SECURITIES AND EXCHANGE COMMISSION
In the Matter of
CARROLL A. WALLACE, CPA
OPINION OF THE COMMISSION
RULE 102(e) PROCEEDING
Grounds for Remedial Action
Improper Professional Conduct
Partner of accounting firm engaged in improper professional conduct in recklessly failing (1) to plan and supervise adequately two annual audits of an investment company; (2) to maintain an appropriate attitude of professional skepticism regarding management representations; and (3) to obtain sufficient competent evidential material to support statements in the auditors' reports for the two annual audits. Held, it is in the public interest for the respondent to be denied the privilege of appearing or practicing before the Commission as an accountant for one year.
George B. Curtis, of Gibson, Dunn & Crutcher LLP, and James D. Goldsmith, of KPMG LLP, for Carroll A. Wallace, CPA.
Robert M. Fusfeld and Julie Lutz for the Division of Enforcement.
Appeal filed: January 29, 2001
Last brief received: June 27, 2001
Oral argument held: August 7, 2003
Carroll A. Wallace, a certified public accountant and a partner in the Denver, Colorado office of KPMG LLP ("KPMG"), appeals from the decision of an administrative law judge. The law judge found that Wallace engaged in improper professional conduct, as defined by Commission Rule of Practice 102(e),1 by recklessly failing to adhere to applicable standards of professional conduct during the course of the audits by KPMG of the 1994 and 1995 fiscal year-end financial statements of the Rockies Fund ("the Fund"), a closed-end investment company. Wallace was the engagement partner for both audits. Specifi-cally, the law judge found that Wallace failed to plan and supervise the audit, failed to maintain an appropriate attitude of professional skepticism with respect to management representations, and failed to obtain sufficient competent evidential material to support statements in the auditors' reports for the two annual audits. The law judge denied Wallace the privilege of appearing or practicing before the Commission as an accountant for one year.2 We base our findings on an independent review of the record, except with respect to those findings not challenged on appeal.
A. Background. The Fund is a business development company ("BDC") that provides venture capital and management assistance to developing companies.3 In 1994 and 1995, Stephen Calandrella was the Fund's president, chief executive officer, and treasurer. He was also a director of the Fund. The other two directors were not affiliated with Fund management. Calandrella owned over 30 percent of the Fund's common stock. Calandrella was the primary liaison between the audit team supervised by Wallace and the Fund.4
In 1992, the Fund began investing in the predecessors of a company called Premier Concepts, Inc. ("Premier"), a company distributing inexpensive copies of designer jewelry and accessories. From March through June 1994, Calandrella was president and chief executive officer of Premier. Calandrella was also a member of the Premier board of directors from March 1994 through February 1995. During the period encompassed by this proceeding, Calandrella held a substantial number of Premier shares for his own account.
The Fund acquired most of its Premier shares through private transactions. Although some of the Fund's Premier shares were unrestricted and freely saleable to the public, most of its Premier shares carried restrictions on their sale. By the end of 1994, shares in Premier comprised 28 percent of the Fund's reported total assets and 40 percent of its reported securities portfolio. By the end of 1995, Premier securities constituted 12 percent of the Fund's reported total assets and 19 percent of its reported securities portfolio. The Fund's holdings in Premier constituted 11.5 percent of all outstanding Premier shares at the end of 1995.
B. Threshold Issues. Wallace challenges on two distinct grounds the Division's allegations that Respondent's conduct with respect to the Fund's 1994 and 1995 fiscal year financial statements was reckless. Because Wallace's threshold challenges to the standards applied to him are questions of law that set the parameters for examining his conduct, we will examine them first. After considering Wallace's challenges to the basis of this proceeding, we then will examine the facts and the law in connection with the specific allegations of audit failures by Wallace.
Wallace contends that use of the recklessness standard codified in the 1998 amendment to Rule 102(e) is an impermissible retroactive application of the Rule to conduct that occurred in 1995 and 1996. Wallace also contends that, even if the recklessness standard contained in Rule 102(e) is applicable here, it requires the Division to show a type of recklessness that approximates an actual intent to aid in the fraud being perpetrated by the audited company.
The application of Rule 102(e) to Wallace's audit of the Fund is not a retroactive application of a new standard of conduct. As we noted in adopting the amended rule and in prior decisions, we have applied a recklessness standard in Rule 102(e) proceedings predating the rule's amendment.5 The 1998 amendment introduced nothing new with respect to the Commission's longstanding use of that standard. Wallace has no basis for claiming that he was unaware in 1994 that a reckless disregard of professional standards would subject him to liability for improper professional conduct under Rule 102(e) as then in effect.
Wallace contends that, in order to establish that he acted recklessly with respect to the audits of the Fund's financial statements, the Division must show a type of recklessness that approximates an actual intent to aid in the fraud being perpetrated by the audited company. Wallace relies on language in the adopting release for the amendment to Rule 102(e) ("Adopting Release") stating that the term "reckless conduct" as used in Rule 102(e) should mean the same thing as courts have defined recklessness to mean under the antifraud provisions.6
Wallace misconstrues the discussion in the Adopting Release. We adopted the definition used in Rule 102(e) "for purposes of consistency under the federal securities laws" and to highlight that reckless conduct is not merely a heightened form of ordinary negligence, but rather a lesser form of intent.7 However, wespecifically noted in the Adopting Release that the standards of professional conduct are not fraud-based.8
The definition of reckless conduct establishes the mental state that must be shown with respect to conduct that results in a violation of applicable professional standards. The question is not whether an accountant recklessly intended to aid in the fraud committed by the audit client, but rather whether the accountant recklessly violated applicable professional standards.9 Recklessness, then, can be established by a showing of an extreme departure from the standard of ordinary care for auditors.
