SECURITIES AND EXCHANGE COMMISSION Washington, D.C. SECURITIES EXCHANGE ACT OF 1934 Rel. No. 39126 / September 24, 1997 ACCOUNTING AND AUDITING ENFORCEMENT Rel. No. 964 / September 24, 1997 Admin. Proc. File No. 3-7998 ________________________________________________ : In the Matter of : : ROBERT D. POTTS, CPA : c/o Briggs and Morgan : 2400 IDS Center : Minneapolis, MN 55402 : ________________________________________________: OPINION OF THE COMMISSION RULE 2(e) PROCEEDING Ground for Remedial Action Improper Professional Conduct Certified public accountant acting as concurring partner engaged in improper professional conduct in concurring in issuance of audit reports containing unqualified audit opinions on the financial statements of a public company that improperly deferred recognition of operating losses and thus materially misstated income. Held, it is in the public interest to suspend the accountant from practice before the Commission for nine months. APPEARANCES: M. Patrick McDavitt and Robert E. Woods, of Briggs and Morgan, for Robert D. Potts. Carl A. Tibbetts and Sara A. Smith, of the Division of Enforcement, for the Office of the Chief Accountant. Appeal filed: June 6, 1994 Last brief received: May 1, 1996 Oral argument: May 23, 1996 I. Robert D. Potts, a certified public accountant and former partner with the accounting firm of Touche Ross & Co. and its successor Deloitte & Touche (each referred to as "Touche"), appeals from the decision of an administrative law judge. Potts was the concurring partner for Touche's audits of Kahler Corporation ("Kahler"), a public company, for the fiscal years 1988 and 1989. An "engagement partner" had primary responsibility for assuring the accuracy of these audits. Potts, as the "concurring partner," provided a second level of review, affording "additional assurance" that "(1) the financial statements [on this] SEC engagement[] . . . [we]re in conformity with generally accepted accounting principles . . . and (2) the firm's report thereon [wa]s in accordance with generally accepted auditing standards." <(1)> The law judge found that Potts engaged in improper professional conduct in connection with the audits at issue and, accordingly, suspended him from practice before the Commission for eighteen months pursuant to Rule 2(e)(1) of our Rules of Practice. <(2)> Our findings are based on an independent review of the record, except with respect to those findings not challenged on appeal. <(1)> American Institute of Certified Public Accountants ("AICPA") Division of CPA Firms SEC Practice Section, SECPS Manual, Appendix E, at 1 (1986) ("SECPS Manual"). The SEC Practice Section is an organization formed by the AICPA in the late 1970s, in the wake of Commission- instituted enforcement actions finding deficiencies in audits by major accounting firms, to establish guidelines and enhance the quality of audits of public companies. One of the guidelines established by the SEC Practice Section is that, for all "SEC engagements," as that term is defined in Appendix D to the SECPS Manual, a concurring partner must review the audit report and the financial statements before the audit report issues. The law judge's decision mistakenly notes that Potts' role was to "insure" that the financial statements and audits satisfied the standards of the profession. Concurring partners, like other accountants, provide only reasonable "assurance" in this regard, not a "guarantee." <(2)> On July 24, 1995, revised Rules of Practice governing Commission administrative proceedings became effective. Because these proceedings were docketed prior to that date, they have been conducted under the former Rules of Practice. See 60 Fed. Reg. 32,738 (1995). Former Rule 2(e)(1) (the basis of this proceeding) is now 17 C.F.R. 201.102(e)(1). We made no substantive changes to this rule. ======END OF PAGE 2====== II. The concurring partner affords this Commission and public investors an independent "check" on the appropriateness of significant accounting, auditing, and reporting decisions. The question before us is whether Potts, as concurring partner, engaged in improper professional conduct when he concurred in his firm's issuance of unqualified audit opinions on Kahler's 1988 and 1989 financial statements. In those statements, Kahler, among other things, accounted for the operating losses of the University Park Hotel ("UPH" or "Hotel") as if they were the results of operations of a significant portion of a business held for disposal. Potts became a Touche partner in 1975 and was Managing Partner for Touche's Twin Cities Office from the fall of 1988 to May 1993. <(3)> In 1986, Potts served Kahler as "General Services Partner," which, accord- ing to Potts, meant that Potts was the Touche partner "responsible for delivery of all services to the organization." <(4)> From 1987-1993, Potts was the concurring partner for Kahler's fiscal year audits. <(5)> During the relevant period, Potts had been practicing before the Commission for at least ten years and had served as concurring partner on approximately a dozen audits in addition to the two on which we focus here. During the period covered by the financial statements at issue, Kahler was a Delaware company with its headquarters in Rochester, Minnesota, that primarily owned and managed hotels. Kahler's securities were registered under Section 12(b) of the Securities Exchange Act of 1934 ("Exchange Act"). Accordingly, Kahler was required by Section 13(a) of the Exchange Act to file with this Commission annual reports containing financial statements that had been certified by independent public accountants (here, Touche), and quarterly reports. Harold W. Milner served as Kahler's Chief Executive Officer through December 1989, when Kahler's Board of Directors replaced him. Gregory J. <(3)> Potts left Touche on August 30, 1993. He subsequently worked as a consultant to the chief executive officer of a public company that was a Touche audit client. Counsel advised at oral argument that Potts currently is President and Chief Operating Officer of a major financial services company in Minnesota. <(4)> Correspondence between Touche and Kahler in July 1986 specified that, as General Services Partner, Potts was responsible for "on-going business consultation." <(5)> In its 1989 engagement letter to Kahler, Touche defined Potts' role as concurring partner broadly, stating that Potts would be "another partner, known to the [Audit Committee] and your management associates, who is familiar with your operations and [who] can substitute for [the engagement partner] in his absence. . . ." ======END OF PAGE 3====== Melsen served as the Touche engagement partner on the Kahler audits at issue. Kahler acquired the UPH in April 1987. In April 1988 the Kahler Board of Directors authorized management to explore the possibility of selling an interest in the UPH. In December 1988 Kahler engaged an investment banking firm, Piper, Jaffray, and Hopwood ("Piper"), to sell a 50 percent interest in an investment partnership, the assets of which consisted of the UPH and another hotel. During the two audit years, Kahler also formulated a number of investment proposals involving the UPH, offering to sell an interest in the Hotel. During all of fiscal 1988 and through the close of business on the last day of Kahler's 1989 fiscal year (December 31, 1989), Kahler carried the UPH on the company financial statements as an "asset held for sale." This accounting implicitly represented that Kahler intended to dispose of the Hotel and also that, under relevant accounting principles, the Hotel's value (after giving consideration to costs and expenses directly associated with the Hotel's disposal and certain estimated income or losses from operations) was sufficient to permit any actual losses generated by the asset to be excluded from Kahler's statement of operations. As a result, the losses were capitalized (that is, added to the Hotel's carrying value on Kahler's books, and not reflected in the company's income statement). In fiscal year 1988, Kahler carried the Hotel at a reflected value of $16.532 million and capitalized operating losses of $1.347 million associated with the property. Kahler also chose to capitalize the $966,000 in losses associated with the Hotel for the entire 1989 fiscal year. As of the close of business on the last day of Kahler's 1989 fiscal year, Kahler "redesignated" the UPH from an asset held for sale to Kahler property held as an operating asset. Kahler began depreciating and amortizing the UPH in 1990. Kahler's accounting for the UPH had a material effect on Kahler's financial statements: Kahler posted net income of $239,000 in fiscal year 1988 rather than the net loss of $1.108 million that otherwise would have been reported had Kahler recognized the UPH's operating losses, and similarly posted a net loss of $1.842 million in 1989, rather than a $2.808 million net loss. <(6)> Potts signed a memorandum concerning both the 1988 and 1989 audits stating that he had completed his review, the purpose of which was, as stated in the memorandum, to "provide additional assurance that the financial statements are in conformity with [Generally Accepted Accounting Principles] and that [his] Firm's report thereon is in accordance with <(6)> The amounts of the Kahler-deferred losses in 1988 were disclosed in the footnotes to the financial statements for fiscal 1988. The amounts of depreciation and amortization (but not the operating losses) not recognized in fiscal 1989 were disclosed in the footnotes to the financial statements for that year. ======END OF PAGE 4====== [Generally Accepted Auditing Standards]." Based on his review, Potts concurred in the decision each year to release Touche's unqualified audit opinion. <(7)> III. Potts claims that the accounting treatment at issue was "appropriate and proper in all respects." This claim is belied by the record. Guided by several key accounting pronouncements recognized as Generally Accepted Accounting Principles ("GAAP"), including the Opinion of the Accounting Principles Board ("APB") No. 30, "Reporting the Results of Operations -- Reporting the Effects of Disposal of a Segment of Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions" ("APB 30"), on which Potts claims to have relied in reviewing the accounting, we conclude that Kahler improperly accounted for the UPH. APB 30 applies to the sale of "segments," defined as the entirety of a line of business. APB 30 permits a company that plans to dispose of a business segment to defer current operating losses generated by the segment, provided the company satisfies a series of requirements. These requirements include that management determine that the company will recognize a net gain upon sale of the business segment; commit to a "formal plan" to dispose of the business segment; and disclose separately in the notes to the company's financial statements the business segment's results of operations and other specified information. <(8)> APB 30 has been interpreted authoritatively by the American Institute of Certified Public Accountants ("AICPA") to require that the gain or loss on a sale of a significant portion of a line of business <(7)> Kahler, its Chief Executive Officer Milner, Kahler Treasurer and Chief Financial Officer Steven R. Stenhaug, and Touche engagement partner Melsen each settled Commission charges relating to their respective roles in what this Commission previously found, in connection with those settlements, to be Kahler's improper accounting treatment and financial statement presentation of the UPH during the audit years at issue. In the Matter of Kahler Corporation, Harold W. Milner and Steven R. Stenhaug, Exchange Act Rel. No. 32916, Acctg. and Audit. Enf. Rel. No. 481 (Sept. 17, 1993), 55 SEC Docket 24; In the Matter of Gregory J. Melsen, CPA, Exchange Act Rel. No. 32917, Acctg. and Audit. Enf. Rel. No. 482 (Sept. 17, 1993), 55 SEC Docket 38. <(8)> APB 30, 8, 14, 15, 18. ======END OF PAGE 5====== -- in contrast to a "business segment" -- should be calculated consistent with APB 30 as if it were a "segment" and to require, with respect to that portion, the specified footnote disclosures set forth in APB 30. <(9)> A subsequently-issued consensus position of the Emerging Issues Task Force ("EITF") of the Financial Accounting Standards Board ("FASB") <(10)> -- "Discontinued Operations with Expected Gain and Interim Operating Losses," EITF Issue No. 85-36 ("EITF 85-36") -- also is relevant here. EITF 85-36 emphasizes that, consistent with the AICPA's interpretation of APB 30, all the conditions of APB 30 applying to the disposal of a segment of a business apply to the disposal of a significant portion of a line of business accounted for pursuant to APB 30. <(11)> EITF 85-36 does not define the