" within the meaning of our Rule 102(e). Instead, Peat Marwick engaged in improper professional conduct only if it acted intentionally, knowingly, or recklessly.99
A.
We hold today that negligence is sufficient to establish "causing" liability under Exchange Act Section 21C(a), at least in cases in which a person is alleged to "cause" a primary violation that does not require scienter.100 Therefore, if Peat Marwick acted at least negligently with respect to whether its conduct would contribute to PORTA's violations, Peat Marwick is liable under Section 21C(a) as a cause of those violations.
Ordinarily, the phrase "should have known" used in Section 21C(a) is classic negligence language.101 On the other hand, the meaning of the phrase is flexible and can vary depending on the context.102 Where, as here, the primary violations do not require culpability beyond negligence, we see no reason not to give the phrase its ordinary meaning103 and much that compels us to adhere to that meaning. As we discuss infra pp. 47-49, the legislative history of Section 21C and its parallel provisions shows that it was designed to provide a flexible remedy against persons who commit isolated infractions and present less threat to investors than do persons against whom injunctive relief is sought.104
We also find support for our holding in the construction of an analogous provision of the Exchange Act, Section 15(c)(4).105 Section 15(c)(4) permits us to proceed administratively against a person who is "a cause of [another person's] failure to comply [with certain provisions of the Exchange Act or rules and regulations thereunder] due to an act or omission the person knew or should have known would contribute to the failure." In George C. Kern, Jr., [1988-1989 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶84,342, at 89,591-92 (Nov. 14, 1988), aff'd in part and vacated in part on other grounds, 50 S.E.C. 596 (1991), then-Chief Administrative Law Judge Warren Blair, taking into consideration the language of the section, its legislative history, and its "disclosure philosophy," among other things, held that a negligence standard governs "causing" liability under Section 15(c)(4). A number of commentators suggest that Section 21C's formulation for "causing" liability appears to be derived from Section 15(c)(4).106
B.
Based on our review of the record, we conclude that Peat Marwick acted negligently, but not recklessly, in concluding that it was independent from PORTA. It was unreasonable for Peat Marwick, in the person of Conway, to overlook how the terms of the Strategies engagement with PORTA compromised Peat Marwick's independence. As the head of Peat Marwick's DPP, Conway was in charge of a "group of experts" to whom Peat Marwick professionals were directed to turn for guidance on questions about independence. Specifically, the DPP was charged with dealing with, among otherthings, independence questions that might arise "in the field."107 As Sturm explained, when he had questions of this sort, he would turn first to "the professional literature" and, if he could not ascertain the answer on his own, he would contact the DPP. It was because he could not, on his own, ascertain the answers to his concerns about Olson's relationship with Peat Marwick and PORTA that Sturm repeatedly contacted the DPP. In early December, for example, Sturm asked Trattou whether Peat Marwick's independence would be impaired if, in addition to performing consulting services for PORTA, Olson functioned as its COO and bore the titles of president and COO of the company. As a result of this inquiry, Conway had reasons to be - and initially was - concerned about Peat Marwick's independence from PORTA. As a consequence, he should have taken the steps necessary to resolve Sturm's inquiry appropriately. He did not do so.
As Trattou's December 5 e-mail indicates, Conway was informed about Sturm's December inquiry shortly after Sturm called Trattou. Although it is not clear from the e-mail what Conway was told about the inquiry in particular, or the PORTA situation in general, it is clear that, based on what he did know, Conway "believed" that the "situation [was] not appropriate." On its face, this e-mail demonstrates that Conway was aware that the PORTA situation raised concerns about independence. Indeed, Peat Marwick's close identification with BayMark and its subsidiaries, the subject of ongoing discussion with OCA, rendered the PORTA situation particularly problematic from an independence standpoint, because Strategies would actively manage PORTA and therefore "indirectly [provide] `representations'" to the audit team.108
Because he had these concerns, and because he was the head of Peat Marwick's DPP, Conway had a duty to inquire carefully about the specifics of Strategies' PORTA engagement and to assess diligently whether the audit could proceed. But he did not do so. Instead, Conway simplyasked someone at Peat Marwick to gather information109 about dual engagements and proceeded with his independence assessment on the basis of a skeletal description of the PORTA situation set forth in a brief chart. That chart included only information on the client's name, year-end date, and assets; a summary description of the services Strategies would provide; and an incomplete description of the fees Strategies would earn. The chart was lacking in basic information -- such as the identity of the Strategies employee who would provide the management services.110
Thus, as Conway himself has admitted, he may well not have known many of the critical specifics of the PORTA situation. He should have. Had he known these facts, along with other facts he did know, he would have known that Peat Marwick's independence was impaired. For example, Conway knew that Peat Marwick had loaned money to the BayMark Principals. That fact, with the fact that a BayMark Principal would serve as PORTA's president (a fact Conway should, but may not, have known), would have given rise to immediate and obvious independence concerns.111 Conway did not know these specifics because he was satisfied with an incomplete account of the PORTA situation.
Conway had ready access to multiple sources of information about the PORTA situation - e.g., Vasquez,112 Trattou, and Sturm. Conway failed, however, to elicit material facts from his colleagues,even though he knew that they possessed information pertinent to the independence inquiries he was obligated to resolve. Despite his responsibility to make independence determinations for Peat Marwick, and despite his concerns, Conway simply never thought through the issues in meaningful detail. Conway's conduct, of course, is attributed to Peat Marwick for purposes of this proceeding.
Conway was not the only Peat Marwick employee whose conduct was negligent. For example, although Sturm was responsible for compliance with GAAS in the conduct of the PORTA engagement,113 Sturm failed to take reasonable steps to assure himself that Peat Marwick was independent from PORTA. Although he knew that he did not know enough about Peat Marwick's relationship with BayMark to assess whether it was "okay" for Olson to perform "COO-type" functions for a Peat Marwick audit client, he attempted to discharge his responsibilities under GAAS by relying without question on DPP's and Vasquez' conclusory assurances that independence had not been impaired. From all that appears in the record, Sturm made no inquiry into the specifics of the Peat Marwick/BayMark alliance, even though he had reason to know that Trattou and Vasquez had access to those facts. Had he made any specific inquiry, he would have learned, for example, that Olson, the person performing the "COO-type" functions for PORTA, had a loan outstanding from Peat Marwick. Instead, he simply relied on the blanket assurances of others that the structure of the alliance was such that it obviated independence issues and that the matter had been discussed with the Commission.
Peat Marwick attempts to minimize the seriousness of its employees' negligence by relying on Conway's discourse with Sutton. In our view, Conway's interactions with Sutton support, rather than undermine, our conclusion that Conway (and hence Peat Marwick) acted unreasonably. Although we have accepted the law judge's finding that Conway concluded his conversations with Suttonbelieving that OCA would not assert that Peat Marwick's independence was impaired with respect to the six overlapping engagements, OCA's position was plainly based on the facts as Conway presented them. But Conway did not tell OCA that Olson would be acting as PORTA's president and COO, nor did he tell OCA that PORTA had promised to pay Strategies a success fee under certain contingencies. Conway could not reasonably have believed that OCA was giving Peat Marwick a "free pass" on any and all independence issues that might arise in the course of the six engagements including issues arising from matters that were never discussed with OCA.
Even when Conway and Sturm had the opportunity to reconsider the PORTA situation, in the context of Sturm's call to Conway as the PORTA audit was nearing completion, neither man asked the other enough to elicit the facts each man claims he did not know, even though Sturm knew, for example, that Olson was providing COO services to PORTA, and Conway knew or was on notice that Olson was a Principal of BayMark. Instead, both men simply fell back on Conway's conversation with Sutton and "reconfirmed that the SEC was aware that BayMark was performing the work at PORTA" and hence that Peat Marwick's independence had not been impaired.
In an attempt to explain why he did not "put the pieces together," Conway observed that "all of my focus was on the relationship with BayMark. I mean, I spent all of my time, virtually all of [it] certainly, talking to [Sutton] about the basic relationship with BayMark. I just never focused on the loan." Although this is certainly an accurate description of Conway's interactions with OCA, it hardly excuses his failure to gather, assess, and impart facts about the specific engagement. Conway was concerned enough about the PORTA situation to seek OCA's guidance; he had the obligation to learn and disclose the salient facts about that situation. His failure to do so cannot be justified by his focus on structural issues or on his perception of views expressed by OCA. Without focusing on all the salient engagement-specific facts, Conway was negligent in concluding that Peat Marwick was independent from PORTA.
At the same time, although it is a close question, we are unable to conclude that Conway or Sturm acted recklessly. Conway talked repeatedly with OCA about independence issues raised by the BayMark alliance. Indeed, he put eighteen engagements on hold while he discussed those issues with OCA. There is no direct evidence that Conway was aware of the material facts that he did not raise with OCA, nor is there evidence that he sought to avoid learning them. When he did consider all the facts, Conway "used a four letter word to [himself] saying that [he] was disappointed in [himself] that [he] didn't realize this before." Conway was alarmingly careless in not learning what he needed to know and in not appreciating the significance of what he knew. But his misconduct, we conclude, fell short of recklessness. Similarly, we do not conclude that Sturm was reckless in relying on DPP's assurances. We particularly note that Sturm may have been misled by Trattou into believing that the PORTA situation had been discussed with OCA as Trattou and Sturm had discussed it, e.g., including information that Olson was performing the management functions at PORTA.
We find that Conway and Sturm negligently failed to inform themselves about facts material to specific issues about independence attending the PORTA situation - when both had questions or concerns about the propriety of the audit and had ready access to relevant information. We therefore conclude that Peat Marwick, through Conway and Sturm, necessarily should have known that its conduct would render false its representation that its audit was in accordance with GAAS, thereby violating Rule 2-02(b)(1). We further conclude that Peat Marwick, through Conway and Sturm, also should have known that its conduct would contribute to PORTA's violations of the securities laws within the meaning of Exchange Act Section 21C(a). Because of the unique posture of this proceeding (see supra note 99), however, we are constrained to conclude that Peat Marwick did not engage in improper professional conduct within the meaning of Rule 102(e).
VI.