The Commission and the investing public rely heavily on accountants to assure disclosure of accurate and reliable financial information as required by the federal securities laws. Adherence to applicable professional auditing standards protects the Commission's processes regardless of whether a fraud has been committed because it ensures that certified financial statements of public companies have been audited appropriately. Requiring proof of a mental state approximating an actual intent to aid in the fraud committed by the audited company would conflict with this purpose and fail to protect the Commission's processes from accountants who lack the requisite professional ability to appear before it.
In light of this analysis, we conclude that application of Rule 102(e) to Wallace's conduct in 1995 and 1996 is not an unconstitutionally retroactive application. We further conclude that recklessness under Rule 102(e) does not require a state of mind approximating an actual intent to aid in a fraud perpetrated by an audited company.
C. The Audits. The Fund retained KPMG as its outside auditor for the 1994 audit; Wallace was the engagement partner for KPMG's audits of the Fund from 1991 to 1996, and in that position supervised the entire audit process for KPMG. Andrew Young, a New Zealand chartered accountant since 1991, was the engagement manager for the 1994 audit, in charge of the day-to-day aspects of the audit under Wallace's supervision.10 Young had received a two-day training program regarding SEC-related filings and issues. In 1994, he worked directly under the engagement manager for the 1993 Fund audit. Wallace had personally supervised Young on three or four audits before the 1994 Fund audit. Young was responsible for reviewing the work papers prepared by the audit staff, reviewing the Fund's financial statements and Form 10-K, and managing the audit field work done at the Fund's offices and the audit work done at KPMG's offices. When asked at the hearing how he would evaluate Young's performance on the 1994 Fund audit, Wallace replied that Young's performance on the Fund audit had been "adequate."
Laurel Hammer was the in-charge accountant. She reported directly to Young and was responsible for performing a substantial amount of the audit field work at the Fund's offices, reviewing the Fund's financial statements and Form 10-K, and supervising the work done by Donna Mah, the staff accountant.11Hammer gained three years of internal audit experience after graduating from college in 1990 and before joining KPMG in 1993. Before working on the 1994 Fund audit, she received KPMG training including a three-day course on SEC rules, regulations, and reporting requirements.
Apart from Wallace, the audit staff for the 1995 audit was new to the client. Tanya Terrion was the engagement manager. Wendy Traiger was the in-charge accountant. Although Wallace testified that he was familiar with the training and background of Terrion and Traiger, the record does not describe their backgrounds or training. Brian Campbell was the staff accountant. With the exception of Wallace, none of the 1995 audit team accountants testified at the hearing.
1. The Classification of Premier Securities in the 1994 Financial Statements. It is undisputed that the Fund's 1994 financial statements mistakenly state that all of its Premier shares were unrestricted. In fact, only 750 of 223,250 Premier shares were unrestricted. The audit of the 1994 financial statements did not uncover the misclassification.
The audit plan for the 1994 audit required the auditors to "review client classification of securities for appropriateness" and to perform a 100 percent confirmation of the existence and ownership of all shares of stock listed in the Fund's portfolio. Wallace knew from his experience with the Fund that most of its investments were purchased in private party transactions under circumstances strongly suggesting that most of the shares owned by the fund would be restricted. Wallace and the audit team were also aware of a deficiency letter sent by Commission staff to the Fund at the conclusion of a February 1994 inspection of the Fund ("Deficiency Letter"). The Deficiency Letter addressed, among other issues, recordkeeping failures with respect to classification of restricted securities. In its response to the Deficiency Letter, the Fund undertook to remedy the reported deficiencies. Moreover, after the 1993 audit, KPMG's audit team, of which Wallace was the engagement partner and Young was the in-charge accountant, drafted a letter to Fund management regarding, among other things, deficiencies in the Fund's recordkeeping and internal controls with respect to restricted securities. Although this letter was not given to Fund management, the KPMG audit team discussed it with Fund management after the 1993 audit.
The auditors began their review of securities classification by inquiring as to the remedial steps taken by the Fund in response to the Deficiency Letter. The auditors' review was cursory at best. After consultation with Windy Haddad, a management representative who worked closely with the auditors providing information on the Fund's processes and procedures, Hammer noted in the work papers merely that the Fund "appeared" to be making a "good faith" effort to remedy the noted deficiencies without identifying measures undertaken by the Fund. The audit work papers also reflect that Haddad informed the auditors that TrustCorp, the Fund's custodian (and an affiliate of one of the Fund's shareholders), had custody of all of the Fund's restricted stock.
Accordingly, the auditors asked TrustCorp to provide a report itemizing the number, value, and classification of the shares it held as custodian for the Fund. TrustCorp responded that it held only 750 shares of Premier, all of themunrestricted. This response, together with the knowledge that most of the 223,250 Premier shares owned by the Fund were acquired in private party transactions and that the Fund had a history of recordkeeping failures with respect to securities classification, should have made the auditors skeptical of Haddad's assertion that all restricted Premier shares were held by TrustCorp.
The auditors did not, however, challenge Haddad's assertion. The auditors confirmed the existence of Premier shares securing debts of the Fund and telephonically confirmed with the Fund's General Counsel the existence of Premier shares involved in the settlement of an employment dispute, but they did not inquire of any person other than TrustCorp about the classification of the securities the person held.12 The auditors did not perform any other audit procedures to test whether any of the Fund's other Premier shares were restricted or unrestricted.13
2. The Valuation of Premier Securities.
a. The 1994 Audit. The Fund's 1994 financial statements valued the Fund's Premier shares at $2.25 per share. This valuation was reached first at a meeting of the Board of Directors ("Board") held on January 11, 1995, the minutes of which state that the Board "ratified, adopted, and approved" a consent resolution valuing the Fund's portfolio as of December 31, 1994.14 Attached to the consent resolution was a valuation policy statement describing the valuation procedures ("Valuation Policy"). Exhibit A to the Valuation Policy values the Fund's Premier shares at the "quoted" price of $2.25 per share. The record does not provide any information about the January 11 meeting or the approval by the Board of the consent resolution at that meeting.