term "significant portion of a line of business." Kahler's accounting for the UPH was based on the assumption -- which we also make here, without resolving the question -- that the UPH, a single hotel, qualified as a significant portion of a line of business. A. To capitalize operating losses under APB 30 and EITF 85-36, an issuer must expect to be able to account for the disposal as a sale pursuant to GAAP. An issuer's ability to recognize a real estate transaction as a sale in its financial statements is determined based upon criteria set forth in FASB's Statement of Financial Accounting Standards ("FAS") 66, "Accounting for Sales of Real Estate." <(12)> Pursuant <(9)> See AICPA Accounting Interpretation AIN-APB30, #1, "Reporting the Results of Operations: Accounting Interpretations of APB Opinion No. 30" (Nov. 1973). <(10)> The EITF's consensus positions on accounting issues are GAAP. <(11)> Kahler referred to the UPH in its financial statements as an "asset held for sale." More precisely, consistent with the relevant accounting pronouncements, Kahler treated the Hotel as a "segment of a business held for disposal." For consistency and simplicity, in this opinion we refer to the UPH as an "asset held for sale" or an "asset," and refer to the relevant accounting treatment of such an asset as "APB 30 treatment." <(12)> FASB Original Pronouncements, Statement of Financial Accounting Standards 66, "Accounting for Sales of Real Estate" (1982) ("FAS 66"). Under FAS 66, a profit or gain may be recognized in full when real estate is sold if, among other things, the seller has transferred to the buyer the usual risks and rewards of ownership and the seller does not have a substantial continuing involvement with the property. FAS 66, 18, 25-31. (continued...) ======END OF PAGE 6====== to FAS 66, a real estate transaction will be accounted for as a financing, leasing, or profit-sharing arrangement rather than a sale if the seller retains certain of the risks of ownership. Here, over the two-year period beginning in April 1988, Kahler formulated at least twelve investment proposals regarding the UPH that sought investor participation in ownership -- not outright sale -- of the UPH. <(13)> Thus, APB 30 treatment of the Hotel's losses should not have been accorded here. B. Moreover, Kahler did not have a "formal plan" of disposal for the Hotel, as that term is used in APB 30 and EITF 85-36. <(14)> In brief, the "formal plan" must at a minimum: (a) identify the asset to be disposed of, the expected method of disposal, and the anticipated period for final disposal, measured from the date that the formal plan was established (the "measurement date"); (b) initiate an active program to find a buyer; (c) provide an estimate of the results of operations of the segment from the measurement date to the disposal date; and (d) estimate the proceeds to be realized from the disposal. Not only can there be no viable "formal plan" under APB 30 and EITF 85-36 if there is no intention to transfer the segment outright, nothing in the record demonstrates that the elements set forth above were satisfied. <(15)> <(12)>(...continued) See, e.g., Stephen P. Clark, CPA, Acctg. and Audit Enf. Rel. No. 239 (Aug. 11, 1989), [198- AAER Transfer Binder] Fed. Sec. L. Rep. (CCH) 73,708, at 63,247-48 (fundamental concept of revenue recognition incorporated in GAAP is that "the seller must transfer the usual risks and rewards of ownership, and must not be obliged to perform significant activities after the sale to earn the profit"). <(13)> For instance, Kahler in certain proposals guaranteed a stated return on the investment, and retained an equity interest in the Hotel. <(14)> APB 30, 14. <(15)> Potts claims that a formal plan was discernible, in its "various components," from the contents of the 1988 and 1989 Top Files. (Touche referred to the folder of its auditors' significant work papers as the Top File.) We do not agree. We find significant APB 30's requirement that a plan be "formal." This is not to say that a formal plan may not be set forth in a form such as minutes of a meeting of a corporate body empowered to make the decisions called for under APB 30. Nevertheless, mere references in meeting minutes to what may be certain elements required for a formal plan are not sufficient (see, e.g., the February 1989 Board of Directors meeting minutes reflecting that the Audit (continued...) ======END OF PAGE 7====== C. In accordance with the threshold requirements for deferral of operating losses set forth in APB 30 and EITF 85-36, a company must estimate the net realizable value ("NRV") of the asset slated for sale -- that is, the gain or loss to be realized on sale. <(16)> The company must satisfy itself that the NRV will result in a gain (after giving consideration to costs and expenses directly associated with the asset's disposal and certain estimated income or losses from operations) or losses may not be deferred. We have concluded, on our review of this record, that, at the time Kahler decided to account for the Hotel as an asset held for sale, Kahler management failed to assess adequately the Hotel's net realizable value and failed to estimate the Hotel's operating losses to be incurred prior to sale. Without adequate estimates, Kahler's management had no valid basis to conclude that the Hotel's operating losses could be deferred. D. Kahler's decision to treat the UPH as an asset held for sale from the beginning of fiscal 1988 also was problematic. Even assuming that APB <(15)>(...continued) Committee was "satisfied" with Touche's accounting for the UPH in a pending sale mode and that "the numbers and assumptions associated with the valuation [were] reasonable"). We also reject Potts' alternative assertion that an oral report to Potts by Melsen, the engagement partner here, amounted to the requisite formal plan. Donald J. Moulin, an expert witness offered by our Office of the Chief Accountant ("OCA"), who had served as a concurring partner on 10 to 20 audits involving APB 30 issues, testified that, in industry usage, "formal plan" indicates a written plan. Both Moulin and Barry Jay Epstein, another OCA expert witness, testified persuasively that Melsen's oral "assurances" to Potts could not in themselves constitute a formal plan. An auditor may describe, in a conversation with his or her partner, the elements of management's formal plan, but that description cannot itself constitute the formal plan. Moreover, we do not agree that documents created by an auditor themselves may constitute a formal plan, although they may memorialize in one location the components of management's formal plan. We thus reject Potts' attempt to fashion a "formal plan" out of a Kahler audit memorandum prepared by Touche, which states that it was Kahler's "intent" to sell the UPH and that "[t]he net realizable value of the property was assessed in the underlying workpapers and the carrying value at cost was deemed appropriate." <(16)> APB 30, 15. ======END OF PAGE 8====== 30 treatment properly could be accorded here (and we do not believe that it could be), Kahler's Board did not authorize disposal of (even an interest in) the Hotel until mid-April 1988. This, therefore, was the earliest colorable "measurement date," or date from which operating losses could be deferred under APB 30. We accordingly conclude on this record that Kahler's financial statements filed with its Forms 10-K and 10-Q during fiscal years 1988 and 1989 were not presented by Kahler in accordance with GAAP because the company improperly deferred operating losses related to the operation of the UPH. <(17)> IV. The Order Instituting Proceedings charged, and the law judge found, that Potts engaged in improper professional conduct in violation of Rule 2(e)(1) of our Rules of Practice. Central to this case were the professional standards governing Potts' conduct. As a certified public accountant, Potts was expected to understand GAAP and Generally Accepted Auditing Standards ("GAAS") and to recognize when departures were made from them. In addition, as a public accountant, Potts was required to determine that financial statements filed with this Commission conformed to the criteria for the form and content of financial statements set forth in our Regulation S-X. <(18)> Potts' status as a concurring partner rather than an engagement partner did not insulate him from these duties to adhere to GAAS and our Regulation S-X, and to recognize departures from GAAP. Potts, as a member of the AICPA and a partner at Touche, itself a member of the AICPA's SEC Practice Section ("SECPS"), also was expected to comply with the AICPA's Auditing Standards and Ethics Rules and to meet the requirements of the SECPS. The SECPS Manual provides criteria and guidelines for member firms' concurring partner review policies, <(17)> We also note that, although Kahler's quarterly reports for the first three quarters of 1988 filed with this Commission disclosed that the asset held for sale was the UPH, Kahler's 1988 and 1989 financial statements departed from APB 30 and EITF 85-36 in not identifying, as required, the particular asset being held for sale, the expected disposal date, or the loss from the beginning of the disposal period. See APB 30, 18. <(18)> 17 C.F.R. 210.1-01 et seq. ======END OF PAGE 9====== <(19)> including the following "minimum" policies and procedures for concurring partner review: [R]eading the financial statements and the firm's report thereon and making an objective review of significant accounting, auditing, or reporting considerations. This review should be performed prior to the release of the report and should include discussions with the partner in charge of the engagement and review of selected working papers. <(20)> Consistent with these requirements, Potts was bound to exercise due professional care in the performance of his professional services. <(21)> GAAS makes clear that all auditors -- not just those serving on the engagement team -- must perform their work with due care. "Due care imposes a responsibility upon each person within an independent auditor's organization to observe the standards of field work and reporting." <(22)> As relevant here, in determining whether the audits were conducted in accordance with GAAS, Potts was required to consider: (1) the Third Standard of Field Work, directing that "[s]ufficient competent evidential matter is to be obtained through inspection, observation, inquiries, and confirmations to afford a reasonable basis for an opinion regarding the financial statements under audit"; <(23)> and <(19)> Potts argues that these guidelines do not apply specifically to his conduct, since only firms can be members of the SECPS. Potts, however, as a concurring partner performing audit functions on behalf of his SECPS member firm, is governed by the SECPS guidelines. It appears that the SECPS has at least in one instance expelled an individual accountant from the Practice Section for, among other misconduct, failing to obtain concurring partner reviews on audits. See Thomas Page Taylor, Exchange Act Rel. No. 31244 (Sept. 28, 1992), 52 SEC Docket 2409, 2411. <(20)> SECPS Manual at 1. <(21)> AICPA, Codification of Statements on Auditing Standards, AU  150.02 (1995) (hereinafter "AICPA AU  __"). Rule 202 of the AICPA's Code of Professional Conduct recognizes Statements on Auditing Standards as interpretations of GAAS. <(22)> AICPA AU  230.02. <(23)> AICPA AU  150.02, Standards of Field Work, 3. See (continued...) ======END OF PAGE 10====== (2) the First Standard of Reporting, specifying that the auditor's "report shall state whether the financial statements are presented in accordance with generally accepted accounting principles." <(24)> Also applicable were GAAS standards establishing requirements for the auditor whose examination causes him to believe that material errors or irregularities may cause the financial statements to contain a material misstatement. These standards require the auditor to consider their implication and, among other things, to extend his auditing procedures, if practicable, "to obtain sufficient evidential matter to determine whether in fact material errors or irregularities exist and, if so, their effect." <(25)> Additionally, Potts, in the exercise of his audit responsi- bilities, was required to consider the related GAAS directive that "[t]here should be stronger grounds to sustain the independent auditor's opinion with respect to those items which are relatively more important and with respect to those in which the possibilities of material misstatement are greater than with respect to those of lesser importance or those in which the possibility of material misstatement is remote." <(26)> <(23)>(...continued) also AICPA, 2 Professional Standards (CCH), ET  201, at 