In determining whether to issue a cease-and-desist order against Peat Marwick, the law judge considered: the egregiousness of the defendant's actions, the isolated or recurrent nature of the infraction, the degree of scienter involved, the sincerity of the defendant's assurances against future violations, the defendant's recognition of the wrongful nature of his conduct, and the likelihood that his occupation will present opportunities for future violations.114
These factors are used by courts in determining whether the Commission has shown a reasonable likelihood of future violation warranting injunctive relief.115 Since we were given cease-and-desist authority in the Securities Enforcement Remedies and Penny Stock Reform Act of 1990 ("RemediesAct"),116 we have not determined whether the Division must show a likelihood of future violations to warrant cease-and-desist relief.117
Our decision to impose any remedial sanction is governed by certain general principles. Within the context of our statutory authority, we have broad discretion in choosing a sanction.118 All that is required is that the remedy we select have a "reasonable relation" to the record before us and to the violations we have found.119 In imposing sanctions, we traditionally have balanced a variety of mitigating and aggravating circumstances, such as the harm caused by the violations, the seriousness of the violations, the extent of the wrongdoer's unjust enrichment, and the wrongdoer's disciplinary record. The questions this case poses are whether, as a matter either of statutory command or in the exercise of our broad discretion, we will require some showing of likelihood of future violations before issuing a cease-and-desist order, and how that showing may be made.
We believe that there must be some likelihood of future violations whenever we issue a cease-and-desist order. The nature of the cease-and-desist remedy almost by definition looks in part to the future. The remedy requires that a wrongdoer "cease" his unlawful conduct and "desist" from such conduct in the future. The forward-looking aspect of the remedy is further evidenced by the authority the statute gives us to impose conditions in cease-and-desist orders to assure future compliance.120 If there is no possible risk of future violation, it is difficult to see the remedial purpose of a cease-and-desist order.121
Though "some" risk is necessary, it need not be very great to warrant issuing a cease-and-desist order. Absent evidence to the contrary, a finding of violation raises a sufficient risk of future violation. To put it another way, evidence showing that a respondent violated the law once probably also shows a risk of repetition that merits our ordering him to cease and desist. Our conclusion is suggested, though not compelled, by the statutory language. The statute specifies that we may impose a cease-and-desist order on a person who "has violated" the securities laws. This contrasts with our authority to seek injunctive relief in those instances when a person "is engaged or about to engage" in violative conduct.122
The public discussion that ultimately resulted in the enactment of our cease-and-desist authority, as well as the legislative history of the Remedies Act, shows that this authority was designed to provide the Commission with a remedy that could be based on a finding of past violation. As far as we are aware, cease-and-desist authority for the Commission was first suggested in 1972 by the late Arthur F. Mathews in a letter to the Commission's Advisory Committee on Enforcement Policies and Practices ("Wells Committee").123 Mathews suggested that a cease-and-desist order remedy similar to that employed by state securities regulators would be a useful remedy "where there does not exist any reasonable likelihood that the person will commit statutory violations in the future."124 The Wells Committee did not adopt Mathews' suggestion.125
A decade later, then-Commissioner Bevis Longstreth, suggested asking Congress for cease-and-desist authority in insider trading cases126 and in 1983, the Commission launched a formal review to study whether it should seek authority to impose administratively a greater range of remedies, including cease-and-desist orders.127 The issue of cease-and-desist authority was again raised in October 1987 by the National Commission on Fraudulent Financial Reporting ("Treadway Commission").128 The Treadway Commission recommended, among other things, that the Commission be authorized "to issue cease-and-desist orders when it finds a securities law violation."129 The Treadway Commission found that cease-and-desist power "would provide increaseddeterrence in . . . financial reporting cases . . . in which the SEC lacks sufficient evidence to demonstrate a reasonable likelihood of future violations."130
On February 1, 1990, then-Chairman Richard Breeden appeared before a Senate committee considering enforcement remedies and requested legislation that would give the Commission authority to issue temporary and permanent cease-and-desist orders. In support of this cease-and-desist power, Chairman Breeden stated that,
On February 9, the Commission submitted to Congress a revised draft of the remedies legislation, which included the new cease-and-desist authority.132
Without further hearings, the Senate Committee on Banking, Housing, and Urban Affairs and the House Committee on Energy and Commerce favorably reported the bill to their respective bodies. Both the House and Senate committee reports on the Remedies Act acknowledged the usefulness of cease-and-desist authority as an "alternative remedy" to an injunction against persons who commit isolated infractions and present a lesser threat to investors.133 Both reports also noted that other agencies have authority to issue cease-and-desist orders, mentioning specifically the CommodityFutures Trading Commission, Federal Trade Commission, National Labor Relations Board, and bank regulatory agencies.134
We have examined the use of cease-and-desist authority by these agencies; their practices do not provide clear guidance. In the case of the National Labor Relations Board, some courts have said that the NLRB must impose at least a cease-and-desist order upon finding that a person has engaged in an unfair labor practice, without regard to any other considerations,135 while other courts have held cease-and-desist orders to be tantamount to an injunction, thus suggesting that the scope of cease-and-desist relief can depend on a finding of likelihood of future violations.136
The Federal Trade Commission's standard for imposing a cease-and-desist order is also unclear. Although Borg-Warner Corp. v. FTC,137 held that the FTC was required to show a "cognizable danger of recurrent violation" in order to impose a cease-and-desist order, the case concerned the unlawfulness of interlocking directorates, and accordingly the court followed the holding in United States v. W.T. Grant Co.,138 the leading case on the subject of interlocking directorates and an injunctive action in federal court.139 Other FTC cases, however, hold that the agency "hasbroad discretion to determine whether . . . [a cease-and-desist] order is needed to prevent resumption of the [violative] practice."140
Federal bank regulatory agencies do not seem to require a finding of a likelihood of future violation before imposing a cease-and-desist order.141 The banking agencies' cease-and-desist authority, however, is somewhat different from ours. It is intended to reverse business practices that may endanger a bank's soundness, whereas ours is intended to prevent resumption of unlawful actions.142
The Commodity Futures Trading Commission, an agency with a mission analogous to that of this Commission, appears to require that its cease-and-desist orders be supported by a reasonable likelihood that misconduct will be repeated.143 This approach appears to have been taken, at leastinitially, in reliance on case law concerning injunctive actions, however.144 Nevertheless, at least one circuit court has held, relying on agency precedent, that, in deciding whether to impose a cease-and-desist order, the CFTC "must determine whether there is a reasonable likelihood that the misconduct will be repeated."145 Another court has required a showing that a violator has a "proclivity" to commit future violations.146
With the experience of other regulatory agencies as an uncertain guide, we rely principally on the language of the Remedies Act and its history. We conclude that, while Congress intended that cease-and-desist orders be forward-looking, like injunctions, it intended that the showing of risk of future violations be significantly less than that required for an injunction. This is a persistent theme of all the discussion leading up to the enactment of the Remedies Act, starting with Arthur Mathews' suggestion in 1972. These comments indicate that, in the ordinary case, a finding of a past violation is sufficient to demonstrate a risk of future ones. Had Congress intended to require more, it would have said as much. And were we to require more, we would frustrate the Congressional purpose ofproviding us with an administrative remedy to use instead of an injunction against persons who pose a lesser threat to investors.147
Along with the risk of future violations, we will continue to consider our traditional factors in determining whether a cease-and-desist order is an appropriate sanction based on the entire record. Many of these factors are akin to those used by courts in determining whether injunctions are appropriate, including the seriousness of the violation, the isolated or recurrent nature of the violation, the respondent's state of mind, the sincerity of the respondent's assurances against future violations, the respondent's recognition of the wrongful nature of his or her conduct, and the respondent's opportunity to commit future violations. In addition, we consider whether the violation is recent, the degree of harm to investors or the marketplace resulting from the violation, and the remedial function to be served by the cease-and-desist order in the context of any other sanctions being sought in the same proceedings.148 This inquiry is a flexible one and no one factor is dispositive. This inquiry is undertaken not to determine whether there is a "reasonable likelihood" of future violations but to guide our discretion.
Applying these factors to the present case, we believe that each of the violations149 we have found today independently calls for cease-and-desist relief.150 Although certain factors, such as the isolated nature of the violations and the lack of demonstrated harm to investors and the marketplace resulting from the violations, tend to counsel against relief, other factors, such as the seriousness of these violations, the wrongdoer's failure to appreciate that seriousness, and, particularly, the forward-looking effect to be served by the cease-and-desist order, all counsel that we grant the requested relief.
Indeed, contrary to the law judge, we consider there to be a serious risk of future violation. Peat Marwick is a Big Five accounting firm whose practice requires it to make independence determinations constantly. Modern multi-disciplinary accounting firms have a wide variety of relationships with third parties. When, as here, a firm enters into complex relationships with other entities that in turn have relationships with audit clients, persons in charge of making independence determinations must exercise particular vigilance. While it is of course appropriate to focus on structural concerns that could impair independence in any and all engagements, such a focus does not excuse a failure to gather, analyze, and assess sufficiently the facts peculiar to each and every engagement.151 Given the lack of care, at senior levels, that attended the determinations at issue here, there is a sufficiently high level of risk of future violations to warrant a cease-and-desist order.
As we have made clear, we consider independence to be a keystone of our disclosure system. In this case, both the engagement partner and the head of Peat Marwick's DPP failed to undertake any reasonable inquiry that necessarily would have led them to discover clear impairments of independence.152 Under these circumstances, we believe that cease-and-desist relief is fully warranted.153
An appropriate order will issue.154
By the Commission (Chairman LEVITT and Commissioners HUNT and UNGER);
Commissioner CAREY not participating.155
Jonathan G. Katz
Secretary
UNITED STATES OF AMERICA
before the
SECURITIES AND EXCHANGE COMMISSION
SECURITIES EXCHANGE ACT OF 1934
Release No. 43862 / January 19, 2001
ACCOUNTING AND AUDITING ENFORCEMENT
Release No. 1360 / January 19, 2001
Admin. Proc. File No. 3-9500
|
In the Matter of KPMG PEAT MARWICK LLP c/o Michael Carroll, Esq. |
: |
ORDER IMPOSING REMEDIAL SANCTIONS
On the basis of the Commission's opinion issued this day, it is
ORDERED that KPMG LLP (formerly known as KPMG Peat Marwick LLP) cease and desist from committing any violation or future violation of Rule 2-02(b) of Regulation S-X, or from being a cause of any violation or future violation of Section 13(a) of the Securities Exchange Act of 1934 or Rule 13a-1 thereunder due to an act or omission KPMG LLP knows or should know will contribute to such violation, by having any transactions, interests, or relationships that would impair its independence under Rule 2-01 of Regulation S-X or under Generally Accepted Auditing Standards (GAAS).