According to the Valuation Policy, the Board would value unrestricted securities (defined as those that had an availablemarket price and were publicly traded on a stock exchange) at the "available market price," which term it left undefined. With respect to restricted securities (defined as those restricted as to sale or for which a public market price was not otherwise available), the Valuation Policy said the Board would value unrestricted securities at their cost to the Fund until events or conditions indicated that their value had either increased or decreased.15 The Valuation Policy stated that Board members often played a significant management role in companies whose stock the Fund owned and, consequently, could provide additional insights on the companies' operations and performance.
On February 15, 1995, the entire Board met again to value the portfolio.16 The February 15 meeting reached the same valuation as the January 11 meeting. The minutes of this meeting memorialize only the action items on the agenda and the action taken. They do not identify the valuation method the Board used, the factors the Board considered, or the documentation on whichthe Board relied. The minutes incorporate by reference an attached schedule of investments and stock valuations. The attachment is not included in the record.
Calandrella testified that, at the February 15 meeting, the Board members discussed every investment position of the Fund, weighing all the available information on each company before agreeing on a valuation. But neither Calandrella nor Cliff Neuman, the Fund's outside counsel who also attended the meeting, could recall the discussions in any detail. The law judge found that their assertions that the Board engaged in detailed analysis of the valuations in the schedule were not credible.
In conducting the 1994 audit, the auditors identified valuation of securities as a critical audit area.17 This determination, according to the 1994 Audit Planning Memorandum, was based "upon the judgment involved in determining the value of the investments held by the Fund and the lack of an available market price for those investments." Furthermore, the value assigned by the Board to the Fund's holdings of Premier met the 1994 audit materiality gauge of $33,000.18
The 1994 audit work papers include a document entitled "Audit Approach Document" which sets forth alternate procedures for confirming the Board's valuation. The first was to confirm the market value of investments with a third party source, i.e. "broker, Wall Street Journal, etc." However, if the securities at issue were not actively traded and "no broker price [was] available," the auditors were to review the client's valuationmethodology and evaluate the reasonableness of the procedures used.
In performing the audit, the audit staff made no determination as to whether Premier securities were actively traded.19 However, the staff implemented the first of the two procedures outlined in the Audit Approach Document. They sent letters to TrustCorp and Hanifen Imhoff, Inc. ("Hanifen Imhoff"), a market maker in Premier, asking for confirmation of "the market value" of Premier. The responses from both entities confirmed a "market price" of $2.25 per share. A follow-up conversation with Hanifen Imhoff informed the auditors that the $2.25 price was the bid price on December 31, 1994 in the National Quotation Bureau Inc.'s "pink sheets."
There also appears to have been a minimal, though incomplete, attempt to perform the second procedure. Hammer noted in the work papers that the auditors "examined the support used by the board in determining valuations as considered necessary and available." The work papers do not, however, detail the "support" examined during the audit. As described above, the Board's minutes and valuation consent resolutions do not identify any documents or analysis purportedly used by the Board in reaching its valuation determination. There is nothing in the work papers suggesting that anything else was done to verify the Board's valuation.20
The auditors reviewed and approved the Fund's 1994 Form 10-K filed with the Commission in an unqualified audit report signed by Wallace stating that the auditors had "reviewed the procedures used by the [Board] in arriving at its estimate of value of such investments [without readily ascertainable market values] and [had] inspected the underlying documentation and, in the circumstances, . . . believe[d] that the procedures [were] reasonable and the documentation appropriate." The report stated that the valuation was in accordance with Generally Accepted Accounting Principles ("GAAP"). The Form 10-K described the four methods for valuing the Fund's securities listed in the Prospectus but did not make any specific mention of discounting restricted securities from the public market price of unrestricted shares.
b. The 1995 Audit. The 1995 audit plan again identified investment valuation as a critical audit area due to the lack of available market prices and its materiality to the financial statements. All Premier shares were classified as restricted. Because the Fund had declined in value since the 1994 audit, the audit team determined to lower the audit gauge to $30,000.
The preliminary 1995 financial statements that Fund management provided to the audit team classified the Fund's Premier shares as restricted and valued them at $0.75 per share. The basis for that valuation does not appear in the audit work papers. Wallace testified at the hearing that Calandrella told Wallace that the valuation was, in large part, based upon pricing discussions with an investment bank regarding a possible offering of Premier stock in the summer of 1996. As Calandrella described them, the negotiations were preliminary and the underwriting itself was not certain to succeed. Wallace told Calandrella that he was not comfortable with a stock valuation on such a speculative basis.
Calandrella testified at the hearing that, subsequent to Wallace's rejection of the $0.75 valuation, he told Wallace that the Board would approve a valuation at $0.625. Subsequently, the audit team received from the Fund a consent resolution dated February 1, 1996,21 adopting the Valuation Policy (which wasattached)22 and an attached schedule valuing Premier stock at $0.625 per share. The Fund did not provide any background material supporting the new, lower, valuation. There was no in-person meeting of the Board to value the portfolio as of December 31, 1995, and there are no other records of the discussions, if any, surrounding the Board's approval of the valuation. On the Form 10-K for 1995, the Premier shares are all listed as restricted and all valued at $0.63 per share. The Form 10-K states that this price is the "quoted market value."23
There is no Audit Approach Memorandum detailing specific testing procedures for valuation of the Fund's holdings for the 1995 audit. However, the 1995 Planning Analysis memorandum ("the Analysis Memorandum") noted that investments were recorded at "market value." The Analysis Memorandum specifically notes that Premier "was not doing well," and that due to Premier's poor financial condition the value of its stock had decreased from the preceding year.