4561 (1996); AICPA AU  326 and 339. <(24)> AICPA AU  150.02, Standards of Reporting, 1. Professional standards further precluded Potts from permitting issuance of an unqualified opinion stating affirmatively that Kahler's financial statements were presented in conformity with GAAP, if those financial statements contained any departure from a promulgated accounting principle that had a material effect on the financial statements taken as a whole. AICPA, 2 Professional Standards (CCH), ET  203, at 4581 (1996); AICPA AU  508.14-15. <(25)> Statement of Auditing Standards ("SAS") No. 16.14 (superseded by SAS No. 53 (codified at AICPA AU  316.08), effective for audits of financial statements for periods beginning on or after January 1, 1989). SAS No. 16.14 specifies that an auditor must exercise "the proper degree of professional skepticism to achieve reasonable assurance that material errors or irregularities will be detected"). SAS No. 53 further specifies that "[s]ince the auditor's opinion on the financial statements is based on the concept of reasonable assurance, the auditor is not an insurer and his report does not constitute a guarantee." <(26)> AICPA AU  150.04. ======END OF PAGE 11====== The foregoing are the professional standards that are relevant in determining whether Potts engaged in improper professional conduct. <(27)> V. Mindful of the AICPA's cautionary language that "the subsequent discovery that a material misstatement exists in the financial statements does not, in and of itself, evidence inadequate . . . judgment on the part of the auditor," <(28)> we now turn to an analysis of Potts' conduct. That analysis is shaped, in part, by our recognition of the following: Potts' extensive professional experience and familiarity with Kahler's operations; Potts' knowledge of the contents of the work papers (given Potts' counsel's statement at oral argument before us that Potts had reviewed the entire Top File for each audit at issue); and Potts' knowledge that the accounting treatment utilized was material to the financial statements. <(27)> In his dissent, Commissioner Wallman states that it is not clear from the record in this matter what was expected of a concurring partner at the time of the Kahler audits. The relevant professional standards we apply here are all taken directly from accounting literature. These standards were just as applicable when Potts performed his Kahler audit work as they are today. The record includes the testimony of three experts in the fields of accounting and auditing who testified in detail and at length, in support of the Division's case, on the role of a concurring partner during the relevant period. Potts offered his own expert's testimony as well, and that expert, Edward J. Kerans (a certified public accountant and a Coopers & Lybrand partner) articulated his own understanding of the concurring partner's role during the applicable period. Each of these witnesses premised his analysis of Potts' conduct on the applicability of GAAS, with the attendant requirement of due professional care, that we discuss and apply here. The record testimony leaves no doubt that the experts offered their opinions based upon the standard applicable to concurring partners when Potts performed his Kahler audit work (which, in any event, as we already have noted, is the same standard in effect currently, and was the standard in effect when the experts testified). We accordingly reject any suggestion that the experts were assessing Potts' role in the audits against a standard not known to him during the time of the audits. <(28)> AICPA AU  316.08. ======END OF PAGE 12====== A. In March 1988, Potts and Melsen met personally with Kahler's Treasurer and Chief Executive Officer, Milner, and Kahler's Chief Financial Officer, Stenhaug, over lunch, and discussed, apparently briefly, the parameters of accounting for the UPH as an asset held for sale. <(29)> Thereafter, Melsen informed Potts that Kahler had adopted a plan to sell its equity interest in the Hotel. These assurances, however, were contradicted by documentary evidence in the 1988 Top File: the April 1988 meeting minutes of Kahler's Board of Directors, which plainly indicate that management had authorized only "the sale of an interest" in the Hotel, and the September 1988 Board meeting minutes, which reflect Board discussion of "[t]he subject of continuing to find a purchaser to share in the ownership of [the Hotel]." Melsen subsequently advised Potts, as the 1988 audit proceeded, that Melsen had uncovered evidence -- a contract letter between Piper and Kahler that engaged Piper to sell a partial interest in the Hotel (which he showed to Potts) -- that caused Melsen to question Kahler's commitment to dispose of its interest outright. In an effort to clarify this inconsistency, Potts and Melsen again met with Milner. After Milner assured the auditors that the company intended to sell the Hotel, and sought to explain away the contract letter as a means of generating interest in an outright purchase of the UPH, Potts suggested that Melsen meet with Kahler's audit committee regarding whether the company in fact was committed to disposal. Potts accepted Melsen's subsequent oral report -- unsupported by documentary evidence undercutting the Board minutes and the Piper letter -- that Kahler was committed to a plan to dispose of its entire interest in the UPH. We conclude that doing so was improper. As an initial matter, we agree with Potts that he, as concurring partner on the audits, did not act unreasonably when he was satisfied initially with his partner Melsen's indications that Kahler intended to dispose of its entire interest in the Hotel. We also agree that Potts, upon becoming aware of audit documentation and his partner's concerns that Kahler planned to sell only a partial interest, acted reasonably in meeting first with Milner and then in directing Melsen to inquire further about Kahler's intentions regarding the Hotel. We conclude, however, that Potts thereafter did not fulfill his responsibilities. Melsen's assessment that management in fact was committed to disposal was based solely on management's oral assurances that did not reasonably explain the contradictory documentary evi- <(29)> The law judge found grave inconsistencies between Potts' investigative and hearing testimony regarding the extent and duration of this discussion about the UPH. We have conducted a de novo review of this matter and do not find the testimony so markedly inconsistent. Accordingly, we disagree with the law judge's finding that Potts' hearing testimony on this point was not credible. ======END OF PAGE 13====== dence. <(30)> We conclude that Potts was obligated to inquire further concerning management's commitment to disposal, as "[t]here should be stronger grounds to sustain the independent auditor's opinion with respect to those items which are relatively more important and with respect to those in which the possibilities of material misstatement are greater than with respect to those of lesser importance or those in which the possibility of material misstatement is remote." <(31)> Potts, for example, readily could have probed Melsen, through obvious follow-up questions, to test the reasonableness of Melsen's conclusions, including whether Melsen had requested and reviewed documentation that Kahler in fact had authorized Piper (or any other entity) to dispose of Kahler's entire interest in the Hotel. Alternatively, Potts could have suggested that Melsen direct Kahler to have Piper representatives speak with Melsen personally about the matter. This approach would have been consistent with the general auditing presumption that "[w]hen evidential matter can be obtained from independent sources outside an entity, it provides greater assurance of reliability for the purposes of an independent audit than that secured solely within the entity." <(32)> Alternatively, Potts could have asked to be shown supporting documentary evidence of management's intent to dispose of the Hotel. This latter request would have yielded results. Potts has conceded that review of the investment proposals, for example, would have cast doubt on the UPH accounting, and, as we have stated, no formal plan for disposal in fact existed. Particularly because the audit documentation to which Potts earlier had been directed contradicted reliance on APB 30, it is our view that Potts acted improperly in failing to pursue -- through one of the alternative means we have laid out above, or another reasonable method -- whether management in fact had documented its commitment to disposal. With respect to Potts' conduct in connection with the fiscal 1989 audit, Potts cites as audit evidence of intent to dispose of the property outright a September 1989 proposal to purchase the UPH that was included in the 1989 Top File. However, also included in that Top File was another investment proposal reflecting Kahler's intention to subsidize the purchasers of the UPH directly to the extent necessary to provide a specified annual return on their investment. Faced once again with contradictory evidence as to the availability of APB 30 treatment, Potts <(30)> We do not agree that the audit committee meeting minutes prepared in February 1989 that are in the 1988 Top File, which reflect that the committee was "satisfied" with the accounting as Melsen explained it, constitute "[s]ufficient competent evidential matter" (AICPA AU  150.02, Standards of Field Work, 3) that Kahler intended to dispose fully of the UPH, or constituted a formal plan. <(31)> AICPA AU  150.04. <(32)> AICPA AU  326.19. ======END OF PAGE 14====== again "went along" with Kahler's decision to defer UPH losses in fiscal 1989. We conclude that Potts acted improperly in both audit years. B. Auditors must satisfy themselves that a company deferring and capitalizing losses from continuing operations in accordance with APB 30 has determined the NRV of the asset held for disposal. <(33)> As the law judge observed, the only NRV-related evidence in the 1988 work papers is a one-page document prepared by a Touche senior manager for the audit. No independent appraisal of the UPH was performed and thus none is included in these work papers. The Touche document, moreover, used two different (but each highly-favorable-to-Kahler) approaches to derive NRV, neither of them valid, as Potts later acknowledged in his hearing testi- mony. <(34)> Potts, in connection with the 1988 audit, failed to ascertain that sufficient competent audit evidence relating to valuation of the UPH supported Kahler's deferral of significant UPH operating losses. This failure amounted to improper professional con- duct. <(35)> In reaching this conclusion, we consider the fact that, as Potts observes in his petition for review, Touche, in connection with the 1988 audit, had determined that the engagement presented "moderate" risk of misstatement. We consider that this risk should have caused Potts, at a minimum, to ask questions and to exercise a heightened degree of professional skepticism on the valuation issue. <(33)> As Potts' witness Thomas Bintinger, a Touche partner and, during the relevant period, national director of accounting and auditing professional standards in the firm's National Office, testified, Kahler's management was responsible for supplying the auditors with NRV estimates that Touche then would review. <(34)> Because the document was offered and received into evidence after the close of the hearing, we have determined not to consider Investigative Exhibit 47 (which the Division of Enforcement ("Division") asserts is the original of the investigative exhibit shown to Potts during his investigative deposition). <(35)> As we stated supra note 30, we do not consider the Kahler Board of Directors' February 1989 meeting minutes -- stating that the Audit Committee considered "reasonable" the numbers and assumptions associated with the valuation -- to be sufficient competent evidential matter of the required formal plan. Nor do we agree with Potts that he could be satisfied solely with Melsen's communication to him that the Audit Committee was "comfortable" that Kahler would recognize a gain on sale. ======END OF PAGE 15====== During the 1989 audit, Melsen asked Kenneth P. Riggs in Touche's Chicago Valuation Office for "assistance in determining the fairness of the carrying value" of the UPH. Riggs used a discounted cash flow analysis to derive a market value of $11.4 million. This value was well below the $16.754 million book value for the Hotel. Accordingly, contrary to Potts' claim to us, Kahler could have had no reasonable expectation of gain on sale of the Hotel (assuming it intended to dispose of its entire interest in the UPH, which the record establishes it did not), as required for