By the Commission.
Jonathan G. Katz
Secretary
Footnotes
1 Peat Marwick has changed its name to KPMG LLP. For purposes of this decision, however, the firm will be referred to as Peat Marwick.
2 17 C.F.R. § 210.2-02.
3 15 U.S.C. § 78m(a) and 17 C.F.R. § 240.13a-1.
4 17 C.F.R. § 201.102(e).
5 15 U.S.C. § 78u-3.
6 The DPP was responsible for resolving certain accounting and auditing issues, including auditor independence issues, for Peat Marwick partners and staff.
7 Perry met with John Riley, then Deputy Chief Accountant, Robert Burns, Chief Counsel, and Roy Van Brunt, then Assistant Chief Accountant.
8 This business alliance was conceived by Thomas E. Vasquez, the partner in charge of Peat Marwick's Corporate Transaction Services Group. Vasquez and others determined that Peat Marwick could expand its business by providing investment banking and financial advisory services to small- and medium-sized businesses. As Vasquez recognized, however, Peat Marwick "fac[ed] tremendous independence issues" in developing such an alliance. For example, Peat Marwick could not "be a broker dealer and be an accounting firm, and [it could not] be an investment banker without being a broker dealer." According to Vasquez and others, the "solution" was to form a "strategic alliance" with another firm that would be newly formed, would have only a "very limited" number of employees, would use the "KPMG" initials, and would employ Peat Marwick's staff and other resources to deliver products and services to clients referred by Peat Marwick.
9 Perry testified that this item was not discussed at the meeting. On the other hand, Riley recalled that Perry said that KPMGCF "may provide certain services to troubled companies" but Riley did not remember discussing the nature of those services and was not certain what they would encompass.
10 According to Vasquez and others familiar with the alliance, Peat Marwick "select[ed] people and form[ed] a group" to run BayMark "that was very consistent with the way that [Peat Marwick] thought about the marketplace and [its] culture." Thus, in 1994, Olson, who was running his own crisis management firm, Ed Olson Consulting Group Ltd., was approached by Vasquez and his (Olson's) attorney, Jim D'Agostino, who "mentioned that they would like to start on a national basis, a crisis management type situation." Vasquez told Olson that he would like Olson to "team up with a partner," Dan Armel, a former partner at Coopers & Lybrand who had done "crisis or consulting work in the past." Vasquez then introduced Olson to Armel and to the persons who would run Capital - Taffet and Maughan. (Before this meeting, Olson did not know and had not even heard of Armel, Taffet, or Maughan. Subsequently, Olson had little interaction with the other three Principals). At the introductory meeting, "it was mentioned that there would be a . . . revolving credit agreement" and that "there would have to be money put into the company." Olson stated that he didn't have money to invest in the company and was told that "there would be a non-recourse personal loan." Following this meeting, Vasquez introduced the BayMark Principals, including Olson, to Merlin Dewing, a recently retired Peat Marwick partner. The Principals decided that Dewing would serve as the chairman of BayMark because he had knowledge of Peat Marwick and its functions.
11 According to a brochure describing the alliance between Peat Marwick and Strategies, Strategies employed eight professionals, including Olson and Armel.
12 The agreement also gave Peat Marwick the right (a) to approve or reject policy and procedures manuals governing such items as the BayMark parties' engagement and client acceptance procedures; (b) to inspect the books and records, properties, and assets of the BayMark parties and to conduct audits of relevant books and records to determine that royalty fees had been accurately determined and paid; (c) to assist the BayMark parties in establishing a marketing and communications program reasonably acceptable to Peat Marwick; and (d) to receive and review annual financial statements audited by an independent accounting firm reasonably acceptable to Peat Marwick. In addition, the agreement prevented the BayMark parties from entering into any joint venture, partnership, or similar arrangement without the express written consent of Peat Marwick. It also provided that, should the control of the BayMark parties' equity interests change without the express prior written consent of Peat Marwick, Peat Marwick could terminate the agreement.
13 During the relevant period, the credit lines were increased and Strategies, for example, ultimately borrowed an amount exceeding $3 million.
14 Although, as we describe below, Peat Marwick subsequently had a series of meetings with OCA about the strategic alliance, it did not supply a copy of the license agreement to OCA. A copy of the agreement was included with Capital's application for registration as a broker-dealer filed with the National Association of Securities Dealers, Inc. ("NASD"). Market Regulation staff obtained a copy from the NASD in mid-November 1995 and forwarded it to OCA. At this point, OCA learned that the $5 million loan mentioned in the September 1994 meeting was actually a loan of $100,000 to each of the four Principals and two revolving credit agreements totaling $4.6 million.
15 The other members of the OCA staff in attendance were Burns, Van Brunt, and Scott Bayless, then Assistant Chief Accountant. A staff member in the Division of Market Regulation also attended the meeting.
16 The POB is an oversight board established by the SEC Practice Section of the American Institute of Certified Public Accountants ("AICPA") to monitor and evaluate, among other things, the activities of the Section's peer review and executive committees. The AICPA is the national membership association for certified public accountants in the United States.
17 In this meeting, as in the preceding meeting and those that would follow, the participants focused primarily on these aspects of the structure of the alliance. To the extent that they discussed specific services, the participants focused not on the entire range of services that BayMark's subsidiaries would provide to clients, but instead on those services that would be provided by Capital (i.e., investment banking and brokerage services).
18 During the meeting, Sutton and others asked questions about the strategic alliance. Thosequestions -- about the nature of the royalty fee arrangement, the terms of the license and loan agreements, and the nature of the services Peat Marwick expected to provide to BayMark clients as a subcontractor -- were addressed (again in a summary fashion) by Perry in a November 6, 1995 letter to Sutton. Illustrative of the summary nature of that letter is its treatment of Peat Marwick's loans to the BayMark Principals: "KPMG has extended a total of $5 million in loans to BayMark and its owners with a scheduled maturity of five years." Before the law judge, Perry explained that he "had no details" about the loans.
19 At all relevant times, PORTA's stock was registered with the Commission under Section 12(b) of the Exchange Act, 15 U.S.C. § 78l(b), and was traded on the American Stock Exchange, Inc.
20 According to an audit completion memorandum signed by Sturm, among others, Olson was hired by PORTA "[t]hrough an introduction made by Len Sturm." Thus, while Olson testified that he acquired PORTA as a client by virtue of his own research, the record discloses that Peat Marwick played a significant role in securing the PORTA engagement for Strategies.
21 PORTA agreed to pay to Strategies: five percent of its quarterly "earnings before interest taxes" at the end of each quarter during the engagement and for three years immediately following the end of the engagement; one percent of the face amount of disposed inventory; and one-half percent of the face amount of total debt restructured or modified, excluding debentures. At the outset of the engagement, Strategies anticipated that the success fee would total $1.5 million. Ultimately, after Strategies was restructured into two new firms, one of the new firms, Dominion Management, LLC, another entity in a strategic alliance with Peat Marwick, received between $400,000 and $500,000 as a success fee.
22 Olson resigned as PORTA's president and COO twelve months after the engagement began.
23 At this point, Sturm was not aware that Olson had an ownership interest in BayMark and Strategies. As far as Sturm understood, Olson was merely an employee of BayMark.
24 See supra notes 8 and 10.
25 Sutton and Burns attended the meeting, as did A.A. Sommer, Jerry Sullivan, and Donald Kirk of the POB.
26 Conway's notes state: "SEC [therefore] says: can't audit SEC registrants who use BayMark if BayMark's services (or arrangements, equity ownership, contingent fees, etc.) are precluded for auditor." Conway testified that these notes reflected not what was actually said at the meeting but rather what he deduced, based on what was said, about the conclusions OCA might reach if "we couldn't get our issues resolved." Even if this were so, Conway's notes demonstrate that he was aware that Peat Marwick's independence from those audit clients that had or would engage BayMark's subsidiaries was subject to substantial doubt.
27 There is no evidence that Peat Marwick imparted to OCA the information provided by Sturm.
28 Sutton and Burns attended the meeting, as did a number of other Commission staff members. Perry was absent.
29 Pitt argued, on behalf of Peat Marwick, that Peat Marwick was independent "in fact" from audit clients that engaged Strategies and Capital and that the Commission's independence standards did not cover "appearance" of independence. Even if they did, Pitt argued, a person informed about the facts would conclude that Peat Marwick's independence was not impaired.
30 It also appears that, at this meeting, there was some general discussion of loans to BayMark Principals.
31 OCA also considered requiring that the revolving lines of credit be canceled and that all outstanding obligations be refinanced through another lender. Ultimately, Sutton chose not to insist on this condition.
32 According to Conway, Vasquez was in Conway's office during the telephone conversation and an e-mail that Conway wrote reflects that Vasquez supplied at least some of the information concerning the revolving credit arrangements discussed in that conversation.
33 It is not clear whether these dual engagements were discussed on December 26, 28, or on both dates. After careful scrutiny of Sutton's, Conway's, and Burns' notes and the participants' testimony about these meetings, we conclude that these engagements were discussed on December 26 and, possibly, on December 28 as well.
34 Conway testified that, at this point, Peat Marwick was "not referring any other work to BayMark. That as I had indicated to Mike Sutton, other than those six engagements that were in process, there were eighteen on hold. So, for all practical purposes, we had shut down operations with BayMark."
35 During the hearing, Conway could not recall whether the chart was prepared by "somebody" in the DPP; he remembered only that it was prepared by "somebody" at Peat Marwick. Conway used the chart, dated December 20, 1995, in preparing for the December 26 meeting with Sutton.
36 In the notes he prepared in anticipation of his meeting with Sutton, Conway put it this way: "[n]eed to finish engagements contracted for - both BayMark and Peat Marwick . . . [n]eed to resolve ASAP -- This week."
37 We do not find, as Sutton recalled, that Conway simply reported the existence of ongoing BayMark engagements. And, although Sutton testified that he did not remember Conway describing any audits as ongoing, we further find, primarily on the basis of Conway's notes, that Conway described the situations as dual engagements - i.e. that the BayMark subsidiaries were providing services to clients Peat Marwick was or would soon be auditing.