The audit work papers include two requests for confirmation of the $0.625 per share price of Premier securities, one sent to TrustCorp and the other to Hanifen Imhoff. These requests were identical to the requests made in 1994 to confirm the market price of Premier when the auditors thought the shares were unrestricted. The confirmation received from Hanifen Imhoff stating that $0.625 was "the year end price" and the confirmation from TrustCorp stating that $0.625 was the "market price" for Premier shares should have been relevant only as a starting place for determining the fair value of the restricted Premier shares.
Wallace assumed that the $0.625 price confirmed by Hanifen Imhoff and TrustCorp represented the closing bid price. He took no steps to confirm that fact.24 He merely noted in the work papers that, although restricted, the Premier shares could besold in a private sale, and that the client had taken the position that the shares should be valued at the quoted bid price "as this is the best indicator of value available." He concluded that this approach did not appear unreasonable "as no better evidence of value exists and because . . . the shares may be sold privately." There is nothing anywhere in the record establishing that the Board made a determination to value the Premier securities at the closing bid price "as the best indicator of value available." The work papers do not identify supporting documents reviewed by Wallace or anyone on his staff pertaining to an analysis of the value of Premier shares.
The 1995 "Completion Memorandum" included in the audit work papers states that the auditors "reviewed and gained an understanding" of the Fund's valuation methodology and noted that valuation "was consistent with prior years." It goes on to state that "unregistered, publicly-held securities" (such as Premier) were "also valued at the quoted bid price, which is consistent with prior years." In fact, use of the quoted bid price for restricted securities is inconsistent with the description in the 1994 Procedures Memorandum, which states that the Board was valuing such securities at cost, unless events including third party transactions (not bid quotes) indicated appreciation in value. The auditors reviewed and approved the 1995 financial statements in an unqualified audit report signed by Wallace stating that, in KPMG's opinion, the valuation policy and the Board's application of that policy were reasonable and in accordance with GAAP.
The Fund's 1995 Form 10-K described the same four valuation methods as described in the Prospectus, but footnote 1(b) noted that, "in the absence of readily ascertainable market values, investments in restricted securities without quoted market prices are carried at estimated fair value . . . [I]nvestments in unrestricted securities and restricted securities with quoted market prices are valued at closing bid price."25
At issue here is Wallace's professional conduct with respect to the 1994 and 1995 audits of the Fund. The Division alleged and the law judge found that Wallace engaged in improper professional conduct with respect to those audits. Specifically the law judge found that, as alleged, Wallace failed to plan and supervise the audits adequately; failed to maintain an appropriate attitude of professional skepticism regarding management representations; and failed to obtain sufficient competent evidential material to support the statements in the auditors' reports. The Division alleged further that the audits materially overstated the asset value of the Fund contrary to the provisions of GAAP, and the law judge so found.
A. Failure to Comply With Generally Accepted Auditing Standards. The first standard of auditing field work requires proper planning and supervision of the audit.26 As the audit engagement partner Wallace was responsible for the overall supervision and conduct of the 1994 and 1995 audits and signed the audit reports. Generally Accepted Accounting Standards ("GAAS") provide that the auditor with final responsibility for the audit is responsible for the supervision of all the accountants working on the audit, which "involves directing the efforts of assistants who are involved in accomplishing the objectives of the audit and determining whether those objectives were accomplished."27 GAAS specifies that the "[e]lements of supervision include instructing assistants, keeping informed of significant problems encountered, [and] reviewing the work performed."28 GAAS provides further that "[t]he extent of supervision appropriate in a given instance depends on many factors, including the complexity of the subject matter and thequalifications of persons performing the audit."29 GAAS required that Wallace review his subordinates' work "to determine whether it was adequately performed and to evaluate whether the results [were] consistent with the conclusions to be presented in the audit report."30
As explained below, Wallace failed utterly to provide the supervision required under the circumstances of the 1994 and 1995 audits. His supervisory failures resulted in the failure of both audit teams to maintain an attitude of professional skepticism and to exercise due professional care in the performance of the audits,31 and the consequent failure to obtain sufficient competent evidential matter as required by GAAS.32
For both audits, Wallace supervised a team that had, for the most part, no prior experience with the client or its business, although Young had worked on the 1993 Fund audit. Young, whose performance on the 1994 audit Wallace rated as "adequate" when he was asked at the hearing, was comparatively inexperienced in the application of U.S. GAAS and GAAP, and had only two days of formal training regarding the Commission's requirements regarding the audit of public companies. Hammer, the in-charge accountant for the 1994 audit was substantially less experienced than Young. The record does not provide the education and background of the accountants on the 1995 audit team. The record does indicate that the accountants on the 1995 team had not worked on previous audits of the Fund. Under these circumstances, Wallace should have exercised heightened supervision of his inexperienced staff. Instead, he spent no more than 10-12 hours on each of the two audits.
Auditors must plan and perform audit tasks with due professional care; that is, auditors must observe the standards of field work and reporting.33 The exercise of due professional care, furthermore, requires an auditor to exercise professional skepticism which requires an auditor not to presume honesty or dishonesty on the part of management but to consider the competency and sufficiency of the audit evidence gathered throughout the audit.34 Accepting management representations regarding the custody of restricted shares of Premier stock without adequate testing, and in the face of audit information at least suggesting the inaccuracy of those management representations, is contrary to the exercise of due care or professional skepticism.