deferral of losses under APB 30 and EITF 85-36. <(36)> On receipt of the Riggs analysis, members of the audit team substituted Kahler's budgeted projections of future cash flows for the projections, based on historical results, used by Riggs, and lowered the discount rate Riggs had utilized. The audit work papers do not explain adequately these alterations or document the basis for these decidedly more favorable assumptions. It appears that the numbers in the work papers were changed in an effort to demonstrate compliance with the requirements of APB 30 and EITF 85-36. We conclude that Potts, who examined both the Riggs analysis and the changes made to it before the 1989 audit report issued, acted improperly in accepting Melsen's statement that the changes were made simply to correct "errors" in the Riggs analysis, rather than regarding these alterations with due professional skepticism. The use of Kahler's projections in particular was problematic, as the 1989 Top File includes various documentation that, when considered together, strongly cautioned against reliance on Kahler-generated projections. <(37)> In light of <(36)> We cannot agree with Potts' assertion before the law judge that he acted reasonably in assuming that, because in late 1989 Kahler received an offer to purchase the UPH for $16.5 million, Kahler reasonably expected a gain on disposal. As the Board meeting minutes Potts reviewed on this matter reflected, Kahler's officers and directors dismissed the offer as not "economically justif[iable]," because it was conditioned on Kahler paying a high level of annual rent to the purchaser. <(37)> For example, a Kahler Board member's expressions of concern over Kahler's "history" of "aggressive projections," are reflected, as is Melsen's comment, in a February 1990 memorandum, that Milner, Kahler's CEO, took an "aggressive posture regarding accounting." The 1989 Top File also includes notes of a conversation between Melsen and Kahler's audit committee chairperson, reflecting that Kahler's Board, after replacing Milner as CEO in late 1989, concurred in the Audit Committee's direction to management "to develop more conservatism in the Company's financial statements." That Top File also includes a December 1989 memorandum reflecting that Touche assessed the (continued...) ======END OF PAGE 16====== the foregoing, we conclude that the evidence available to Potts before the 1989 audit report issued demonstrated that there could be no reasonable expectation of gain on sale of the UPH. <(38)> C. With respect to Kahler's decision to treat the UPH as an asset held for sale from the beginning of fiscal 1988, Potts testified that he and Melsen, after discussion, agreed that the appropriate measurement date was "towards the end of the first quarter." Accordingly, Potts' concurrence in Kahler's reliance on APB 30 and EITF 85-36 for the entirety of fiscal 1988 is inexplicable. We agree with the law judge that, in this connection, too, Potts engaged in improper professional conduct. D. With respect to Potts' liability in connection with the 1989 financial statements, we reject his claim that Touche's National Office's concurrence in treating the Hotel as an operating asset as of the close of business on the last day of 1989, and in approving proposed footnote disclosure of the change in status from the end of 1988, insulates his conduct. Our focus, unlike that of the National Office, is not on the end- of-year financial statement presentation of the UPH. Rather, it is on Potts' concurrence in Kahler's reliance on APB 30 and EITF 85-36 for any <(37)>(...continued) "[m]ain sources of audit risk . . . [as] the client's aggressive attitude toward account- ing. . . ." <(38)> Potts contends that, because Kahler reclassified the UPH as an operating asset as of the close of business on December 31, 1989, the applicable accounting authority shifted from APB 30's and EITF 85-36's NRV analysis to an "impairment of value" analysis under another EITF Issue. See 1 EITF Abstracts, EITF Issue No. 84-28, "Impairment of Long-Lived Assets," at 59-60. Accordingly, in Potts' view, the alterations in the Riggs discounted cash flow valuation are not probative of any improper professional conduct (since the Riggs analysis was irrelevant at the time it was created and altered). To the contrary, consistent with the basic premise of APB 30 and EITF 85-36, a company must have a reasonable expectation of gain on disposition during the entire time an asset is held for sale in order to defer operating losses, and APB 30's requirements must be met during the entire period of deferral. By deferring the losses on the UPH, Kahler utilized APB 30 accounting for the entirety of 1989. The Riggs valuation was highly relevant to whether that accounting was permissible. ======END OF PAGE 17====== portion of fiscal year 1989, given the "red flags" raised about the propriety of this accounting treatment. <(39)> VI. In sum, Kahler's financial statements for fiscal years 1988 and 1989 departed from GAAP in a number of significant respects, and the Touche audits of those financial statements were not conducted in accordance with GAAS. Based on our de novo review, we agree with the law judge that Potts acted recklessly <(40)> in indicating, with respect to both audits, that he had reviewed the financial statements and concluded that they satisfied the standards of the profession. <(41)> We conclude that, <(39)> We have not undertaken to analyze whether the accounting treatment accorded the UPH in the 1989 financial statements would have been consistent with GAAP, had Kahler in fact intended during a portion of fiscal year 1989 to dispose of the Hotel (and met the other requirements for deferral of losses set out in APB 30 and EITF 85-36), and we thus take no position on that issue. <(40)> As noted in our opinion in Checkosky & Aldrich, Exchange Act Rel. No. 38183 (January 21, 1997) 63 SEC Docket 1948, 1957, n.23, citing SEC v. Steadman, 976 F.2d 636, 641-42 (D.C. Cir. 1992), recklessness has been described as "not merely a form of ordinary negligence; it is an 'extreme departure from the standards of ordinary care, which presents a danger of misleading buyers or sellers that is either known to the defendant or is so obvious that the actor must have been aware of it.'" We reject Potts' claim that, because the Order Instituting Proceedings in this matter did not specify that Potts acted recklessly, Potts cannot be found to have acted recklessly. The Order charged that Potts "engaged in improper professional conduct" by violating GAAS and by not following GAAP. Commission counsel put on evidence of Potts' recklessness beginning with the testimony of its first witness, and Potts' counsel specifically addressed Potts' state of mind at the hearing and in briefing. <(41)> We reject Potts' claim that there is no factual basis for the law judge's decision against Potts. As the Division points out, the staff introduced over 200 exhibits, and the law judge received expert testimony from a number of witnesses. Expert testimony can constitute direct evidence. ======END OF PAGE 18====== in light of the "total audit environment," <(42)> which reflected the keen significance to the financial statements of UPH loss deferrals and the heightened risk of material misstatement present in both audit years, Potts' deviations from the duties imposed by GAAP and GAAS constitute improper professional conduct. <(43)> A concurring partner provides important additional assurance that the audit has been conducted consistent with GAAS and that the financial statements meet the requirements of GAAP; his or her role is to provide substantially more than "window dressing." Potts' substantial departures from his professional duties establishes that this Commission cannot rely upon Potts to perform diligently and with reasonable competence his audit responsibilities. <(44)> VII. On several fronts, Potts challenges our authority to institute this action. First, Potts challenges our general authority to discipline accountants. Our Rule 2(e), however, is a valid exercise of the Commission's rulemaking authority under Section 23(a)(1) of the Exchange Act. The appellate courts that have addressed the validity of our Rule <(42)> Ernst & Ernst, 46 S.E.C. 1234, 1262 (1978); compare Touche Ross & Company, 45 S.E.C. 469, 473 (1974) (settlement) (circumstances should have required [auditor] to extend substantially its auditing procedures and to regard management representations with extreme care"). <(43)> Potts, in his role as concurring partner on these audits, was obligated to make an objective review of significant accounting, auditing, or reporting considerations. (See text accompanying notes 1, 19, & 20, supra.) As we have discussed in detail (see Part V of this opinion, supra), this record is replete with instances of Potts' demonstrated disregard for his obligation to exercise due care with respect to, and to bring professional skepticism to bear upon, the information he obtained in connection with the two audits. <(44)> Because we conclude that Potts acted recklessly, it is not necessary that we reach here the issue Commissioner Wallman explores in dissent -- "whether mere negligence, or even no culpable state of mind, is sufficient for an action under the Rule." Compare Checkosky, 63 SEC Docket 1948 (addressing, on remand from court of appeals, whether Rule 102(e)(1)(ii) requires a particular mental state). We do agree that, in certain instances, an appropriate response to a professional's actions may be this Commission's referral of that professional to a professional association. ======END OF PAGE 19====== 2(e) authority have held that the Rule "is 'reasonably related' to the purposes of the securities laws." <(45)> Second, Potts contends that we have acted unfairly by enforcing Rule 2(e) against him in this context. In his view, Rule 2(e) is unconstitutionally vague as applied to concurring partners because it fails to provide adequate notice of what conduct is prohibited. <(46)> While this matter represents the first litigated proceeding to come before us involving an accountant acting solely as a concurring partner, we cannot agree that Potts was without guidance as to appropriate professional standards. As an initial matter, disciplinary rules, like Rule 2(e), long have withstood vagueness challenges because professionals are deemed to know the standards that govern their conduct. <(47)> The standards we enforce <(45)> Davy v. SEC, 792 F.2d 1418, 1421 (9th Cir. 1986); Touche Ross & Co., supra, 609 F.2d at 582 (citation omitted). See also Checkosky and Aldrich v. SEC, 23 F.3d 452, 456 (D.C. Cir. 1994) (opinion of Silberman, J.) (noting that the D.C. Circuit, in Polydoroff v. ICC, 773 F.2d 372, 374 (D.C. Cir. 1985), affirmed the principle, articulated by the Second Circuit in Touche Ross & Co., that there can be little doubt that the Commission, like any other institution in which lawyers or other professionals participate, has authority to police the behavior of practitioners before it). <(46)> Potts argues, among other things, that this Commission may act against a concurring partner only after it (1) promulgates a rule that sets forth the required scope of a concurring partner's review of an audit of a public company (or that specifies what constitutes "improper professional conduct" by an accountant acting solely in the capacity of a concurring partner) or (2) sets forth, in an adjudicatory opinion with solely prospective application, what amounts to such a rule. <(47)> See, e.g., United States v. Hearst, 638 F.2d 1190, 1197 (9th Cir. 1980), cert. denied, 451 U.S. 938 (1981) (the phrase "conduct unbecoming a member of a bar" is not unconstitutionally vague because "[i]t refers to the legal profession's 'code of behavior' and 'lore,' of which all attorneys are charged with knowledge" and which are illustrated by the American Bar Association's Code of Professional Responsibility); Crimmins v. American Stock Exch., Inc., 368 F. Supp. 270, 277 (S.D.N.Y. 1973), aff'd, 503 F.2d 560 (2d Cir. 1974) (rejecting a vagueness challenge to American Stock Exchange, Inc. rule barring conduct in violation of (continued...) ======END OF PAGE 20====== in this matter -- basic precepts of GAAS, such as the duties to exercise due care, to evaluate whether audit conclusions are supported by sufficient competent evidential matter, and to bring to the work an appropriate level of professional skepticism, and of GAAP -- are standards to which all accountants must adhere, and within Potts' ready understanding. Accordingly, we have the power to apply them in analyzing conduct in this proceeding. We need not act prospectively, given that, as just discussed, we have concluded that GAAP and GAAS apply and that Potts, during the two audit