38 The chart described the PORTA situation as follows: PORTA was identified as the "Active SEC Attestation Client"; its year-end date was identified as 12/31; its total assets were said to amount to $85 million; the type of BayMark engagement was described as "Strategies/Acting as President"; and the transaction value of the BayMark engagement was estimated to be $12,000/month for 15 months. The other five dual engagements involved Capital and its provision of investment banking and brokerage services to audit clients.
39 Conway testified that he was "not even sure" that he knew these facts when he talked with Sutton in late December, although "perhaps" he knew that a BayMark Principal was the person providing the management services. Of course, as the content of Conway's conversations with Sutton shows, Conway knew that Peat Marwick had loaned $400,000 to the BayMark Principals. Indeed, he received and, in anticipation of his first meeting with Sutton, reviewed a copy of the November 6 correspondence from Perry to Sutton stating that Peat Marwick had loaned money to the four Principals of BayMark, that two of those Principals had over 45 years of management/bankruptcy experience, that Strategies provided corporate managementturnaround and bankruptcy services, and that Strategies employed only seven professionals. He also reviewed a copy of the September 29 correspondence from Perry to OCA stating that Olson (who was described as having "operational expertise" and being experienced in the area of corporate turnaround consulting) was an owner of BayMark. Conway testified that not until May 1996 (when a lawyer for Peat Marwick informed him of the loan) did he put the "pieces" of information together that would have led him to understand that the firm had a loan to an officer of an audit client.
40 On the basis of Sutton's, Conway's, and Burns' notes and relevant testimony, we find that Sutton's notes accurately reflected the substance of Conway's description of the PORTA situation as the provision of top level management, not as management consulting as Sutton recalled, or merely "involvement" in operations as the Division contends.
41 Although there had been some indication in earlier meetings that BayMark might earn contingent fees in connection with engagements, nothing in the record suggests that Conway disclosed to Sutton that Strategies would be earning a "success fee" in connection with its PORTA engagement. At oral argument, we repeatedly asked counsel for Peat Marwick whether Conway informed Sutton about the success fee PORTA would pay to Strategies. Counsel repeatedly answered "yes" and in one instance explained that OCA had been provided with the license agreement and, indeed, "all the documentation" in 1995. This answer is not accurate. It confuses the question whether OCA knew about the success fee PORTA agreed to pay Strategies (under their turnaround agreement) with the question whether OCA knew about the royalty fee Strategies agreed to pay Peat Marwick (under their license agreement). In addition, it confuses the question of whether one or both of these arrangements was structured as a contingent fee with the question whether, when both arrangements are considered together, they resulted in Peat Marwick's receipt of a contingent fee. While OCA did obtain a copy of the BayMark/Peat Marwick license agreement from the Division of Market Regulation (not from Peat Marwick) (see supra note 14), it was Strategies' turnaroundagreement with PORTA that contained the provision for a "success fee." Neither Peat Marwick nor anyone else provided OCA with a copy of that turnaround agreement until PORTA's 10-K was filed with the Commission in 1996. Nor did Peat Marwick (or anyone else) disclose to OCA the bulk of that agreement's contents (including the success fee provision) before the filing of the Form 10-K. Both royalty fee and success fee arrangements existed in this case and, as we discuss below, the question is whether, when both arrangements are considered together, they resulted in Peat Marwick's receipt of a contingent fee.
42 Sutton stated that he would not have been surprised, however, to learn that the audit was being conducted at that time, because he was aware that many audits of public companies are calendar year-end engagements.
43 Conway testified that this portion of his e-mail reflected his belief that, when Sutton received approval for the agreement Conway and Sutton had worked out, Peat Marwick should begin its discussions with staff in the Division of Market Regulation.
44 At around the time the audit began, no one from Peat Marwick informed Olson that the Commission had voiced concerns about the BayMark/Peat Marwick alliance nor that any agreement had been reached to modify the alliance. Indeed, it was not until July 1996 that Olson was made aware that he should repay the $100,000 loan from Peat Marwick.
45 The Form 10-K did not disclose that Peat Marwick had loaned money to Olson. Moreover, although the turnaround agreement was attached to the Form 10-K and, therefore, the success fee to be paid to Strategies was disclosed, the fact that Strategies was obligated to a pay a percentage of its fee income to Peat Marwick was not.
46 Conway also told Sturm that the "KPMG" initials were in the process of being removed from BayMark's name, but the change would not be effective until BayMark had its annual meeting.
47 Van Brunt and Bayless, as well as staff members from the Division of Market Regulation, participated in the call.
48 Sutton, Burns, Van Brunt, Bayless, and Michael Kigin of OCA attended the meeting, as did George Diacont of the Division of Enforcement.
49 A second audit, paid for by Peat Marwick and conducted by another auditing firm, reached the same results as did Peat Marwick in its audit.
50 Accounting Series Release ("ASR") 296 (Aug. 20, 1981), published in Codification of Financial Reporting Policies ("FRC"), § 601.01, 7 Fed. Sec. L. Rep. (CCH) ¶73,251, at 62,882; see General Accounting Office, The Accounting Profession, Major Issues: Progress and Concerns 26 (Sept. 1996) ("GAO Report").
51 From its inception, the Commission consistently has emphasized that auditor independence is critically important to the efficient functioning of the nation's securities markets, which depend on a continuous flow of reliable financial information. E.g., Cornucopia Gold Mines, 1 S.E.C. 364, 367 (1936) (insistence on certification by independent public accountant "signifies the real function which certification should perform . . . [:] the submission to an independent and impartial mind of the accounting practices and policies of registrants . . . to the end that . . . security holders will be protected against unsound accounting practices and procedure and will be afforded . . . the truth about the financial condition" of the issuer); Revision of the Commission's Auditor Independence Requirements, Exchange Act Rel. No. 43602 (Nov. 21, 2000), __ SEC Docket __, __ (stating that independent auditors have "an important public trust . . . . [T]he auditor's opinion . . . furnishes investors with critical assurance that . . . financial statements have been subjected to a rigorous examination by an objective, impartial, and skilled professional, and that investors, therefore, can rely on them").
52 ASR 296, FRC § 601.01, 7 Fed. Sec. L. Rep. (CCH) ¶73,251, at 62,882.
53 For example, registration statements filed under the Securities Act of 1933 must be accompanied by financial statements certified by an independent public or certified accountant. See ¶¶25 and 26 of Schedule A, 15 U.S.C. § 77aa(25) and (26). In addition, Sections 12(b) and 13(a) of the Securities Exchange Act of 1934, 15 U.S.C. §§ 78l(b) and 78m(a), provide that the Commission may require registrants by rule or regulation to file financial statements certified by independent public accountants as part of, among other things, periodic reports. Other provisions of the federal securities laws also recognize the importance of independent audits. See, e.g., Section 17(e) of the Exchange Act, 15 U.S.C. § 78q(e) (requiring registered brokers and dealers to file annually with the Commission financial statements certified by independent public accountants); Section 17(f) of the Investment Company Act of 1940, 15 U.S.C. § 80a-17(f) (authorizing the Commission to require periodic inspections by independent public accountants of registered management companies); Section 30(g) of the Investment Company Act, 15 U.S.C. § 80a-29(g) (authorizing the Commission to require investmentcompanies to file annual reports accompanied by financial statements certified by independent public accountants); and Section 203(c) of the Investment Advisers Act of 1940, 15 U.S.C. § 80b-3(c) (authorizing the Commission to require applications for investment adviser registration to include financial statements certified by independent public accountants).
54 As we have stated, the federal securities laws make "independent auditors the `gatekeepers' to the public securities markets. This statutory framework gives auditors both a valuable economic franchise and an important public trust. Within this statutory framework, the independence requirement is vital to our securities markets." Revision of the Commission's Auditor Independence Requirements, Exchange Act Rel. No. 43602 (Nov. 21, 2000), __ SEC Docket __, __ (citation omitted).
55 See, e.g., Securities Act § 19(a), 15 U.S.C. § 77s(a), and Exchange Act § 3(b), 15 U.S.C. § 78c(b).
56 17 C.F.R. § 210.2-01. On June 30, 2000, we published a proposal to amend this rule (Proposed Revision of the Commission's Auditor Independence Requirements, Exchange Act Rel. No. 42994 (June 30, 2000), 72 SEC Docket 2384) and on November 21, 2000, we adopted amendments. See Revision of the Commission's Auditor Independence Requirements, Exchange Act Rel. No. 43602 (Nov. 21, 2000), __ SEC Docket __. Of course, the rule as it existed and was interpreted before this amendment governs our decision in this proceeding.
57 As a practical matter, an auditor's independence may be assessed only by evaluating relevant relationships with the audit client. It would be a rare situation in which direct information concerning an auditor's mindset was available.
58 17 C.F.R. § 210.2-01(b). The rule also set out other examples of situations in which "independence will not be deemed to be affected adversely." Id. Thus, as commentators have recognized, the concept of "appearance of independence" can be traced to the very first enactment of the rule. By using the word "considered," for example, the rule from its outset "officially introduced into the concept of independence as it applied to the accounting profession . . . the element of appearance, in addition to the element of actuality." 2 John L. Carey, The Rise of the Accounting Profession to Responsibility and Authority: 1937-1969, 176-177 (American Inst. of Certified Pub. Accountants 1970). Thus, as commentators have recognized, this Commission has, from its beginning, refused to accept "`certificates' from auditors whose relations with clients would appear to the public to create conflicts of interest." Id. at 180.
59 17 C.F.R. § 210.2-01(c).
60 E.g., Cornucopia Gold Mines, 1 S.E.C. at 364 (determination that auditor was not independent because, among other things: (a) person in charge of audit simultaneously was made comptroller of registrant and (b) firm received set fee plus one percent of registrant's sales of certain products for one year); A. Hollander & Son, Inc., 8 S.E.C. 586 (1941) (among other things, stockholdings in registrant and loans to and from registrant's officers and directors precluded auditor from being regarded as independent); South Bay Indus., Inc., 42 S.E.C. 83 (1964) (accountant's equity interest and positions as promoter, vice president, and director of a company co-owned by officer of audit client compromised independence); Russell Ponce, Exchange Act Rel. No. 43245 (Aug. 31, 2000), 73 SEC Docket 442 (unpaid fees for prior services rendered auditor lacking in independence), appeal docketed, No. 00-71398 (9th Cir. Nov. 1, 2000).