Much of the auditor's work consists in obtaining and evaluating evidential matter regarding the assertions made by the audited company in its financial statements.35 The auditor's objective is to obtain sufficient evidential matter to provide a reasonable basis for forming an opinion regarding the financial statements.36 Wallace allowed the audit team to stop short of gathering the needed evidential matter regarding the Fund's classification of Premier shares in the 1994 financial statements and regarding the valuation of Premier shares in both the 1994 and 1995 financial statements.
Because the GAAS-related audit failures are closely interrelated, we discuss them in the context of the substantive areas in which the audit failures occurred, rather than separately discussing each failure to meet professional standards.
1. Audit Failures With Respect To Classification Of Premier Securities In The 1994 Financial Statements. The audit plan required the auditors to obtain 100% confirmation of the classification of the Fund's Premier securities. The auditors failed to follow their own audit plan. They sought confirmation of classification concerning only TrustCorp's holdings of Premier, even though they sent letters to all the other holders of the Fund's Premier shares. Instead of maintainingprofessional skepticism with respect to management representations, the auditors accepted without question Haddad's assertion that any restricted shares were held by TrustCorp, even though TrustCorp denied that it held any restricted shares.
This failure represented an extreme departure from the standard of ordinary care for auditors. Specifically, the audit team failed to maintain professional skepticism as evidenced by failing to test management representations regarding who had custody of restricted shares. In turn, that failure led to a failure to gather sufficient competent evidential matter. Wallace's supervision was deficient in not detecting the shortcomings of the audit team's work.
Proper supervision by Wallace would have made a difference to the audit because of his experience with the client and the classification issue. Wallace knew from his involvement in the 1993 audit and from the Deficiency Letter that securities classification was a problem area for the Fund. He knew that, because the Premier shares had been acquired in private party transactions, the audit's conclusion that none of the Premier shares were restricted was highly improbable. GAAS required him to review the work performed by his team in reaching the conclusion that no Premier shares were restricted. Had Wallace provided any meaningful review, he would have detected the failure to follow the audit plan.37 The acceptance by the audit team of Haddad's representation without additional testing, and despite the highly questionable results from TrustCorp, was a failure to maintain professional skepticism for which GAAS holds Wallace, as the engagement partner, responsible.38
Having accepted as true the Fund's representations regarding restricted shares, the audit team failed to ask other holders of Premier shares to identify the classification of those shares. That failure is a failure to comply with the auditor's GAAS obligation to obtain sufficient competent evidential matter regarding the classification of the Fund's Premier shares. Again, GAAS holds Wallace responsible for the failure of the audit team to comply with GAAS.
2. Audit Failures With Respect To The Valuation of Premier Securities. Investment Company Act Section 2(a)(41) requires that, where market quotations cannot reasonably be used to determine market value, the securities should be carried at fair value as determined in good faith by the board of directors.39 GAAP requires that, regardless of whether securities are restricted or unrestricted, the "independent accountant . . . [must] independently verify all the quotations used by the company at the balance sheet date and satisfy himself that such quotations may properly be used. . . ."40 GAAP further provides that, where there is a thin market for a security, consideration must be given to whether "market quotations are readily available" within the meaning of Section 2(a)(41) of the Company Act. According to GAAP, "market value" is an inappropriate valuation method for restricted securities.41
If a board of directors determines that securities must be valued by the fair value method, GAAP requires that the board take "into consideration all indications of value available to them in determining the 'fair value' assigned to a particular security."42 Having done that, "[t]he information so considered together with, to the extent practicable, judgment factors considered by the board of directors in reaching its decisions should be documented in the minutes of the directors'meeting and the supporting data retained for the inspection of the company's independent accountants."43
When a board has performed a good faith fair valuation of securities, the auditor "does not function as an appraiser and is not expected to substitute his judgment for that of the company's directors." Rather, he is expected to "review all information considered by the board or analysts reporting to it, read relevant minutes of directors' meetings, and ascertain the procedures followed by the directors."44
The procedures followed by the auditors with respect to the valuation of the Premier holdings in both the 1994 and 1995 audits did not comport with the dictates of ASR-118. There was never any clear determination as to whether the securities were being valued by the market or fair value method. Wallace knew that the Prospectus conceded that it was "highly probable" that the securities held by the Fund would not have a public market, and the 1994 Audit Planning Memorandum notes the lack of an available market for the Fund's investments. Wallace knew, in fact, that throughout the period under review Premier was thinly traded.45 These facts indicated that the fair value method should be followed. However, the auditors sent out confirmation request letters in accordance with the procedure in the 1994 Audit Approach Document for securities that were actively traded with an available market price, a method appropriate for determining market value, not fair value.
To the extent any attempt was made to employ a fair valuation methodology, the procedures were inadequate. The relevant minutes of the directors' meetings do not contain or identify any information considered by the Board. They do not detail any analysis performed by the Board in reaching its valuation determination. The valuation methodology attached to the minutes is at odds with that outlined in the Fund's Prospectus, thus creating, at the least, ambiguity as to what methodology the Board was purporting to use in its valuation. There is no indication in the record that the auditors engaged inany discussion with the Board concerning the Board's valuations until late 1995, when the erroneous classification of the Premier shares was discovered.46 On the basis of this record, the auditors had inadequate information to form a basis for their belief that the procedures used by the Board to determine fair value were "reasonable", as required by ASR-118.
As noted, Wallace spent only 10 to 12 hours on each audit, even though the audit teams were relatively inexperienced regarding the Fund. The audit team failed to apply consistent audit tests of the Board's valuation of the Premier shares and accepted valuations by the Board without the supporting documentation required by ASR-118. It was Wallace's supervisory responsibility under GAAS to catch these errors in the audit team's work. His repeated failures to do so were reckless.