years at issue, recklessly failed to carry out his important professional responsibility to provide additional assurance regarding the financial statements under audit. <(48)> Additionally, in our opinions and orders in a range of settled matters, we have provided guidance to the accounting profession as to the standards expected of concurring partners that we enforce here. <(49)> In Lester Witte & Co., Exchange Act Rel. No. 17423, Acctg. Ser. Rel. No. 285 (Jan. 7, 1981), [1937-1982 ASR Transfer Binder] Fed. Sec. L. Rep. (CCH) 72,307, at 62,859, for example, we made it quite clear that the purpose of a concurring partner review was reasonably to assure that the quality of the work performed during the audit was consistent with the standards of the profession. <(50)> In SEC v. Grant Thornton, Civ. <(47)>(...continued) "just and equitable principles of trade" because an experienced securities representative "may fairly be charged with knowledge of the ethical standards of his profession"). <(48)> In William R. Carter, et al., 47 S.E.C. 471, 508 (1981), in contrast, we concluded that no "generally recognized norms of professional conduct" governed the conduct at issue. <(49)> Various commentators have duly noted our recognition of the significance of concurring partner review. See, e.g., Robert K. Mautz and Louis W. Matusiak, Concurring Partner Review Revisited, Journal of Accountancy, March 1988, at 56, 60. <(50)> Id. at 62,865. We found that the concurring partner whose conduct we reviewed relied unduly on the engagement partner's oral assurances, looked at only a few accounts receivable work papers (although he considered accounts receivable and inventory the most important asset accounts of the company), and failed to inquire into, among other things, the lack of work paper documentation. We did not sanction the concurring partner, as we concluded that the partner's laxity could be attributed in part to the firm's "inadequa[te]" concurring partner review program. Id. (continued...) ======END OF PAGE 21====== Act. No. 86-6832 (S.D. Fla.), Acctg. and Audit. Enf. Rel. No. 118 (Oct. 16, 1986), [1982-87 AAER Transfer Binder] Fed. Sec. L. Rep. (CCH) 73,518, we instituted and settled an action against, among others, an "impartial quality control review" auditor who, like Potts, had the responsibility to detect inconsistencies or errors that appeared in the workpapers that might evidence violations of GAAP and GAAS. We alleged that the auditor failed to detect numerous inconsistencies, errors, and violations of GAAP and GAAS disclosed by the workpapers and notes to the financial statements. <(51)> Further, the Stephen O. Wade matter, Exchange Act Rel. No. 21095, Acctg. and Audit. Enf. Rel. No. 32 (June 25, 1984) [1982-1987 AAER Transfer Binder], Fed. Sec. L. Rep. (CCH) 73,416, highlighted the improper conduct of a concurring partner who permitted a company improperly to defer losses on secur- ities. <(52)> We also previously have explored the nature of due care and professional skepticism, for example, as these concepts relate to accountants generally. We concluded, for instance, in one settled matter presenting circumstances with marked similarity to those at issue here, Robert E. Nilssen, 48 S.E.C. 570 (1986), that the partner in charge of the audits at issue engaged in improper professional conduct because he had not followed up on his request to management for information on the disposition of a significant portion of a company's shares, made after his review of documentary evidence that contradicted outside counsel's "verbal assurances" that the shares were not regarded as out- standing. <(53)> Similarly, in Hertz, Herson & Co., 45 S.E.C. 889 <(50)>(...continued) In settling the proceeding, the firm agreed to submit to a review by the SECPS's Peer Review Committee of, among other things, its quality control policies and procedures on Commission audits. <(51)> That auditor consented to the entry of an injunction permanently enjoining him from future violations of Section 17(a) of the Securities Act. <(52)> We concluded that the concurring partner knew both that the relevant accounting pronouncements permitted loss deferral only where the securities were substantially the same, and that the securities at issue differed in the key respects of interest rate, estimated lives and yields. In settling the proceeding, the concurring partner agreed to a three-year suspension from auditing Commission-filed financial statements. <(53)> Id. at 571, 573, 583. We found that the auditor "did not require production of any further documentary or further corroborating evidence relevant to the assertion" that the shares should not be treated as (continued...) ======END OF PAGE 22====== (1975), we concluded that a firm of accountants that had relied unduly on management representations concerning the collectibility of delinquent leases, "failed to use due professional care in that it did not sufficiently extend its audit tests by obtaining . . . adequate, competent evidential matter to determine the veracity of management's representations." <(54)> Also, in Stephen Kutz, Exchange Act Rel. No. 24027, Acctg. and Audit. Enf. Rel. No. 127 (Jan. 28, 1987), [1982-1987 AAER Transfer Binder], Fed. Sec. L. Rep. (CCH) 73,527, at 63,389-29, we advised that, "[w]here the audit evidence is inadequate or suspect, the auditor must exercise an increased degree of professional skepticism." Accordingly, under all the circumstances, we conclude that the requirements of due process have been amply met in this proceeding. <(55)> <(53)>(...continued) outstanding. Id. at 573. We accordingly concluded that the auditor "placed undue reliance on management representations," and, "in failing to make additional inquiry, failed to exercise sufficient professional skepticism and obtain adequate competent evidential matter relevant to the issue as required by GAAS." Id. For these and other failures, the auditor consented to a twelve-month suspension from practice before us. <(54)> We also commented that the accountants had failed to evaluate "documentation" where it was available. Id. at 890. See also Norman Abrams, 49 S.E.C. 753, 757 (1988) (sanctioning, on consent, accountants for failing to gather competent evidential matter on a wide variety of issues and for accepting "without appropriate professional skepticism, undocumented representations of [the company's] management"). <(55)> We reject Potts' claim, made in reliance on Upton v. SEC, 75 F.3d 92 (2d Cir. 1996), that this proceeding is an attempt to sanction him pursuant to a substantial change in our enforcement policy that we have not communicated to the public. Nor can we agree with the dissent's suggestion that the standards that we discuss and apply here may very well not be the standards in place when Potts performed his Kahler audit work. The dictates of GAAS and GAAP themselves, with their attendant requirements, determine whether Potts engaged in improper professional conduct as a concurring partner. Here we are evaluating Potts' conduct against well-established professional and auditing standards relating to the conduct of auditors that were promulgated long before this respondent assumed his audit responsibilities. In so doing, we are not holding that Potts was obligated to "insure" the accounting treatment here. ======END OF PAGE 23====== VIII. Potts makes various allegations of procedural impropriety, which we have determined to reject. He contends that the law judge's determination to exclude the testimony of Roberta Karmel, who is not an accountant, was improper, and proffers that Ms. Karmel would have testified that the role and responsibilities of the concurring partner have not been clearly defined by this Commission. A decision to exclude such testimony was within the law judge's discretion, and we believe it was proper. Mere opinion on the law such as that to be offered by Ms. Karmel would not provide evidence under Rule 14(a) of our Rules of Practice. <(56)> Potts also claims that the law judge improperly relied on settlements entered by others implicated in this matter as indicia that Potts had acted improperly. <(57)> The law judge's references to these settlements were not improper, as they were not a basis for establishing Potts' liability. The reference to our settlement with Melsen, for instance -- like that included early in this opinion <(58)> -- explained why Melsen is not a party to this action. Moreover, we do not agree that the law judge considered the settlement arising from Potts' earlier conduct as an engagement partner in deciding liability. Rather, the law judge considered that settlement in fashioning a sanction. <(59)> <(56)> Former Rule 14(a) provides that a hearing officer shall receive relevant and material evidence, but should exclude irrelevant evidence. 17 C.F.R.  201.14(a) (1994). The testimony of expert witnesses on questions of law may be precluded, because adjudicators -- courts and administrative law judges -- are themselves qualified to determine and interpret the law. See, e.g., United States v. Bilzerian, 926 F.2d 1285, 1294 (2d Cir.), cert. denied, 502 U.S. 813 (1991). <(57)> The law judge noted in his opinion that Kahler, its officers, and Melsen had settled with this Commission. The law judge also noted that Potts had been the engagement partner on an audit which resulted in a settled Rule 2(e) proceeding against the audited company and Touche. <(58)> See note 7 supra. <(59)> The use of a prior settlement for such a purpose is well-established by our precedents and, in any event, has little significance here, as we have determined to impose a lesser sanction than that imposed by the law judge. Compare, e.g., Belton v. Fibreboard Corp., 724 F.2d 500, 505 (5th Cir. 1984)(admitting evidence of settlements for purposes other than proving liability or the amount of damages does not contravene Rule 408 of the Federal Rules of Evidence). ======END OF PAGE 24====== We now turn to Potts' claims that the law judge prejudged the outcome in this matter and was prejudiced against him. Our de novo review of this record leaves us convinced -- despite the law judge's unfortunate reference to our charging decision <(60)> -- that the law judge's conclusion that Potts engaged in improper professional conduct rested not on our decision to institute proceedings, but on the evidence received at the hearing. Potts also contends that the law judge impermissibly shifted the burden of proof to him. The law judge did not. The statements to which Potts points merely suggest that the law judge found the Division's witnesses credible and that, as a result, the Division had presented a prima facie case against Potts. <(61)> The burden of persuasion always remained with the Division. Although we do not consider the law judge's comments improper, we have weighed the evidence and find that the Division has proven its case by a preponderance of the evidence. We are convinced that the law judge permitted Potts to put on the evidence he wished and to defend himself fully, <(62)> that Potts was accorded a fair hearing, and that the law judge's decision was not the product of bias. Moreover, we have engaged in extensive de novo review in this case, dissipating the possibility of bias. <(63)> In sum, we have reviewed <(60)> We refer to the law judge's statement that "even if there was some indication that Potts acted in good faith, it is irrelevant to the issue to be determined in this case. . . . [I]f Potts had merely made an error of judgment or had been careless, it is unlikely that the Commission would have considered him an appropriate subject for professional discipline." <(61)> Compare, e.g., Donald T. Sheldon, 51 S.E.C. 59, 77 (1992), aff'd, 45 F.3d 1515 (11th Cir. 1995) (burden of defending pricing of securities shifted to respondents following presentation of evidence that it was fraudulent). <(62)> While counsel urges that we find bias from the fact that the law judge brusquely interrupted counsel's cross-examination of a Division expert witness to direct, in effect, that counsel's questioning be kept brief and focussed, the law judge permitted counsel to conduct a cross-examination of significant length. <(63)> Potts reasonably objects to the law judge's finding that Milner was "more credible" than Potts in testimony as to why Kahler's financial statements did not identify the UPH as the asset held for sale. Milner in fact had not offered an explanation: the law judge mistakenly attributed to Milner the explanation that Commission counsel, in a question put to Potts, had offered on the point. We, however, reject as without, variously, legal or record support, Potts' additional arguments, including that (1) we (continued...) ======END OF PAGE 25====== with care Potts' claims of bias as against the