61 See Office of the Chief Accountant, Securities and Exchange Commission, Staff Report on Auditor Independence, 20-34, 36-37 (1994) (discussing releases) ("Staff Report").
62 These interpretations (including illustrations of situations that have involved questions of independence) are collected in Section 600 of the FRC under the heading entitled "Matters Relating to Independent Accountants" and are published in 7 Fed. Sec. L. Rep. (CCH) ¶73,251, et seq. The codification is meant to provide guidance to registrants, independent public accountants, and others in complying with the Commission's requirements relating to financial reporting. See Financial Reporting Release ("FRR") 1 (Apr. 15, 1982), 7 Fed. Sec. L. Rep. (CCH) ¶72,401, at 62,021. Our amendment to Rule 2-01 brings together much of the Commission's precedent, including much of Section 600 of the FRC, into the text of the rule.
63 AICPA Professional Standards, Vol. 1, AU § 150.02 (June 1, 1996). Citations to GAAS, Statements on Auditing Standards, the AICPA Code of Professional Conduct, and the interpretations and ethics rulings regarding Code rules, are to text current as of June 1, 1996.
64 See supra note 16.
65 AICPA Professional Standards, Vol. 1, AU § 220.03. Interpretations of GAAS are issued as Statements on Auditing Standards by the Auditing Standards Board - the entity designated by the AICPA to issue pronouncements on auditing matters.
66 The Commission has referred registrants and their auditors to AICPA standards to the extent that they do not conflict with those of the Commission. FRR 50 (Feb. 18, 1998), 7 Fed. Sec. L. Rep. (CCH) ¶72,450, at 62,308. In some instances, the Commission's interpretiveguidance has been more expansive or more explicit than the AICPA's. See Staff Report, supra, at Appendix II (discussing the then-current differences between AICPA and Commission auditor independence standards). Thus, conduct that does not run afoul of GAAS may nevertheless be inconsistent with Rule 2-01(b).
67 SAS No. 1 provides that "[i]nsofar as . . . precepts [to guard against the presumption of loss of independence] have been incorporated in the [AICPA Code of Professional Conduct], they have the force of professional law for the independent auditor." AICPA Professional Standards, Vol. 1, AU § 220.04. According to expert testimony in this proceeding, this means that "the way you determine whether you are independent or not [for purposes of GAAS] is by [consulting] the rules in the Code of Professional Conduct."
68 Carey, supra at 175.
69 See, e.g., id. at 179.
70 Qualifications and Reports of Accountants; Proposed Amendment of Rules Regarding Independence of Accountants, Exchange Act Rel. No. 19137 (Oct. 14, 1982), 26 SEC Docket 559, 560; see, e.g., A. Hollander & Son, Inc., 8 S.E.C. at 613 (stating that "one of the purposes of requiring a certificate by an independent public accountant is to remove the possibility of impalpable and unprovable biases which an accountant may unconsciously acquire" because of certain relationships with clients); SEC, Tenth Annual Report of the Securities and Exchange Commission 205 (1944) (stating that the Commission "has viewed the requirement of independence not only as a safeguard against conscious falsification but also as a preventive of impalpable and improvable biases . . . which may arise as a result of incompatibleinterests or relationships"); ASR 165 (Dec. 20, 1974), FRC § 601.02, 7 Fed. Sec. L. Rep. (CCH) ¶73,252, at 62,882 (stating that independence "in fact and appearance is an essential ingredient" of the disclosure system); ASR 296, FRC § 601.01, 7 Fed. Sec. L. Rep. (CCH) ¶73,251, at 62,881 (stating that an auditor "is deemed to be independent if he is independent in fact and if he appears to be independent. He must act in an unbiased and objective manner and he must be free of any . . . interest which would create the perception that he may not be independent").
71 See United States v. Arthur Young & Co., 465 U.S. 805, 819 n.15 (1984) ("If investors were to view the auditor as an advocate for the corporate client, the value of the audit function itself might well be lost"). See also GAO Report, supra, at 37 ("The auditor must be independent in both fact and appearance so that the results of the auditor's examination are perceived to be fair and impartial").
72 AICPA Professional Standards, Vol. 1, AU § 220.03 (emphasis omitted).
73 AICPA Professional Standards, Vol. 2, ET §101.02.
74 See, e.g., 17 C.F.R. § 210.2-01(b) and supra note 58. By the use of the introductory words "for example" our rule made it clear that "relationships which would prevent an accountant from being independent in fact" include, but are not limited to, the relationships set forth in the rule. ASR 44 (May 24, 1943), [1937-1982 Accounting Series Releases Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶72,062, at 62,134 (amending the rule to insert the words "for example" at the beginning of the second sentence of paragraph (b)). In circumstances where the relationship at issue is not otherwise delineated, the basic test that has emerged from our pronouncements is: whether a reasonable investor, knowing all relevant facts and circumstances, would perceive an auditor as having neither mutual nor conflicting interests with its audit client and as exercising objective and impartial judgment on all issues brought to the auditor's attention.
FRR 50, 7 Fed. Sec. L. Rep. (CCH) ¶72,450, at 62,307-08; see Staff Report, supra, at 2.
75 See, e.g., AICPA Professional Standards, Vol. 2, ET § 55.01 ("Independence precludes relationships that may appear to impair a member's objectivity in rendering attestation services").
76 We wish to make clear, however, that, depending on how they are structured and their practical consequences, so-called "strategic alliances" can raise serious independence issues. In not reaching the independence issues raised by the BayMark alliance, we state no view whether the alliance passed muster under Rule 2-01(b) as then in effect, much less under our recently amended rule. We further remind accountants that they have a non-delegable responsibility to assess their independence.
77 See, e.g., FRC § 602.02.g, 7 Fed. Sec. L. Rep. (CCH) ¶73,272, at 62,905 (stating that direct and material indirect business relationships -- such as those between a creditor and debtor (see example 2, FRC § 602.02.g) - with a client or with persons associated with the client in a decision-making capacity, such as officers, "will" adversely affect the accountant's independence with respect to that client); see also Harmon R. Stone, 41 S.E.C. 532, 536 (1963).
78 FRC § 602.02.g, 7 Fed. Sec. L. Rep. (CCH) ¶73,272, at 62,905; cf. A. Hollander & Son, Inc., 8 S.E.C. at 615-616 (viewing loans that accountant extended to, and made from, officers of audit client to "constitute additional evidence of the accountant's lack of independence" and stating that an "accountant's interest as a lender in seeing to it that the borrower is able to repay the loan may be a potent factor in depriving the accountant of this independence").
79 See FRC § 602.02.g, 7 Fed. Sec. L. Rep. (CCH) ¶73,272, at 62,905; cf. Harmon R. Stone, 41 S.E.C. at 536.
80 Rule 101 of the AICPA Code of Professional Conduct provides that a "member in public practice shall be independent in the performance of professional services . . .". AICPA Professional Standards, Vol. 2, ET § 101.01. Interpretation 101-1 lists certain transactions, interests, or relationships that give rise to an accountant's independence being"considered to be impaired." Loans to or from an audit client and persons closely associated with the client (officers, directors, and principal shareholders) are included in this list. AICPA Professional Standards, Vol. 2, ET § 101.02.
81 Moore Stephens, P.C., Exchange Act Rel. No. 41425 (May 19, 1999), 69 SEC Docket 2469, 2482 (settled case).
82 Other testimony was consistent. Another expert retained by Peat Marwick to testify in this case, who had been an auditor for over 30 years and who had participated in approximately 100 audits, acknowledged, for example, that he had never participated in an audit in which he or his firm had a loan outstanding to an audit client or an officer of an audit client.
83 Peat Marwick elicited testimony below that this impairment was merely "technical" in the sense that it was trivial. We could not disagree more strongly. As noted above, independence requirements serve a vital public interest, and we regard a blatant violation of an unambiguous prohibition as anything but trivial.
84 AICPA Professional Standards, Vol. 2, ET § 302.01. Peat Marwick contends that this rule is not an independence rule and therefore a violation of the rule does not constitute an appropriate basis for finding a lack of independence. We disagree. The examples of independence impairing relationships in Interpretation 101-1 are expressly "not intended to be all-inclusive" and as the Division's expert opined, "[t]his rule has generally been understood by professional accountants to be related to maintaining audit independence." This makes sense: the receipt of contingent fees raises obvious concerns about whether an auditor has a mutuality of interest with its client incompatible with the maintenance of objectivity and integrity in an audit. Peat Marwick also argues, and its expert opined, that the royalty was not a fee paid for services and therefore cannot be considered a contingent fee. But this ignores the fact that the amount of the royalty that Peat Marwick received would have depended on the results of Strategies' management of PORTA's operations.
85 The Division also asserts, without any analysis, that these arrangements impaired Peat Marwick's independence under former Rule 2-01. We reject this assertion.
86 AICPA Professional Standards, Vol. 2, ET § 391.033-034. The receipt of certain commissions is similarly prohibited by Rule 503 (AICPA Professional Standards, Vol. 2, ET § 503.01) and the same test governs when commissions are deemed received as governs contingent fees. Thus, ethics ruling 17 goes on to give an example involving commissions: "if in one year a member sells a life insurance policy to a client and the member's commissionpayments are determined to be a fixed percentage of future years' renewal premiums, the commission is deemed to be received in the year the policy is sold."
87 Peat Marwick asserts that we lack the authority under former Rule 2-01 to sanction for the appearance of lack of independence because the rule used the phrase "in fact independent" and stated that we would give "appropriate consideration to all relevant circumstances" in determining whether a person may in fact be not independent. As explained supra pp. 21-28, however, the rule by its terms embraced the element of appearance, and for many decades we have interpreted the rule (in our adjudicatory decisions, in our codification of financial reporting policies, and in various other formal and informal contexts), to encompass myriad relationships that would cause the reasonable investor to conclude that the auditor is not independent. To interpret the rule otherwise would run contrary to its purpose. Only if investors perceive auditors to be independent will audits perform the critical function of enhancing financial statement credibility.
88 See Bollt & Shapiro, 38 S.E.C. 815, 820 (1959) (that the accuracy and completeness of the registrant's balance sheets was not questioned in the proceedings did not either cure or reduce the importance of the lack of independence by the certifying accountant).
89 In any event, the firm is the "accountant" under these circumstances, since the audit opinion was issued in the firm's name, and it is the firm's independence that is in question.