Both the 1994 and the 1995 audit teams accepted without question the Board's unsupported assertion that it had applied appropriate fair-valuation methods to the Fund's Premier shares, despite the absence of supporting documentation. The Board resolution valuing the Premier shares did not reflect the factors used by the Board to value the shares or any other information reflecting the analysis the Board may have used. Yet, without this information mandated by ASR-118, the auditors were allowed by Wallace to conclude that the Board had acted appropriately. This was a reckless failure to comply with the GAAS requirement to maintain skepticism and to "be thorough in his [or her] search for evidential matter and unbiased in its evaluation."47
Again, as occurred with respect to the classification of the Fund's Premier shares, the auditors' failure to question -- and seek proof for -- management assertions led to the failure to require the Fund to provide documentation substantiating its assertions. That documentation was necessary for the auditors to have a basis for the reported conclusion that "the procedures [were] reasonable and the documentation appropriate."
Wallace argues on appeal that it was appropriate to use the closing bid price (obtained from the confirmation letters) as a valuation of the restricted Premier shares, and that this approach was consistent with Board-approved policies. He argues that use of the closing bid price did not mean that the shares were being valued by the public market method identified in the 1983 prospectus. Since the Valuation Policy defined unrestricted securities as those with an available market price and that were traded on a stock exchange, he reasons that the over-the-counter quotes obtained for Premier were not "public market prices" as contemplated by the public market method in the prospectus.48
He argues that the market that was the source of the Premier bids was characterized by illiquidity. He then contends that the Fund's Board-approved policies provided different valuation methodologies based on market liquidity rather than classification of securities. He claims that use of the bid quotes from this illiquid market were consistent with the 1983 prospectus' "private party method," requiring the use of actual or proposed transactions. However, Wallace cites to nothing in the record to show that this gloss on the written Board-approved policies was in fact the Board's understanding of how it would apply its valuation procedures.
Wallace then claims that the Board, in valuing the Fund's Premier holdings, "was aware" of various factors concerning Premier's operations, citing to the factors identified in the 1994 Procedures Memorandum such as the competence of Premier's chief executive, that Premier was purportedly developing strong operations and market share "in the second half of 1994 and throughout 1995," and that the Board "chose to consult directlythe third party quotes provided."49 He concludes that the auditors reviewed the Fund's exercise of judgment and found it reasonable.
Wallace's arguments do not withstand scrutiny. Wallace's assertion on appeal that the auditors considered factors such as Premier's strong operations is belied by the conclusion in the 1995 audit work papers that Premier "was not doing well." Moreover, there is nothing in the record, other than the self-serving testimony of Wallace and Calandrella, to suggest that any of the analysis offered by Wallace in his appeal was done by the auditors at the time of the audit. In any event, the law judge did not credit this testimony by Wallace.50
Wallace relied almost exclusively on Calandrella for information concerning Premier's operations and viability. As Wallace was aware, Calandrella owned a large block of Premier securities. This created an obvious conflict of interest. GAAS requires independent confirmation of information under such circumstances.51 Wallace's lack of skepticism with regard to his discussions with Calandrella in connection with the 1995 valuation is striking. The initial valuation of $0.75 was patently too high, and based on an offering that Calandrella hoped would take place some six months in the future. Although Calandrella abandoned the preliminary valuation when Wallace objected to it, Wallace did not even inquire regarding the basis for the reduced, revised valuation with which he was presented shortly thereafter.
B. Failures To Comply With Generally Accepted Accounting Principles. The Division charged that the Fund's 1994 financial statements materially overstated the Fund's net assets because restricted Premier securities were misclassified by the Fund asunrestricted and valued by the Board on the basis of that misclassification. Correct classification of securities can have a material impact on financial statements.52 GAAP requires that restricted securities be valued at a discount from the market price of unrestricted shares.53 Because of the undetected misclassification, this discount was not taken into account, the portfolio was not valued in accordance with GAAP, and the Premier shares were overvalued by a material amount. Because the Premier shares represented 28 percent of the Fund's assets and 40 percent of the Fund's portfolio, the overvaluation of the Premier shares resulted in the Fund's net assets being materially overstated.
The Division charged that the Fund's 1995 financial statements materially overstated the Fund's net assets because restricted Premier securities were not valued in conformity with GAAP. Approximately 431,000 of the Fund's Premier shares were restricted. All of them were valued at $0.625.54 The two confirmations obtained by the audit team gave the market price at $0.625. Assuming this to be a valid market price, the fair value of restricted shares would have been significantly less.55 In fact, the only bid on December 29, 1995 (the last day of trading for the year) was $0.25.56
Wallace also argues, in effect, that the valuation of the Premier shares was covered by the "most unusual situations" language of ASR-113. According to Wallace, that language would apply whenever a BDC must determine the fair value of the stock of one of the companies that it assists with financing or managerial expertise, among other things. Wallace offers no support for the novel proposition that an entire class ofinvestment companies should have their valuation decisions fall within this limited exception to ASR-113, and we have found none. Our cases have recognized a much narrower scope for that exception than that argued by Wallace.57 The resulting overstatement is material.
Rule 102(e) provides that the Commission may censure a person or deny a person the privilege of appearing or practicing before it upon a finding that the person has engaged in improper professional conduct. Under all of the circumstances, we believe that the appropriate sanction for Wallace's improper professional conduct is to deny him the privilege of appearing or practicing before the Commission for one year.
Wallace violated fundamental principles of audit work. He failed to plan the audits adequately, failed to supervise his subordinates appropriately, failed to maintain an attitude of professional skepticism, and failed to collect sufficient competent evidential matter to provide a basis for an audit opinion. Overall, he failed to exercise due care in the conduct of the Fund's audits. These significant departures from the standards of his profession establish that the Commission should protect the Commission's processes from the possibility of similar lapses by Wallace in the immediate future.