fairness and reasonableness of the law judge's evidentiary rulings and factual and legal conclusions. In our view, this remedial action properly may be based on the record as developed before the law judge. IX. Potts contends that the suspension ordered by the law judge is excessive. Under all the circumstances, we believe that the appropriate response to Potts' improper professional conduct is a nine-month suspension from practice before us. This proceeding brings into sharp focus the consequences of a concurring partner's failure to fulfill his or her professional responsibilities. Potts' actions evidence a lack of sensitivity to his obligations as an accountant concurring in the release of unqualified audit opinions on financial statements reviewed by public investors. Given Potts' long experience in the accounting profession, he may return to that profession and again conduct concurring partner reviews. A suspension is necessary to impress upon him the need to exercise due care and professional skepticism, and to comply with other essential standards of his profession when he conducts such reviews and engages in other conduct as an accountant. <(63)>(...continued) engaged in selective prosecution in bringing this action against him; (2) the staff advocated strict liability in arguing that a violation of GAAS and GAAP is improper professional conduct; (3) the law judge erred in not permitting Potts to depose Walter P. Schuetze, then our Chief Accountant, concerning Mr. Schuetze's views that existing standards for concurring partner review should be strengthened; and (4) the location of the hearing -- on four days out of eight -- in a Commission conference room rather than a public meeting room rendered the hearing nonpublic in violation of the Administrative Procedure Act. We also deny Potts' motion to take Mr. Schuetze's deposition. Pursuant to Rule 18 of our former Rules of Practice, we have determined to accept all briefs filed by the parties in connection with this matter. We will not make a part of this record -- nor have we considered the parties' filings with respect to the contents of -- the AICPA's October 1994 letter to Chairman Levitt. This letter was an ex parte communication. The AICPA failed to seek leave either to be heard before the hearing officer, as our former Rules of Practice permit (Rule 9(c) and (f), 17 C.F.R. 201.9(c) and (f) (1994)), or to file with us an amicus brief -- the appropriate vehicles for addressing the Commission concerning matters in litigation. ======END OF PAGE 26====== An appropriate order will issue. <(64)> By the Commission (Chairman LEVITT and Commissioner HUNT); Commissioner JOHNSON concurring; Commissioner WALLMAN dissenting. Jonathan G. Katz Secretary Commissioner JOHNSON, concurring: I concur in the majority's judgment that Robert D. Potts engaged in improper professional conduct. See Commission Rule of Practice 102(e)(1)(ii). I write separately to emphasize several points. In Checkosky & Aldrich, a case in which Commissioner Wallman did not participate, I dissented from the opinion of two commissioners who held that negligence may be a sufficient basis for liability under Rule 102(e)(1) -- in my view, scienter is required to establish a violation of Rule 102(e). See Exchange Act Release Rel. No. 38183 (Jan. 21, 1997), 63 SEC Docket 1948, 1975-77 (dissenting opinion). As reflected in his dissenting opinion in this case, Commissioner Wallman concurs that mere negligence is insufficient for liability under Rule 102(e)(1). <(1)> The current Commission is thus evenly split two-two on this issue. My view on the outcome of this case differs from Commissioner Wallman's because I believe that Potts acted with scienter. Commissioner Wallman questions whether sufficient guidance on the question of concurring partner responsibilities existed at the time of Potts' conduct. While I acknowledge that there may not have been an abundance of authority on the subject at that time, I believe that professional standards and requirements applicable to all accountants required Potts to exhibit a greater degree of care than he did. Under existing accounting standards, a concurring partner -- like any accountant -- has, at a minimum, an obligation to make "an objective review of significant accounting, auditing, or reporting considerations." <(2)> Moreover, GAAS requires that accountants obtain "[s]ufficient competent evidential matter" to <(64)> All of the contentions advanced by the parties have been considered. They are rejected or sustained to the extent that they are inconsistent or in accord with the views expressed herein. <(1)> See infra text accompanying dissent note 1. Commissioner Wallman believes that a pattern of negligent behavior demonstrating incompetence, for instance, may satisfy Rule 102(e)(1). I continue to adhere to the view I expressed in Checkosky that only improper professional conduct committed with scienter is sufficient. <(2)> SECPS Manual at 1. ======END OF PAGE 27====== afford a reasonable basis for an opinion. <(3)> Potts did not meet these standards. What is plain is that Potts clearly had notice of irregularities in accounting for the University Park Hotel and that he failed to require the engagement partner to support the accounting treatment used. Underscoring Potts' work here was the importance of the accounting treatment of the hotel in the overall context of the Kahler audits. The decision to capitalize losses flowing from the hotel, as opposed to treating them as losses and expensing them, was not a peripheral accounting issue, but instead a primary focus of the audit. Under any accounting standard, Potts was required to do more than simply recognize that irregularities in the audit existed; he was obligated to go further to assure that the accounting treatment used had an adequate basis. Potts' failures allowed Kahler to overstate net income and understate net losses for those two years in a material way. In light of Potts' conduct and his probable future practice before the Commission, a sanction here is warranted. I agree that a nine-month suspension from practice before the agency is consistent with past Commission precedent. Commissioner WALLMAN, dissenting: I. Introduction The majority of the Commission affirms the law judge's finding in this case that Mr. Potts, a concurring partner for audits of Kahler Corporation in fiscal years 1988 and 1989, engaged in improper professional conduct under Rule 102(e)(1)(ii) (the "Rule") of the Commission's Rules of Practice. As a result, Mr. Potts has been suspended from practicing before the Commission for nine months. This case raises, once more, the issue of the appropriate standard to be used by the Commission in connection with taking action under the Rule. I write separately to express my views on that increasingly ambiguous matter. In addition, the majority finds that Mr. Potts was reckless with regard to his actions as a concurring partner on the Kahler audit. I dissent from that finding. It is not possible to reach that conclusion based on the record before us as to the standards that existed regarding the required conduct, almost a decade ago, of concurring partners. II. Summary The opinion of two of the Commissioners describes why Kahler's accounting treatment of, among other things, the University Park Hotel, was not in accordance with Generally Accepted Accounting Principles (GAAP) and why the audits were subsequently faulty. I agree that Kahler's accounting was faulty. I also agree that the audit was poorly crafted and not in conformance with Generally Accepted Auditing Standards (GAAS). I further agree that the engagement partner did not comply with GAAS, and that Mr. Potts' actions as concurring partner did not prevent these audit failures. <(3)> AICPA AU  150.02, Standards of Field Work, 3. ======END OF PAGE 28====== I find, however, that the lack of clarity regarding the standard for concurring partners in 1988 and 1989, combined with this record -- and its many infirmities -- provides insufficient information to allow a determination as to whether Mr. Potts was reckless or negligent (or perhaps even something less) in connection with his concurring partner duties in this audit. Consequently, because I dissent from that finding of recklessness, it is necessary for me to reach the issue of whether mere negligence, or even no culpable state of mind, is sufficient for an action under the Rule. As more fully described below, our inquiry in actions under the Rule must be focussed on the fitness of a professional to continue to practice before the Commission. Accordingly, I believe the minimum standard for action under Rule 102(e)(1)(ii) must be something more than mere or simple negligence. An act of mere negligence, or less, simply does not threaten the Commission's processes in a manner that should permit the Commission to take action under the Rule. To act in such a case evidences a desire to punish negligence or an error, not to protect the Commission. The securities laws provide remedies for wrongful actions, and sometimes there is liability for behavior that is negligent (or under certain strict liability provisions, for behavior that is wrong, even where there is no negligence). <(4)> The Rule, by contrast, is designed to protect the Commission's processes on a prospective basis. Transforming it into another arrow in the quiver of available remedies whenever anything goes wrong is, in my view, unwise over the long term. It will chill professionals in the appropriate discharge of their duties, bias audits and other professional judgments, increase costs, and result in lesser, not greater, professional involvement with difficult judgment calls. Ultimately, such actions will disserve the investing public. I also believe, however, that the Rule is well designed to reach activities that do evidence an unfitness to practice before the Commission. Simply put, the Commission must be able to protect itself from the clear incompetence of incorrigibly inept professionals practicing before it, as well as from miscreants. Consequently, a pattern of negligence may rise to the level where a professional should not be permitted to practice before us. But that is different than saying that mere negligence could constitute unethical or improper professional conduct under the rule sufficient to bar a professional from his livelihood. Consideration of a professional's mental state helps inform the decision as to whether it is appropriate for the Commission to protect its processes by taking action under the Rule. Past negligent acts (other than those evidencing a pattern) would not support a conclusion that action is appropriate. I make this point particularly mindful of the ease with which one or more difficult judgment calls made by a professional -- which subsequently prove to be incorrect -- might be improperly characterized as "negligence." In sum, to support a suspension or bar of a professional under Rule 102(e)(1)(ii), I believe a professional must have evidenced unfitness to <(4)> In those circumstances there generally are numerous limitations on the actions and protections for the defendants. ======END OF PAGE 29====== continue to practice before the Commission. In other words, the professional must have acted such that (i) the behavior is known by the professional to be wrong (e.g., lacking in character or integrity, or unethical or improper) or the professional was reckless in not knowing that it was wrong, or (ii) the Commission can conclude that the professional will likely engage in such wrongful behavior in the future (e.g., a pattern of acts indicating that the professional lacks the knowledge, competence or moral fiber to perform the responsibilities and duties expected of such a professional). My respected colleague, Commissioner Johnson, would set the standard under Rule 102(e)(1)(ii) such that an action could be maintained only in instances where the professional's work is imbued with scienter. I would not necessarily raise the bar to that level because, as I have noted, there are instances where a pattern of negligence justifies action under the Rule. III. The Standard for Action Under Rule 102(e)(1)(ii) A. Negligence Introduction. In Checkosky & Aldrich, <(5)> an opinion in which I did not participate, the Commission, in a two to one decision (Commissioner Johnson dissenting), articulated a standard for action under Rule 102(e)(1)(ii). In that case, the Commission stated that "Rule 2(e)(1)(ii) does not mandate a particular mental state and that negligent actions by a professional may, under certain circumstances, constitute improper professional conduct." I believe the standard for actions under Rule 102(e)(1)(ii) can be satisfied by negligent actions only when such acts bespeak a pattern of incompetence. I