90 In addition, Peat Marwick claims that it was denied due process when it was "denied access" to "potentially exculpatory documents" it had a right to receive under Brady v. Maryland, 373 U.S. 83 (1963). The apparent basis for this claim is the law judge's refusal to order the Division to search in Commissioners' offices for documents relating to communications between OCA and Peat Marwick. The law judge made this ruling after directing the Division, both orally and in writing, to make available to Peat Marwick all Brady material in the possession, custody, or control of divisions located in the Commission's headquarters. The law judge also relied on the Division's repeated representations (a) that it was aware of the appropriate standards for Brady disclosure (and that it had in fact employed a standard more liberal than required and had turned over favorable documents without regard to their materiality); (b) that it had undertaken a search of headquarters divisions and OCA to identify all disclosable material and had turned over all such material; and (c) that it had reviewed relevant action memoranda from staff to the Commission and was satisfied that there was not Brady material in those memoranda. The law judge was entitled to rely on these representations (see Landry v. FDIC, 204 F.3d 1125, 1137 (D.C. Cir. 2000)), to conclude that the scope of the search was reasonably designed to identify all disclosable material, and therefore to deny Peat Marwick the right to launch a search of the offices of individual Commissioners. Cf. Orlando Joseph Jett, 52 S.E.C. 830, 830-831 (1996) (Brady does not authorize a respondent to engage in fishing expeditions through confidential government material) (citations omitted).
Although, before us, Peat Marwick specifically identifies two such "potentially exculpatory" items, it failed to bring them to the law judge's attention. It failed to do so, even though it had been provided with documents referring to them at least by the time of the hearing on this matter and even though the law judge, after he made his ruling, emphasized that "[s]omething could come up, in which case, things could change." Indeed, he expressly invited Peat Marwick to make a showing that there was information "out there that [the Division] [(]A[)] doesn't know about and maybe with some looking around could find, or [(B)] does know about and is withholding." Since the items were within the scope of the Division's search and since Peat Marwick does not even attempt a plausible showing that they contain favorable and material information, we reject this due process challenge. Cf. Orlando Joseph Jett, 52 S.E.C. at 831 (to obtain in camera review, plausible showing must be made that document in question contains information that is both favorable and material to respondent's defense); Landry v. FDIC, 204 F.3d at 1137 (party's conclusory suspicions are insufficient to impel adjudicator to delve behind government's representation that it has conducted Brady review and found nothing).
91 Grayned v. City of Rockford, 408 U.S. 104, 108 (1972).
92 Village of Hoffman Estates v. Flipside, Hoffman Estates, 455 U.S. 489, 498 (1982).
93 Trinity Broadcasting v. FCC, 211 F.3d 618, 628 (D.C. Cir. 2000) (quoting General Elec. Co. v. EPA, 53 F.3d 1324, 1329 (D.C. Cir. 1995); see Freeman United Coal Mining Co. v. FMSHRC, 108 F.3d 358, 362 (D.C. Cir. 1997) (regulations will be found to satisfy due process "so long as they are sufficiently specific that a reasonably prudent person, familiar with the conditions the regulations are meant to address and the objectives the regulations are meant to achieve, would have fair warning of what the regulations require").
94 Thus, while Peat Marwick appears to argue that our findings would involve us in "retroactive rulemaking," we conclude that Peat Marwick had adequate notice of the grounds of impairment we find in this opinion. Moreover, it is well established that, because we cannot foresee every possible application of rules, we may determine specific applications on a case-by-case basis in adjudication. See Shalala v. Guernsey Mem. Hosp., 514 U.S. 87, 96-97 (1995) ("The APA does not require that all the specific applications of a rule evolve by further, more precise rules rather than by adjudication"); SEC v. Chenery Corp., 332 U.S. 194, 203 (1947) ("[T]he choice made between proceeding by general rule or by individual, ad hoc litigation is one that lies primarily in the informed discretion of the administrative agency"); see also NRDC, Inc. v. SEC, 606 F.2d 1031, 1055 (D.C. Cir. 1979) ("Traditionally, it is the agency, not the court, which determines whether to proceed by rulemaking, by individual adjudication, or by a combination of the two").
95 The Division asserts, without contest, that a showing of negligence or other mental state is not required to prove a violation of Regulation S-X.
96 When an auditor is not independent, "any procedures he might perform would not be in accordance with generally accepted auditing standards, and he would be precluded from expressing an opinion on [financial] statements." AICPA Professional Standards, Vol. 1, AU § 504.09. Accordingly, under those circumstances, GAAS requires an accountant to "disclaim an opinion with respect to the financial statements" and to "state specifically that he is not independent." Id.
97 Section13(a)(2) of the Exchange Act, 15 U.S.C. § 78m(a)(2), permits the Commission to require that certain issuers file annual reports certified by independent public accountants. Rule 13a-1, 17 C.F.R. § 240.13a-1, requires issuers to file annual reports and 17 C.F.R. § 249.310 requires that a Form 10-K be used. Form 10-K (Item 8) in turn requires issuers to furnish financial statements meeting the requirements of Regulation S-X, including the requirement in Rule 2-02 that an accountant's report (defined in 17 C.F.R. § 210.1-02(a) as a document in which an "independent" public or certified accountant sets forth certain information) state whether the audit was made in accordance with GAAS. See also Rule 1-01(a)(2) of Regulation S-X, 17 C.F.R. 210.1-01(a)(2) (directing that Regulation S-X govern "the form and content of and requirements for financial statements required to be filed as part of" annual reports, among other filings).
98 15 U.S.C. § 78u-3(a).
99 When we recently amended Rule 102(e), we stated that, regardless of when the violation at issue occurred, the amended rule would automatically apply in all cases considered after the amendment's effective date, except for trials already underway. Securities Act Rel. No. 7593 (Oct. 19, 1998), 68 SEC Docket 707, 708. In this case, the hearing commenced before Rule 102(e) was amended and, on Peat Marwick's motion, the law judge determined to apply a scienter standard, including recklessness. In giving content to that standard in his opinion (rendered after the rule was amended), the law judge applied the definition of recklessness set forth in the adopting release. Id. at 710 & nn. 36-37. That standard is derived from Sundstrand Corp. v. Sun Chemical Corp., 553 F.2d 1033, 1045 (7th Cir. 1977) and defines recklessness to mean an "extreme departure from the standards of ordinary care, and which presents a danger of misleading buyers or sellers that is either known to the [actor] or is so obvious that the actor must have been aware of it" (internal quotation omitted). Neither party asked to reopen the record or suggested that it would suffer unfair prejudice from the application of this standard. Accordingly, we do not consider whether Peat Marwick engaged in "highly unreasonable" conduct in circumstances in which it knew, or should have known, that heightened scrutiny was warranted as specified in amended Rule 102(e).
Before us, Peat Marwick argues that application of Rule 102(e) would violate due process. Citing Checkosky v. SEC, 139 F.3d 221, 225 (D.C. Cir. 1998), Peat Marwick asserts that "at the time the conduct that was the subject of this proceeding took place, the term `improper professional conduct' as used in the rule simply, as the D.C. Circuit has held, `yields no clear and coherent standard' that would have put Peat Marwick on notice that its conduct was prohibited . . .". Peat Marwick mischaracterizes the Checkosky decision. The court in Checkosky vacated the Commission's decision because the Commission failed in that case to articulate clearly the mental state required to find improper professional conduct. The court did not, however, disavow earlier decisions that the Commission had the power to disciplineaccountants for intentional or reckless misconduct. The high culpability standard applied by the law judge and that we apply today is not novel and had been used in proceedings that predated both Checkosky and Peat Marwick's conduct here. See Albert Glenn Yesner, Exchange Act Rel. No. 42030 (Oct. 19,1999), 70 SEC Docket 2743, 2747 (citing Potts v. SEC, 151 F.3d 810, 812 (8th Cir. 1998), cert. denied, 119 S. Ct. 1574 (1999)).
100 Our holding applies to Exchange Act Section 21C(a) and parallel provisions in the Securities Act of 1933, Section 8A(a), 15 U.S.C. § 77h-1(a), the Investment Company Act, Section 9(f), 15 U.S.C. § 80a-9(f), and the Investment Advisers Act, Section 203(k), 15 U.S.C. § 80b-3(k).
101 See, e.g., Davis v. Monroe County Board of Education, 526 U.S. 629, 642 (1999) (noting that the Court had previously declined to hold a school district liable under Title IX of the Education Amendments of 1972 for failure to react to teacher-student harassment of which it knew or should have known; to do so would have "impose[d] liability under what amounted to a negligence standard"); United States v. Finkelstein, 229 F.3d 90, 95 (2d Cir. 2000) ("should have known" connotes a concept "more akin to negligence than to knowledge"); United States v. Ladish Malting Co., 135 F.3d 484, 488 (7th Cir. 1998) (unelaborated "should have known" jury instruction is the usual formulation in civil negligence cases); Dickey v. Royal Banks of Missouri, 111 F.3d 580, 584 (8th Cir. 1997) ("knew or should known" language is "at home in negligence cases"); Knippen v. Ford Motor Co., 546 F.2d 993, 1003 (D.C. Cir. 1976) ("knew or should have known" is "the language of negligence").
102 See, e.g., Bilden v. United Equitable Ins. Co., 921 F.2d 822, 828 n.7 (8th Cir. 1990) (elaborated "knew or should have known" language in jury instruction correctly imposed recklessness standard); Rolf v. Blyth, Eastman Dillon & Co., 570 F.2d 38, 47 n.16 (2d Cir.1978) (suggesting that "knew or should have known" can constitute a "less strict test" of recklessness).
103 It can be argued that a standard higher than negligence should be applied to limit the reach of the statute and so avoid the spectre of cease-and-desist orders against persons who have little contact with the primary actor. At least in cases such as this one involving non-scienter-based primary violations, however, this concern does not warrant our imposing a standard higher than negligence. If Congress wanted to apply such a culpability standard, it could easily have used different language, for example, language such as that employed in Section 20(e) of the Exchange Act, 15 U.S.C. § 78t(e) (deeming persons who "knowingly provide[] substantial assistance to another person" in violation of Exchange Act provisions to be in violation of such provisions "to the same extent as the person to whom such assistance is provided").