Wallace did recognize that Calandrella's proffer of a $0.75 per share valuation for the 1995 year-end valuation was excessive and unsupportable. Moreover, as the law judge noted, Wallace's problems on the audits at issue here appear to have more to do with over-commitment outside of his practice rather than dishonesty or irremediable incompetence. In that context, we find that a year's separation from appearing or practicing before the Commission is the appropriate sanction.
An appropriate order shall issue.58
By the Commission (Chairman DONALDSON and Commissioners GLASSMAN, GOLDSCHMID, ATKINS and CAMPOS).
Jonathan G. Katz
In the Matter of
CARROLL A. WALLACE, CPA
ORDER IMPOSING REMEDIAL SANCTIONS
On the basis of the Commission's opinion issued this day, it is
ORDERED that Carroll A. Wallace be temporarily denied the privilege of appearing or practicing before the Commission as an accountant for one year, effective at the opening of business on September 2, 2003.
By the Commission.
Jonathan G. Katz
|1||17 C.F.R. § 201.102(e).|
|2||The Division of Enforcement sought a permanent bar against Wallace with a proviso that no request for reinstatement could be considered by the Commission before the expiration of three years. The law judge denied this requested sanction, and the Division did not appeal that denial.|
|3||BDCs are investment companies regulated pursuant to Sections 54-65 of the Investment Company Act of 1940, 17 U.S.C. §§ 80a-54 to -65.|
|4||Calandrella is a respondent in a pending related proceeding, The Rockies Fund, Inc., Admin. Proc. File No. 3-9615.|
|5||Amendment to Rule 102(e) of the Commission's Rules of Practice, Securities Exchange Act Rel. No. 40567 (Oct. 18, 1998), 68 SEC Docket 707, 709 (hereinafter "Adopting Release"); Russell Ponce, Exchange Act Rel. No. 43235, (Aug. 31, 2000), 73 SEC Docket 442, 467 n.57, appeal pending, No. 00-71398 (9th Cir.); Albert Glenn Yesner, CPA, Exchange Act Rel. No. 42030 (Oct. 19, 1999), 70 SEC Docket 2743, 2746-47; Robert D. Potts, CPA, 53 S.E.C. 187, 203-04 (1997); Marvin E. Basson, Exchange Act Rel. No. 35840 (June 13, 1995), 59 SEC Docket 1650.|
|6||Adopting Release, 68 SEC Docket at 710.|
|7||Adopting Release, 68 SEC Docket at 710, (citing SEC v. Steadman, 967 F.2d 636, 641 (D.C. Cir. 1992) (quoting Sundstrand Corp. v. Sun Chemical Corp., 553 F.2d 1033, 1045 (7th Cir. 1977)); Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193-94 n.12 (1976)).|
|9||For this reason, the cases cited by Wallace in support of his claim that recklessness for the purposes of determining a violation of Rule 102(e) should be defined as approximating actual intent to aid in the fraud perpetrated by the audited company are inapposite. In re Software Toolworks, 50 F.3d 615, 627 (9th Cir. 1994); Decker v. Massey-Ferguson, Ltd, 681 F.2d 111, 121 (2d Cir. 1982); and SEC v. Price Waterhouse, 797 F. Supp. 1217, 1240 (S.D.N.Y. 1992) are all cases involving actions against accountants or others for violations of the antifraud provisions of the federal securities laws.|
|10||A "chartered accountant" is a professional designation in the United Kingdom, Australia, Canada, and New Zealand equivalent to a certified public accountant.|
|11||The record has no information regarding Mah's background, credentials, or experience and very little about her assigned duties.|
|12||None of the responding persons volunteered the classifica-tion of the Premier shares they held.|
|13||During 1995, the Fund discovered that the Premier restricted shares had been misclassified and disclosed the error. The Fund did not restate its financial reports for 1994. The failure to restate is not at issue in this case.|
|14||It is undisputed that this Board meeting was not in-person, but the record does not specify how it was conducted.|
|15||The Valuation Policy differed from the valuation procedures set forth in the Fund's 1983 prospectus ("the Prospectus"). The Prospectus provided that the securities in the Fund's portfolio would be valued at either market value or in good faith at fair value. The Prospectus defined "fair value" as the amount the Fund could expect to realize from the current sale of the securities. The Prospectus described four methods for the valuation of its security portfolios and ranked them in order of preference. The most favored method, the "public market method," used the bid price for those securities traded on a stock exchange. The Board was to value restricted shares at a discount from the market price for unrestricted shares of the same issuer and class. The Prospectus noted that it would be "highly probable" that the securities of many of the portfolio companies would not have a public market. In that event, their valuation was to be based on the "private market method." This method valued the stock on the basis of actual or proposed third-party transactions. The third method, the "appraisal method," used when there were no third-party transactions in the securities, valued shares by an appraisal which was to take into consideration events that occurred since the purchase of the stock. Finally, if no other method was feasible, the Prospectus directed the Board to value the shares at their cost to the Fund.|
|16||The record provides no explanation for the calling of a second valuation meeting.|
|17||See AICPA, Codification of Statements on Auditing Standards, §§ 312.20(a), .20(c), .21 (hereinafter "AICPA, AU"). Hammer testified that a critical audit area requires a greater amount of subjective judgment by management and, as a result, poses a greater risk of misstatement in the financial statements. As used in Generally Accepted Auditing Standards terms, a critical audit area presents a higher inherent audit risk. AICPA, AU § 312.20(a). The existence of this inherent risk obliges an auditor to reduce the chance that any misstatement that might occur would go undetected. AICPA, AU § 312.21. Simply stated, Wallace had a professional obligation to take special care with critical audit areas.|
|18||The audit gauge establishes the level above which an audit variance will, in most cases, be deemed material to the Fund's financial reports.|
|19||In fact, they made no such determination with respect to any of the Fund's investments, but there was no charge with respect to this failure.|
|20|| Wallace points to "the extensive detail in the work papers demonstrating the fact that the auditors did indeed document their review" of the Fund's valuation process, citing notations in the work papers that the auditors reviewed several specific documents. Wallace claims that these notations demonstrate the scope of the auditors' review of the Board's valuation of its securities, "most particularly those of Premier."