explicitly reject any view that, for example, "mere negligence" is sufficient for action under the Rule. The language of Rule 102(e)(1)(ii), its history and its purpose all indicate that some form of knowing behavior, recklessness amounting to knowing behavior, or a pattern of culpable behavior by a professional -- in each case behavior that <(5)> Exchange Act Release No. 38183 (Jan. 21, 1997), 63 SEC Docket 1948. ======END OF PAGE 30====== amounts to a threat to our processes -- is required before the Commission can deny him or her the privilege of practicing before it. Rule 102(e)(1)(ii) states: The Commission may censure or deny, temporarily or permanently, the privilege of appearing or practicing before it in any way to any person who is found by the Commission after notice and opportunity for hearing in the matter: *** ii) To be lacking in character or integrity or to have engaged in unethical or improper professional conduct; *** Rule 102(e)(1) was first enacted by the Commission shortly after its creation in 1934. The Rule was part of the Commission's Rules of Practice promulgated under the Commission's general rulemaking powers. <(6)> In its original incarnation, the rule provided that the Commission, in its discretion, could "suspend or disbar, any person who does not possess the requisite qualifications to represent others, or who is lacking in character, integrity, or proper professional conduct." The current language of Rule 102(e)(1)(ii) was enacted by the Commission in 1946. <(7)> The Commission's authority to adopt and administer the Rule has been upheld by the federal courts including the Second Circuit Court of Appeals which found that the Rule "provides the Commission with the means to ensure that those professionals, on whom the Commission relies heavily in the performance of its statutory duties, perform their duties diligently and with a reasonable degree of competence." <(8)> The Rule was promulgated to protect the integrity of the Commission's processes. <(9)> It addresses the problem of professional misconduct, "and its sanction is limited to that necessary to protect the investing public and the Commission from the future impact on its processes of <(6)> Exchange Act Release No. 17597 (February 28, 1981), 22 SEC Docket 292. <(7)> Securities Act Release No. 3154 (Sept. 4, 1946). In 1970, the Commission added a third prong to the rule, specifically addressing "willful" violations of the federal securities laws as a basis for denying professionals the privilege of practicing before the Commission. Amendment of Rule 2(e) of the Rules of Practice, Securities Act Release No. 5088 (Sept. 24, 1970). <(8)> Touche Ross & Co. v. SEC, 609 F.2d 570 (2d Cir. 1979). See also, cases cited in Carter & Johnson; Checkosky & Aldrich. <(9)> See Carter & Johnson. ======END OF PAGE 31====== professional misconduct." <(10)> As the Commission recognized in Carter & Johnson, "Not every violation of law . . . may be sufficient to justify invocation of the sanctions available under Rule 2(e). The violation must be of a character that threatens the integrity of the Commission s processes in the way that the activities of unqualified or unethical professionals do." <(11)> Notwithstanding the Rule's over sixty year life, until the Checkosky & Aldrich opinion, the Commission has never stated that mere negligence was sufficient to sustain an action under Rule 102(e)(1)(ii). <(12)> And with this case, the Commission now no longer can sustain that holding -- at the very least it is split evenly on that issue -- as both Commissioner Johnson and I explicitly believe that mere negligence is insufficient, with Commissioner Johnson requiring scienter. Language of Rule 102(e)(1)(ii). The issue in these cases focusses on the term "improper professional conduct" in Rule 102(e)(1)(ii), as if that term stands alone. But "improper professional conduct" does not stand alone. As it is used in the Rule it is inextricably intertwined with "unethical" conduct, as well as with the phrase "lacking in character or integrity." Unlike, for example, different sections of a statute as in Aaron v. SEC, <(13)> or even different subsections of a rule -- here we are interpreting the words in but one prong of one rule. Unethical conduct includes an element of bad faith and thus some form of intent on the part of the actor, as do issues relating to character or integrity. One does not negligently have bad character, lack integrity or act unethically. Reading "improper" outside the clear context of the rest of the words in this prong of the Rule would mislead as to its meaning. <(10)> Id. at 297. <(11)> Id. at 298. <(12)> The Commission never rendered a decision in Danna and Dentinger v. SEC, No. C-93-4158 (N.D. Cal. Feb. 8 1994), and the reviewing court held only that the Commission s authority under the Rule is not limited to cases of bad faith or intentional misconduct -- a view to which I also subscribe. <(13)> 446 U.S. 680 (1980). My analysis is consistent with the Supreme Court's analysis in Aaron. In analyzing section 17 of the Exchange Act, the Court was analyzing separate subsections of the statute, not words within the same prong of a rule. More importantly, the Aaron Court distinguished, as do I, between the effect of the particular conduct on the public -- as I will discuss below -- versus the culpability of the person responsible and the effect of the professional's behavior (which can include the professional's state of mind) on the Commission's processes. The entirety of the second prong of Rule 102(e)(1) focuses on the actions of the professional as they relate to the Commissions processes, including when such actor engages in improper professional conduct. ======END OF PAGE 32====== Simply put, prong two uses three terms that clearly include some sense that the person is a bad actor; it would be odd then to interpret the fourth -- in the same prong and linked to the other three -- to embody a different standard. <(14)> Mere negligence in satisfying generally accepted auditing standards, unless it bespeaks a pattern of incompetence, clearly does not fit. Purpose of Rule 102(e)(1)(ii). As noted, the Rule was promulgated by the Commission "in order to protect the integrity of its processes." <(15)> If a person commits a merely negligent act, it will not necessarily raise any threat to these processes. A past negligent act may, of course, cause a financial statement to be misleading, or an opinion of counsel to be inaccurate, as can a completely innocent mistake. However, unless a past wrong informs a conclusion that there exists a threat to the Commission's future processes, it is not proper to utilize the fact that there is an impact from that wrong to justify taking action under the Rule. If we sanction under the Rule by focussing on the effect of past acts, why require the professional to have acted negligently at all -- why not concentrate just on the impact and make it clear that any act that results in a material misstatement is obviously "improper" and will be actionable? The public is harmed, the Commission's and the statute's intricate balance of disclosure and investor reliance are all upset, with costs visited on investors and our whole system of capital formation just as surely by a disclosure that is materially inaccurate or a financial statement that is materially misstated because of non-negligent mistakes as by negligent or intentional ones. The answer, of course, is obvious. The Rule, and for good reason, does not provide liability and some punishment when an inaccurate disclosure is made by a covered person because of the impact of the act on public filings. Rather, it is designed to protect the Commission's processes from future harm that would result from continuing professional misconduct. Merely negligent actions by a professional years ago do not present any realistic threat to the Commission s future processes today. Yet, under the standard articulated in Checkosky, any act of negligence supports a conclusion that a professional presents a threat to the Commission. It is hard to perceive where a line will be drawn with respect to a professional who makes a negligent mistake. Presumably, under this standard, there will always be -- almost by definition -- a similar threat to the Commission's future processes whenever negligence, or any mistake, exists. Something more is needed to guide professionals and to inform the Commission when action under the Rule is appropriate; standards must have substance for them to be meaningful. As the Commission in Carter & Johnson <(14)> As used in this prong, unethical and improper are, I believe, intended to be relatively consistent as to their reach. In any event, there clearly is sufficient ambiguity as to what "improper" means -- with two of the current four Commissioners taking a position different from that of the other two -- that resort to the surrounding context for assistance in interpreting its meaning is obviously important. <(15)> See Carter & Johnson. ======END OF PAGE 33====== noted, "It is that element of [wrongful] intent which provides the basis for distinguishing between those professionals who may be appropriately considered as subjects of professional discipline and those who, acting in good faith, have merely made errors of judgment or have been careless." <(16)> The securities laws and regulations, and particularly the accounting rules that must be interpreted and applied by professionals, are complex. Reasonable people differ on the interpretations of those laws and regulations. Professionals must have some flexibility to exercise their judgment in difficult situations. They should not be subject to action under Rule 102(e)(1)(ii) for making an incorrect decision -- especially one that we would characterize as "negligent" or "merely negligent." My colleague Commissioner Johnson stated this thought quite aptly in his dissent in Checkosky where he wrote: A professional often must make difficult decisions, navigating through complex statutory and regulatory requirements, and in the case of accountants, complying with Generally Accepted Auditing Standards ("GAAS") and applying Generally Accepted Accounting Principles ("GAAP"). These determinations require the application of independent professional judgment and sometimes involve matters of first impression. For this reason, I believe that an earlier Commission was correct to assert that, if a professional is to exercise his or her best independent judgment . . . [the professional] must have the freedom to make innocent - - or even, in certain cases, careless -- mistakes without the fear of [losing] the ability to practice before us. <(17)> I concur with Commissioner Johnson's statement: "I simply do not believe that we should recast negligent violations of an accounting standard as improper professional conduct under the Commission's Rules of Practice." <(18)> <(16)> This statement from Carter & Johnson is made within the section of the opinion discussing aiding and abetting in prong (iii) of the Rule. I believe this statement underscores the purpose of the Rule generally. <(17)> Checkosky at 1976 (citations and footnotes omitted). <(18)> Id. at 1977. ======END OF PAGE 34====== B. Scienter Constituting Scienter. For the above reasons, I believe the minimum standard for improper professional conduct under Rule 102(e)(1)(ii) is behavior that is known by the professional to be wrong (or the professional was reckless in not knowing that it was wrong) or that supports a conclusion by the Commission that the professional will likely engage in such wrongful behavior in the future. Consequently, I do not believe the standard includes only actions imbued with scienter. Clearly, scienter, which could be satisfied by reckless behavior, is sufficient to take action under the Rule. As the majority opinion notes, recklessness is "not merely a form of ordinary negligence; it is an `extreme departure from the standards of ordinary care, which presents a danger of misleading buyers or sellers that is either known to the defendant or is so obvious that the actor must have been aware of it.'" <(19)> This type of behavior is obviously a danger to the Commission's processes. <(20)> However, the issue is not one of negligence versus scienter. Rather, the issue is whether the individual has the professional fitness to continue to practice before the Commission. For example, there may be situations in which a pattern or series of negligent acts rises to a level that warrants Commission action under Rule 102(e)(1)(ii). Depending on the specific circumstances, where a professional commits a negligent act, is made aware of the negligence or mistake and repeats the same or similar act, such repeated negligence should make the person aware that they