104 Our holding today is consistent with our prior pronouncements (see, e.g., Securities Act Rel. No. 7593 (Oct. 19, 1998), 68 SEC Docket 707, 710 & n.38 (stating that, in certain instances, the federal securities laws subject persons to liability without requiring intentional conduct, giving as an example Section 11 of the Securities Act, 15 U.S.C. § 77k, which allows recovery for negligent conduct, and noting Section 21C and its "knew or should have known" language)), congressional testimony (see Staff Report on Private Securities Litigation: Hearing Before the Subcomm. on Securities of the Senate Comm. on Banking, Housing, and Urban Affairs, 103rd Cong. 49 & n.27 (1994) (written statement of Chairman Levitt that the scope of liability as a "cause" of a violation under Section 21C "would appear to be as broad, if not broader, than aiding and abetting liability" and noting that "knew or should have known" equates with negligence in other contexts)), statements in a number of consent orders, (e.g., Rita L. Schwartz, Exchange Act Rel. No. 42684 (Apr. 13, 2000), 72 SEC Docket 514, 518 (citing Carole L. Haynes, Init. Dec. No. 78 (Nov. 24, 1995), 60 SEC Docket 2294, 2341, for the proposition that the "should have known" language in Section 21C "sets forth [a] negligence standard"); Incomnet, Inc., Exchange Act Rel. No. 40281 (July 30, 1998), 67 SEC Docket 2062, 2070 (same)), commentary (see, e.g., 5D Arnold S. Jacobs, Litigation and Practice Under Rule 10b-5, § 261.05[e][vii] at 11-391(2000) (identifying "should have known" language in cease-and-desist provisions as "a negligence standard" but opining that, in the context of a primary violation of the antifraud provisions of Rule 10b-5, 17 C.F.R. § 240.10b-5, "contribute" ought to be equated to traditional 10b-5 secondary liability theories); William R.McLucas, Stephen M. DeTore & Arian Colachis, SEC Enforcement: A Look at the Current Program and Thoughts About the 1990s, 755 PLI/Corp 283, 323 (1991) ("cause" standard makes relief applicable against "a broader class of persons than the primary violators and aiders and abettors that can be sued in judicial proceedings"); S. Scott Luton, The Ebb and Flow of Section 10(b) Jurisprudence: An Analysis of Central Bank, 17 U. Ark. Little Rock L.J. 45, 67 (1994) ("By employing this `negligence-sounding standard,' the SEC can reach a person who causes securities law violations as long as he `should have known' that an act or omission would contribute to a violation, even if [the] person is neither a primary violator nor an aider and abettor")) and numerous decisions by law judges (e.g., Edward D. Jones & Co., Init. Dec. No. 125 (Apr. 15, 1998), 66 SEC Docket 3086; Carole L. Haynes, supra).
105 15 U.S.C. § 78o(c)(4).
106 See, e.g., Ann Maxey, SEC Enforcement Actions Against Securities Lawyers: New Remedies vs. Old Policies, 22 Del. J. Corp. L. 537, 571 (1997); Ralph C. Ferrara, Thomas A. Ferrigno & David S. Darland, Hardball! The SEC's New Arsenal of Enforcement Weapons, 47 Bus. Law. 33, 59-60 (Nov. 1991).
107 By virtue of his position at Peat Marwick, and as a member of the AICPA's Independence and Behavioral Standards Subcommittee and various other professional groups, Conway was very experienced in identifying and resolving independence questions.
108 Before the law judge, Conway testified that his belief about the propriety of the situation was grounded on two concerns. First, "that was at the time that the staff was raising issues about our relationship with BayMark, and I didn't understand where those issues were going to go." Second, because PORTA was a "troubled company" and Strategies, an entity using the "KPMG" initials, was "going to have someone in there in a key management position, . . . there was some risk to reputation in the event something went wrong." In our view, under the circumstances of this case, Conway's concern that, in the event of audit failure, Peat Marwick would risk its reputation when it got "representations" from a party with whom it had financial ties was equivalent to being concerned that a reasonable person would perceive Peat Marwick to have impaired its independence.
109 Although the record is silent as to the identity of that person, it does disclose that Trattou asked Sturm various questions about the audit Sturm planned to conduct (see infra p.12) and that Sturm was aware that Trattou was "conferring" with Conway about the PORTA situation.
110 As noted above, Strategies employed only seven or eight professionals. Under these circumstances, the identity of the Strategies' employee who was providing the management services to PORTA was highly relevant.
111 Conway also knew that Strategies was obligated to pay five percent of its fee income to Peat Marwick. Inasmuch as Strategies would receive a success fee from PORTA (a fact Conway may not, but should, have known), the royalty fee arrangement gave rise to significant independence concerns.
112 As set out above, Vasquez conceived of the strategic alliance and selected and formed the group that would run the alliance partner. Thereafter, he was kept apprised of the alliance's operations. Thus, for example, Strategies sent him status reports providing the following information about its engagements: client name, status of engagement, category of service provided, amount of fees (and calculation of success fees, if any), BayMark contact, and Peat Marwick contact. Indeed, he was informed about the very engagement at issue in this case. A memorandum addressed to him and dated October 31, 1995, advised that Olson and Van Lanier, another Strategies employee, were directing three "crisis management" engagements,including one that Olson was directing for PORTA. The PORTA engagement was described as beginning on October 31, Strategies functioning as "Interim COO," and yielding fees of "$240,000+" and success fees of "$1.5 mm." The Strategies contact was identified as Ed Olson and a senior manager in Peat Marwick's Corporate Transaction Services Group was identified as the Peat Marwick contact. Vasquez also received copies of significant correspondence and memoranda concerning the alliance. Thus, for example, he was informed about the independence issues arising from the structure of the alliance (and the progress of discussions between OCA and Peat Marwick about those issues) and even was informed (by the December 5 e-mail) about certain independence concerns attending the PORTA engagement. Indeed, Vasquez was physically present in Conway's office during one of the conversations between Sutton and Conway in which independence issues were discussed and he provided information, in response to Sutton's questions, about the loans to the BayMark subsidiaries. It would have been an exceedingly simple matter for Conway to learn the specifics of the Strategies' PORTA engagement from Vasquez.
113 See, e.g., AICPA Professional Standards, Vol. 1, AU § 161.01-.03.
114 71 SEC Docket at 1508 (citing Joseph J. Barbato, 69 SEC Docket 178, 200 n.31 (Feb.10, 1999) (quoting Steadman v. SEC, 603 F.2d 1126, 1140 (5th Cir. 1979), aff'd on other grounds, 450 U.S. 91 (1981))).
115 See, e.g., SEC v. Steadman, 967 F.2d 636, 647-648 (D.C. Cir. 1992) ("[t]he ultimate test of whether an injunction should issue is whether the defendant's past conduct indicates . . . that there is a reasonable likelihood of further violation[s] in the future . . . . The relevant factors we consider . . . include whether a defendant's violation was isolated or part of a pattern, whether the violation was flagrant and deliberate or merely technical in nature, and whether the defendant's business will present opportunities to violate the law in the future" (internal quotations omitted)).
116 Pub. L. No. 101-429, 104 Stat. 931 (1990).
117 Our analysis in this opinion concerning the legislative history of our cease-and-desist authority and the standards governing the issuance of cease-and-desist orders by other agencies is largely similar to that appearing in a law review article entitled "SEC Cease-And-Desist Orders" 51 Admin. L. Rev. 1197 (Fall 1999). At the time that article was published, its author was a member of the Commission staff, and the article grew out of his work as a Commission employee.
118 See Butz v. Glover Livestock Comm'n Co., 411 U.S. 182, 185 (1973) (holding that an agency's choice of sanction is "peculiarly a matter for administrative competence") (internal quotations omitted). See also id. at 187 (holding that a court of appeals erred when it held that an agency could impose a sanction only for intentional and flagrant misconduct when the statute granting sanctioning authority made no reference to intentional misconduct).
119 FTC v. National Lead Co., 352 U.S. 419, 429 (1957).
120 Securities Act Section 8A(a), 15 U.S.C. § 77h-1(a); Exchange Act Section 21C(a), 15 U.S.C. § 78u-3(a), Investment Company Act Section 9(f), 15 U.S.C. § 80a-9(f), and Investment Advisers Act Section 203(k), 15 U.S.C. § 80b-3(k). (providing that a cease-and-desist order may "require [a violator] to comply, or to take steps to effect compliance, with [the securitieslaws], upon such terms and conditions and within such time as the Commission may specify in such order").
121 We also are guided by the general "reasonable relation" requirement. See supra note 119; see also FTC v. Colgate-Palmolive Co., 380 U.S. 374, 394-395 (1965). Thus, for example, when, as we have determined to do in this case (see infra p. 53) we exercise our authority (e.g., Exchange Act 21C(a), 15 U.S.C. § 78u-3(a)) to order a person to cease and desist from "future violations of the same provision, rule or regulation" we have found that person to have violated in the past, our order will extend only to violative acts "the threat of which in the future is indicated because of their similarity or relation to those [past] unlawful acts." NLRB v. Express Pub. Co., 312 U.S. 426, 436 (1941).
122 Compare Securities Act Section 8A(a), 15 U.S.C. § 77h-1(a), and Exchange Act Section 21C(a), 15 U.S.C. § 78u-3(a), with Securities Act Section 20(b), 15 U.S.C. § 77t(b), and Exchange Act Section 21(d), 15 U.S.C. § 78u(d).
But see Section 209(d) of the Investment Advisers Act, 15 U.S.C. § 80b-9(d), and Section 42(d) of the Investment Company Act, 15 U.S.C. § 80a-41(d), which both authorize the Commission to seek an injunction against any person who "has engaged" in violations of the respective statutes. Several cases applying these provisions have required the Commission to demonstrate a "reasonable likelihood of future violations," relying on cases applying the somewhat different language of the injunctive provisions of the Securities Act and Exchange Act. See, e.g., SEC v. Suter, 732 F.2d 1294, 1301 (7th Cir. 1984); SEC v. Keller Corp., 323 F.2d 397, 402 (7th Cir. 1963); SEC v. S&P Nat'l Corp., 360 F.2d 741, 747 (2d Cir. 1966). One court, however, granted an injunction to the Commission relying solely upon the "has engaged" language of Investment Advisers Act Section 209(d). SEC v. Olsen, 243 F. Supp. 338, 339-340 (S.D.N.Y. 1965).
123 Arthur F. Mathews, The SEC and Civil Injunctions: It's Time to Give the Commission an Administrative Cease and Desist Remedy, 6 Sec. Reg. L. J. 345, 345 (1979).