This argument is disingenuous. None of the documents specifically identified by Wallace relate to Premier. In fact, the omission from the work papers of any supporting documentation with respect to Premier in the face of specific mention of documentation with respect to several of the Fund's other holdings supports our finding that theauditors did not, in fact, review underlying documentation of the value of the Fund's shares of Premier.
|21||The consent resolution is erroneously dated February 1,1995.|
|22||This was the same Valuation Policy attached to the 1994 valuation.|
|23||As noted below, the 1995 Form 10-K also stated that both restricted and unrestricted securities with quoted market prices were valued at the closing bid price.|
|24||Wallace contends on appeal that, in fact, the closing bid on the last trading day of 1995 was "most likely" $0.375.|
|25||Wallace drafted this footnote. There is no indication that the Fund's Board ever approved the valuation procedures in the footnote.|
|26||AICPA, AU § 311.01. The obligation to plan an audit adequately encompasses the obligation to prepare audit programs and obtain knowledge of the entity's business.|
|27||AICPA, AU § 311.11|
|30||AICPA, AU § 311.13.|
|31||AICPA, AU § 316.16 (audit of financial statements in accordance with GAAS should be planned and performed with an attitude of professional skepticism); AICPA, AU § 150.02 (auditor to exercise due professional care in conduct of audit and preparation of audit report).|
|32||AICPA, AU § 150.02, Standard of Field Work, ¶ 3 (auditor must obtain "[s]ufficient competent evidential matter . . . through inspection, observation, inquiries, and confirmations to afford a reasonable basis for an opinion regarding the financial statements under audit").|
|33||AICPA, AU § 230.02.|
|34||AICPA, AU § 316.16.|
|35||AICPA, AU § 326.02.|
|36||AICPA, AU § 326.22.|
|37||Wallace argues that the misclassification of the securities made no difference in the financial statements because the securities were so thinly traded. Wallace is in error. See Financial Accounting Standards Board Concept Doc. No. 2 ¶ 128(c) (1980). Misclassification makes a portfolio appear more liquid by presenting shares as freely saleable when, in fact, they are not.|
|38||AICPA, AU § 311.11.|
|39||15 U.S.C. § 80a-2(a)(41).|
|40||Accounting for Investment Securities by Registered Investment Companies, Accounting Series Rel. No. 118 at 5 (Dec. 30, 1970) ("ASR-118"). The AICPA Audit and Accounting Guide: Audits of Investment Companies, (hereinafter "AAG") is the source for GAAP regarding investment companies. The AAG references ASR-118 and Restricted Securities, Accounting Series Rel. No. 113, at 3 (Oct. 21, 1969) ("ASR-113") as GAAP for valuation of securities for which market quotations are not readily available. AAG § 2.33.|
|41||ASR-113, at 3.|
|42||ASR-118 at 5.|
|44||ASR-118 at 3.|
|45||Wallace concedes as much by arguing that the difference between the price of restricted and unrestricted shares is insignificant when the shares are as thinly traded as those of Premier in 1994 and 1995.|
|46||The 1994 Procedures Memorandum states that, for restricted securities, Calandrella indicated that the Board "generally maintains investments at cost" until events such as strong operations, growing market share, or third party transactions indicate appreciated value. The Memorandum concludes that, from its review of the Board minutes and conversations with Calandrella, it appears that the Board "has adequate information to value the portfolio." Since this discussion in the Memorandum pertains to restricted securities, there is no reason to suppose that these purported conversations with Calandrella involved Premier shares, which were classified as unrestricted in 1994. In any event, the 1994 Procedures Memorandum does not specify the information that was deemed "adequate."|
|47||AICPA, AU § 326.23.|
|48||Wallace offers no authority for the novel proposition that quotations in the over-the-counter market are less public than those on stock exchanges. Moreover, the $0.625 valuation used for the 1995 financial statement was significantly higher than the only bid on the last day of trading for 1995, i.e. $0.25.|
|49||As noted above, the factors cited in the Procedures Memorandum would not appear to have been applied in the 1994 audit with respect to the Fund's holdings of Premier which were not then classified as restricted securities.|
|50||We accept a law judge's credibility finding unless substantial evidence suggests that we should not do so. See Laurie Jones Canady, Exchange Act Rel. No. 41250 (Apr. 5, 1999), 69 SEC Docket 1468, 1480-81, aff'd 230 F.3d 362 (D.C. Cir. 2000). Nothing in the record suggests that we not accept the law judge's finding here.|
|51||AICPA, AU § 316.17.|
|52||See Financial Accounting Standards Board Concept Doc. No. 2 ¶ 128(c) (1980).|
|53||ASR-113, at 3.|
|54||The financial statements identified all of the shares as restricted.|
|55||ASR-113, at 3.|
|56||Several trades of unrestricted shares occurred that day at $0.625 (13,000 shares), $0.65625 (13,000 shares), and $0.6875 (5,000 shares). The last trade before December 29 occurred on December 6, 1995, a sale of 20,000 shares at $0.625 by Hanifen Imhoff.|
|57||See Christiana Sec. Co., 45 S.E.C. 649, 662 n.43 (1974), aff'd 432 U.S. 46 (1977) (valuation of a restricted "control block" of DuPont stock presents "a most unusual circumstance").|
|58||We have considered all of the parties' contentions. We have rejected or sustained them to the extent that they are inconsistent or in accord with the views expressed in this opinion.|
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