are incompetent to continue performing in this professional capacity. Continuing to act with such awareness may rise to the level of recklessness. But even if it does not, the Commission must be able to protect itself from the clear incompetence of incorrigibly inept professionals practicing before it. But saying that a pattern of negligence could rise to the point where a professional should be barred or suspended from practice before us is very different from <(19)> Opinion at n.40 (citations omitted). <(20)> It might be argued that an act of mere negligence presents a similar threat to the Commission's processes on a theory that a professional whose negligence has been discovered on one occasion is more likely to make other negligent mistakes in the future than a professional whose record is unblemished. However, as the culpability associated with a particular act increases, the likelihood that a professional might act similarly in the future -- and thus threaten the Commission s processes -- also increases. Reckless conduct, including, for example, conduct occurring several years ago, could support Commission action under the Rule, as such conduct bespeaks a callousness regarding, and a willingness to disregard, basic principles of duty and care. As I indicate later in this dissent, the Commission could modify its Rules of Practice if it makes the determination that it must protect its processes against mere negligence; but, Rule 102(e)(1)(ii), as presently written, does not encompass such negligence. ======END OF PAGE 35====== adopting a standard that a single act of negligence can be deemed unethical or constitutes improper professional conduct sufficient under the Rule to preclude a professional from pursuing his livelihood. IV. Other Concerns Prosecutorial Discretion. As a matter of policy, the Commission could make the standard for Rule 102(e)(1) as low as possible and then exercise prosecutorial discretion in determining when to suspend individuals from practicing before it. I believe that to do so, however, would confuse the prosecutorial function of the Commission with its adjudicatory obligations. Certainly, from a prosecutorial standpoint a lower standard is better, enabling the Commission to be flexible and exercise its discretion. In our adjudicatory role, however (as we are acting here), the Commission is charged with interpreting and applying the law. We need to act as impartial judges blind to our role as prosecutor -- not as advocates for our prosecutorial function. Distinctions Between Accountants and Other Professionals. Separately, I also find very troubling the notion that the Commission applies different standards for actions under Rule 102(e)(1) to accountants as compared to attorneys. The Commission has generally refrained, as a matter of policy, from using Rule 102(e)(1) to make determinations regarding the professional obligations of attorneys. As a result, Rule 102(e)(1) proceedings against attorneys have generally arisen only where the attorney s conduct has already been adjudicated to violate the law, almost exclusively by federal courts in non-Rule 102(e)(1) proceed- ings. <(21)> These cases, since the decision in Ernst & Ernst v. Hochfelder, <(22)> must generally involve knowing or reckless conduct by the attorney involved. As a result, a negligence standard under the "improper professional conduct" provision of Rule 102(e)(1) would likely never be the basis for such an action against attorneys. Under the opinion of two of my colleagues in Checkosky and Aldrich, however, for accountants with GAAP and GAAS standards to adhere to, the Commission could bring a case based on negligence in the violation of those standards, finding that the behavior constituted "improper professional conduct." I do not believe there is a legitimate reason for such a dramatic distinction. Rulemaking. Finally, I note the obvious: Rule 102(e)(1) is a Commission rule. Clearly it is sufficiently vague that reasonable minds differ -- and have differed -- strongly about the standards applicable to actions under its terms. Notably, the Commission is now either moving away from its recent holding in Checkosky and Aldrich, or split evenly on this precise issue. If the Commission believes that mere negligence should be the basis for denying a professional the privilege of practicing before it, the Commission should amend its own Rule to make the standard clear. It is unfair to the professionals practicing before the Commission, and an enormous waste of Commission resources, to be unable to discern from the face of our rules what standards are to be applied. I find it extremely strange that this debate is pursued in the context of opinions in <(21)> Id. <(22)> 425 U.S. 185 (1976). ======END OF PAGE 36====== enforcement proceedings as opposed to in a rulemaking where the Commission can state its own mind clearly, after notice and comment and due reflection of the issues, and without the press of individual professional careers, and audit failures, at stake. Why don't we propose to amend the Rule if we believe mere negligence is sufficient? Today, we send no clear message, other than that two of us believe mere negligence is insufficient. We should now address this matter through rulemaking. V. The Standard for Concurring Partner Review Assuming the standard for liability is one of recklessness, the majority finds on the record before us that Mr. Potts' actions satisfied that standard. I cannot agree because the lack of clarity as to the standard of conduct for concurring partners during the relevant time period, combined with this record, does not allow us to make this finding. Mr. Potts was a concurring partner in 1988 and 1989. He acted in this capacity only because, as a member of the SEC Practice Section of the American Institute of Certified Public Accountants, Deloitte and Touche required a concurring partner for SEC engagements, such as the Kahler audits. <(23)> As concurring partner, Mr. Potts was to provide a second level of review affording "additional assurance" that the company's financial statements were presented in accordance with GAAP and that the audit procedures were conducted in accordance with GAAS. <(24)> The AICPA's SECPS Manual provided, at best, guidelines for concurring partner review, but the record does not indicate whether there were any standards for this "additional assurance" in the late 1980s, and if so what they were. Was it to review the audit in detail, or perhaps ask some questions to assure that the engagement partner was attempting to comply with GAAS, or was it something more or something less? The SECPS Manual guidelines included reading the financial statements and the audit firm s report thereon, and making an objective review of significant considerations, along with discussing such matters with the engagement partner and reviewing selected work papers. All this, Mr. Potts did. He might not have done it as well as we might like -- but he did do it. Did he do it so poorly that his actions were reckless -- or merely negligent or something less? The opinion of two of the Commissioners cites to general literature as to the obligations of auditors and the requirements for an auditor, such as the engagement partner, in connection with performing an audit under GAAS. These requirements are clear and not controverted. But the opinion confuses the obvious. Of course auditors are to exercise due care, evaluate properly and employ professional skepticism. This applies to all auditors everywhere, including those in the national offices and on other audits. So what? The issue is what was a concurring partner on an engagement in 1988 and 1989 supposed to be doing in the context of this kind of audit for the Kahler Corporation being run by a presumably competent engagement partner in one of the nation's respected accounting firms. Specifically, what is unclear and controverted is what precisely were the then obligations of the concurring partner -- not the engagement partner -- in concurring with respect to an audit. The majority cannot say what they were, because there is no answer in the record. <(23)> See Opinion at n.1. <(24)> Id. ======END OF PAGE 37====== The opinion of two of the Commissioners cites expert testimony on the role of a concurring partner during the relevant period. <(25)> The experts address generally what they believe a concurring partner is meant to do. They all agreed that the general requirement for a concurring partner was to provide additional assurances. They all also concurred that there are no written standards specifying what this additional assurance requires on the part of the concurring partner (other than the general SECPS Manual guidelines noted above). In fact, one of the experts noted, in response to a question about why he was testifying, that he "felt that the profession would be enhanced if there were clarification of the requirements so that others in the profession would really understand clearly what was intended by the SEC Practice Section rules on concurring review." <(26)> Obviously, even when this expert recently testified, there was uncertainty in the area that needed clarification. If there is uncertainty in the profession now, as I understand there is, it seems fair to assume that even greater uncertainty existed in the late 1980s. Understanding the applicable standard and practice today, one could conclude that Mr. Potts' mistakes were negligent. Some, including the ALJ and the majority, conclude that these mistakes amounted to recklessness. But without knowing the applicable standard almost ten years ago, it is not possible to tell what they were then. <(27)> <(25)> See Opinion at n.27. <(26)> Testimony of Donald Moulin, Transcript at p. 752. <(27)> The opinion of two of the Commissioners asserts that Mr. Potts did something wrong and there were "red flags" so he must have engaged in improper professional conduct and been reckless. See Opinion text accompanying n.39. But reckless compared to what standard? Again, clearly, the audit went badly awry. Clearly, the engagement partner failed to comply with GAAS. Clearly, Mr. Potts did not prevent that and he made a mistake by either not recognizing the red flags, or not pursuing them vigorously enough. But since we don t know exactly, or even somewhat broadly, what was expected of a concurring partner almost a decade ago, it is hard to tell how egregious these errors were. If a concurring partner was supposed to repeat the audit, then clearly this behavior was reckless. If a concurring partner, at that time, was supposed to ask questions to obtain a feel for whether the audit was being performed correctly, but not much else other than to comply with the cursory statements in the SECPS Manual, then Mr. Potts' actions hardly constitute negligence. The majority concludes recklessness. But without certainty as to what the standard was, I see no basis for such a belief. ======END OF PAGE 38====== In sum, in order to resolve this case fairly, either it should be returned to a different ALJ for further development of the record, <(28)> or the parties should be given a further opportunity to present briefs or testimony on the specific issue of concurring partner practice in 1988 and 1989. <(29)> For the above reasons, I respectfully dissent from the majority's assertion that Mr. Potts was reckless. <(28)> I am troubled by statements of the ALJ such as: "[I]f Potts had merely made an error of judgment or had been careless, it is unlikely that the Commission would have . . . [brought the case]." See Opinion at n.60. Such a statement makes me question, strongly, the record as a whole on which we rely. <(29)> The opinion of two of the Commissioners suggests that I infer that relevant standards have evolved since the audits were conducted. Opinion at n.27. I intend no such inference, but merely believe the record does not contain sufficient evidence to support an assumption that these standards have not changed over the relevant time period. ======END OF PAGE 39====== UNITED STATES OF AMERICA before the SECURITIES AND EXCHANGE COMMISSION SECURITIES EXCHANGE ACT OF 1934 Rel. No. 39126 / September 24, 1997 ACCOUNTING AND AUDITING ENFORCEMENT Rel. No. 964 / September 24, 1997 Admin. Proc. File No. 3-7998 ________________________________________________ : In the Matter of : : ROBERT D. POTTS, CPA : c/o Briggs and Morgan : 2400 IDS Center : Minneapolis, MN 55402 : ________________________________________________: ORDER IMPOSING REMEDIAL SANCTIONS On the basis of the Commission's opinion issued this day, it is ORDERED that Robert D. Potts, CPA, be, and he hereby is, suspended from practice before the Commission for a period of nine months, to be served beginning October 6, 1997. By the Commission. Jonathan G. Katz Secretary