124 Id. at 346.
125 Id.
126 Bevis Longstreth, SEC Battle Against Insider Trading is Worth the Effort, Legal Times, May 10, 1982, at 16 (stating that cease-and-desist remedy would "provide relief from the . . . traditional equitable requirements for obtaining an injunction -- most notably the need to prove the defendant is likely to violate the law again in the future").
127 See Letter from John S.R. Shad to the Hon. Timothy E. Wirth, Chairman, Subcomm. on Telecommunications and Finance of the House Comm. on Energy and Commerce, dated Feb. 22, 1984. See also Irwin B. Arieff, SEC Studying Trio of New Enforcement Tools, Legal Times, Mar. 14, 1983, at 4.
128 Report of the National Commission on Fraudulent Financial Reporting, 63-64 (Oct. 1987). A former Commissioner of this agency, James Treadway, was the Chairman of the Treadway Commission.
129 Id. at 65.
130 Id. at 66.
131The Securities Law Enforcement Remedies Act of 1989: Hearings Before the Subcomm. on Securities of the Senate Comm. on Banking, Housing, and Urban Affairs on S.647 to Amend the Federal Securities Laws to Revise Enforcement Remedies for Civil Violations of Those Laws, 101st Cong. 56-57 (1990) (footnote omitted) (written statement of Richard Breeden).
132 S. Rep. No. 101-337, at 5 (1990); H.R. Rep. No. 101-616, at 39 (1990).
133 S. Rep. No. 101-337, at 18; H.R. Rep. No. 101-616, at 24.
134 S. Rep. No. 101-337, at 19; H.R. Rep. No. 101-616, at 23.
135 See, e.g., IUUAAAIW v. NLRB, 427 F.2d 1330, 1332-1333 (6th Cir. 1970) (holding that the law "commands that when the [NLRB] finds that an unfair labor practice has occurred, `. . . [it] shall issue [a cease-and-desist order]'") (emphasis in original) (citing IWA, AFL-CIO v. NLRB, 380 F.2d 628, 630-631 (D.C. Cir. 1967)).
136 See NLRB v. Ochoa Fertilizer, 283 F.2d 26, 29 (1st Cir. 1960) ("An order, when implemented by us, becomes an injunction"), rev'd on other grounds, 368 U.S. 318 (1961); NLRB v. Lipshutz, 149 F.2d 141, 142 (5th Cir. 1945) ("When sustained by the court, the order is in effect an injunction, hence it must be exact and specific in what it requires or forbids"); cf. Local 1814, ILA, AFL-CIO v. NLRB, 735 F.2d 1384, 1400 (D.C. Cir. 1984) ("The proper scope of a cease-and-desist order is determined only by inquiry into whether the Board could reasonably conclude from the evidence that the order was necessary to prevent further violations").
137 746 F.2d 108, 110-111 (2d Cir. 1984).
138 345 U.S. 629 (1953).
139 See, e.g., SCM Corp. v. FTC, 565 F.2d 807, 812 (2d Cir. 1977) (applying W.T. Grant standard).
140 Deer v. FTC, 152 F.2d 65, 66 (2d Cir. 1945). See Grand Union Co. v. FTC, 300 F.2d 92, 100 (2d Cir. 1962) ("Administrative agencies have a wide discretion to frame orders enjoining continuation of past practices found unlawful"); Zale Corp. v. FTC, 473 F.2d 1317, 1320 (5th Cir. 1973) (stating that courts leave to the FTC's discretion "the question whether the public interest requires the protection of an order in cases where the unlawful practices have been discontinued") (quotation omitted).
141 See, e.g., Interamericas Investments Ltd. v. Federal Reserve Board, 111 F.3d 376, 385-386 (5th Cir. 1997); Saratoga S&L v. Federal Home Loan Bank Board, 879 F.2d 689, 693 (9th Cir. 1989). See also Lindquist & Vennum v. FDIC, 103 F.3d 1409, 1418 (8th Cir. 1997) (holding that "the FDIC need only show proof of misconduct to exercise its power to order a party to cease and desist from that misconduct"); Greene County Bank v. FDIC, 92 F.3d 633, 636 (8th Cir. 1996) ("Proof of misconduct alone entitles the FDIC to invoke its broad cease and desist enforcement powers").
142 The cease-and-desist orders of the banking agencies usually contain detailed plans for avoiding future problems. See First Nat'l Bank of Bellaire v. Comptroller of the Currency, 697 F.2d 674, 681 (5th Cir. 1983) (OCC may only impose a cease-and-desist order where a bank's violative practices have a "reasonably direct effect on a bank's financial stability").
143 See, e.g., In re Mayer, 1998 WL 80513 at *29 (Feb. 25, 1998), aff'd sub nom. Reddy v. CFTC, 191 F.3d 109 (2d Cir. 1999) ("Cease and desist orders are appropriate where there is a reasonable likelihood the conduct will be repeated") (citing In re GNP Commodities, [1990-1992 Transfer Binder] Comm. Fut. L. Rep. (CCH) ¶25,360, at 39,223 (Aug.11, 1992), rev'd on other grounds, sub nom. Monieson v. CFTC, 996 F.2d 852 (7th Cir. 1993)); In re Brody, [1986-1987 Transfer Binder] Comm. Fut. L. Rep. (CCH) ¶23,081, at 32,181 (May 20, 1986) (cease-and-desist order "`is appropriate enforcement tool if there is a reasonablelikelihood that earlier violations will be repeated'") (quoting In re Dillon-Gage, Inc., [1984-1986 Transfer Binder] Comm. Fut. L. Rep. (CCH) ¶22,574, at 30,482-83 (June 20, 1984)).
144 Thus, the first significant CFTC decision on the subject of which we are aware, relying on a decision in an injunctive action, held that, in order to impose a cease-and-desist order, the agency would "look to whether `there is a reasonable likelihood that the wrong will be repeated.'" In re Richardson Securities, Inc., [1980-82 Transfer Binder] Comm. Fut. L. Rep. (CCH) ¶21,145, at 24,647 (Jan. 27, 1981) (quoting CFTC v. British Am. Commodity Options Corp., 560 F.2d 135, 141 (2d Cir. 1977) (citations omitted)). British Am. Commodity Options Corp. was an injunctive action.
145 Reddy v. CFTC, 191 F.3d 109, 125 (2d Cir. 1999) (citing In re Fetchenhier, published as amended in [Current Transfer Binder] Comm. Fut. L. Rep. (CCH) ¶27,055, at 45,016 (May 13, 1997)). It appears that when Fetchenhier addressed "likelihood" of future wrongdoing, however, it did so not in connection with determining whether to issue a cease-and-desist order but in connection with determining whether to deny Fetchenhier's application for registration as a floor trader.
146 Precious Metals Assocs., Inc. v. CFTC, 620 F.2d 900, 912 (1st Cir. 1980) (holding that the CFTC may issue a cease-and-desist order "when the party who commits statutory transgressions is likely to persist in the contumacy in the future, unless restrained" and citing NLRB v. Union Nacional de Trabajadores, 540 F.2d 1, 11 (1st Cir. 1976) for how "proclivity" is shown).
147 Commentators have concluded that the Remedies Act does not require a finding beyond a past violation for us to order cease-and-desist relief. 10 Louis Loss & Joel Seligman, Securities Regulation 4989 (3d ed. rev. 1996) ("An obvious advantage of the administrative cease and desist route in contrast to an injunction is that it does not require the Commission to show a likelihood of future violation"); Gary G. Lynch & James D. Liss, The Securities Enforcement Remedies and Penny Stock Reform Act of 1990, in Securities Enforcement and Penny Stock Reform Act of 1990, at 65, 75, PLI Corp. Law and Practice Course Handbook Series No. 718 (1990) (noting that the Remedies Act "does not require the Commission to find that a violator is likely to violate the law again before issuing a cease and desist order"); Cease-and-Desist Authority May Have Limited Use, SEC Staff Officials Say, 23 Sec. Reg. & L. Rep. (BNA) 369, 370 (1991) (comments of the Division's then Associate Director, to the effect that "the [C]ommission does not have to show the likelihood of future violations with a cease-and-desist order").
148 In some instances, we also may consider the function that a cease-and-desist order serves in alerting the public that a respondent has violated the securities laws.
149 As explained above (supra pp. 36, 44-45), Peat Marwick was not independent as a result of two relationships, each of which, standing alone, compromised Peat Marwick's independence and thereby led to Peat Marwick's primary violation of Rule 2-02 and to its causing violations of Section 13(a) and Rule 13a-1. Either the "causing" violations or the primary violation are sufficient, standing alone, to support cease-and-desist relief.
150 Peat Marwick contends that the order proposed by the Division would be overbroad. The order we will issue encompasses conduct reasonably related to the violations we have found.
151 Peat Marwick argues that it is not considering pursuing an alliance structure similar to that of its BayMark alliance. The risk of future violations, however, arises not so much from the likelihood that Peat Marwick will again rely on the same structure, but that it will again provide the same inadequate level of scrutiny to independence issues.
152 It is apparent that their ignorance may have resulted, at least in part, from a failure among their colleagues, particularly Trattou and Vasquez, to adhere to systems designed to provide assurance that the firm maintained its independence. We expect each firm practicing before usto adopt, implement and maintain a thorough system of quality control policies and procedures to provide it with reasonable assurance that it is conforming with GAAS, including its independence standards, in its audit engagements. GAAS certainly requires as much. See, e.g., AICPA Professional Standards, Vol. 1, AU § 161.02-.03; AICPA Professional Standards, Vol. 2, QC § 10. In this case, it is beyond doubt that Peat Marwick's system failed.
153 In the exercise of our discretion, however, we decline to impose the reporting requirements sought by the Division. In appropriate circumstances a detailed order may be necessary to make a cease-and-desist order effective. In light of the circumstances here, however, we believe that a more limited directive will be sufficient.
154 We have considered all of the contentions advanced by the parties. We reject or sustain them to the extent that they are inconsistent or in accord with the views expressed herein. On July 19, 2000, Peat Marwick sought leave to file a surreply. We hereby grant that request. We deny the Division's request to file a "rejoinder" to the surreply.
155 As reflected in the record, the Secretary's office received notification on September 6, 2000, that Commissioner Carey had determined to recuse himself from participation in any matters concerning this proceeding.