-------------------- BEGINNING OF PAGE #i ------------------- UNITED STATES OF AMERICA Before the SECURITIES AND EXCHANGE COMMISSION SECURITIES EXCHANGE ACT OF 1934 Release No. 36700 / January 11, 1996 ACCOUNTING AND AUDITING ENFORCEMENT Release No. 751 / January 11, 1996 ADMINISTRATIVE PROCEEDING File No. 3-8921 ______________________________ : ORDER INSTITUTING PROCEEDINGS In the Matter of : PURSUANT TO SECTION 21C OF THE : SECURITIES EXCHANGE ACT OF William F. Moody, Jr. : 1934, MAKING FINDINGS AND : IMPOSING A CEASE AND DESIST Respondent : ORDER --------- FOOTNOTES --------- ______________________________ : I. The Securities and Exchange Commission (the "Commission") deems it appropriate that public administrative proceedings be instituted pursuant to Section 21C of the Securities Exchange Act of 1934 ("Exchange Act"), against William F. Moody, Jr. ("Moody"). Accordingly, IT IS HEREBY ORDERED that proceedings pursuant to Section 21C of the Exchange Act be, and hereby are, instituted. In anticipation of the institution of these administrative proceedings Moody has submitted an Offer of Settlement, which the Commission has determined to accept. Solely for the purposes of these proceedings and any other proceedings brought by or on behalf of the Commission or in which the Commission is a party, and without admitting or denying the findings herein, except that Moody admits the jurisdiction of the Commission over him and over the subject matter of these proceedings Moody consents to the entry of this Order Instituting Proceedings Pursuant to Section 21C of the Securities Exchange Act of 1934, Making Findings and Imposing a Cease and Desist Order ("Order") and to the entry of the findings and imposition of the sanctions as set forth below. II. FINDINGS On the basis of this Order and the Offer of Settlement of Moody, the Commission makes the following findings. A. THE RESPONDENT 1. Moody, age 63, was American Aircraft Corporation's ("AAC's") President and Chief Executive Officer ("CEO") until he resigned in November 1994. -------------------- BEGINNING OF PAGE #ii ------------------- B. BACKGROUND On March 4, 1988, AAC, a public company, and Phalanx Organization, Inc. ("Phalanx"), a private company controlled by Moody, completed a reverse acquisition in which AAC acquired Phalanx's operations and management, and Moody became AAC's President, CEO and controlling shareholder. After the acquisition, AAC was reportedly developing several aircraft capable of vertical flight. In August 1990, AAC suspended all development work except for the Penetrator helicopter, which was a material modification of an existing UH-1 Huey helicopter. In 1991, AAC completed construction of a single pre-production prototype of the Penetrator helicopter, which has not yet completed testing. AAC and its officers and employees, including Moody, had little or no expertise in accounting or Generally Accepted Accounting Principles ("GAAP"). AAC's bookkeeper told Moody in December 1988 that Moody should hire a capable accountant who could properly prepare AAC's financial statements. Moody did not hire such an accountant. As described below, during fiscal years ended November 30, 1988 through November 30, 1991, Moody caused AAC to overvalue certain aircraft designs (the "Designs") and to capitalize as assets certain research and development ("R&D") costs that should have been expensed. As a result, AAC materially overstated its assets in amounts ranging from $5,509,069 to $7,097,332 and materially understated its net losses in amounts ranging from $366,062 to $1,153,829 for fiscal years 1988 through 1991 in interim and annual financial statements filed in Forms 10-Q and 10-K. Moody signed all of these filings with the Commission, except for AAC's Form 10-Q for its second quarter of fiscal 1988. C. MOODY CAUSED AAC TO MATERIALLY OVERSTATE THE VALUES OF ITS ASSETS 1. The Designs From the second quarter fiscal 1988 Form 10-Q through the fiscal 1991 Form 10-K, Moody caused AAC to report the Designs as assets valued at $4,687,500 before amortization, which represented at least 50% of AAC's total assets in each filing. AAC should have reported the Designs at zero. As a result, AAC materially overstated its total assets in its Forms 10-K and 10- Q from the second quarter of fiscal 1988 through fiscal 1991. Moody developed the Designs, with virtually no monetary investment, between July 1987 and February 1988. Under GAAP, Moody should have expensed as incurred any R&D costs in developing the Designs and, as a result, should have carried the Designs at a zero value. See Financial Accounting Standards Board Statement ("FAS") 2, 12. AAC, as part of the AAC-Phalanx reverse acquisition, acquired the Designs from Moody for 2.5 million AAC restricted shares on February 17, 1988. Under GAAP, AAC should have reported the Designs at Moody's basis, which was zero, because AAC acquired the Designs from Moody in connection with a reverse acquisition. See Accounting Principle Board Opinion No. 16, 70; see also Staff Accounting Bulletin Topic 2.A. ii -------------------- BEGINNING OF PAGE #iii ------------------- At the time AAC acquired and recorded the Designs, Moody understood that AAC's acquisition of the Designs was part of the AAC-Phalanx reverse acquisition and that the Designs would comprise most of AAC's assets. Moody believed, at the time, that the Designs should have been valued at zero because they could not be objectively valued. iii -------------------- BEGINNING OF PAGE #iv ------------------- Despite such knowledge, AAC improperly valued the Designs at $4,687,500, using 50% of the then NASDAQ quoted $3.75 per share price to value the 2.5 million shares exchanged.-[1]- AAC did not have the accounting expertise to record the Designs, so AAC's auditor prepared the entry recording the Designs as an AAC asset at $4,687,500. 2. The R&D Costs AAC, during fiscal years 1988 through 1991, improperly capitalized certain R&D costs as tooling and inventory assets. GAAP requires that R&D costs be expensed as incurred. FAS 2, 12. Similarly, AAC represented in its Forms 10-K and 10-Q that AAC expensed R&D costs when incurred. As a result of improperly capitalizing R&D costs, from fiscal year 1988 through 1991, AAC materially overstated its assets by amounts ranging from $821,569 to $3,288,738 and materially understated its net losses by amounts ranging from $366,062 to $1,153,829. a. The Tooling AAC disclosed in its fiscal 1990 and 1991 Forms 10-K that it had not completed development of its Penetrator helicopter project. Moody signed management representation letters to AAC's auditor concerning AAC's fiscal 1990 and 1991 financial statements. In these letters Moody represented to AAC's auditor that AAC had progressed beyond the R&D stage in developing the Penetrator helicopter and other projects and was properly capitalizing the related tooling costs. AAC's auditor told Moody on several occasions that the tooling costs were R&D and should be expensed. AAC initially recorded the tooling costs as expenses when incurred. Moody argued with AAC's auditor that the costs should be capitalized because the tooling could have possible use if the Penetrator and other models were ever manufactured. In Forms 10-K and 10-Q for fiscal years 1988 through 1991, AAC reported tooling costs as assets at amounts ranging from $776,350 to $1,228,711, net of amortization, causing AAC to materially overstate assets. AAC's reporting the tooling costs as assets rather than expenses also caused it to materially understate its net losses in Forms 10-K and 10-Q for fiscal years 1988 through 1990 in amounts ranging from $315,559 to $862,649. b. The Prototype During fiscal 1990 through 1991, AAC capitalized certain costs related to the manufacture of prototypes. AAC disclosed in its fiscal 1991 Form 10-K that since January 1990, it had been developing the Penetrator helicopter, consisting of major technological modifications to the obsolete UH-1 Huey helicopter. AAC's fiscal 1991 Form 10-K further disclosed that AAC had --------- FOOTNOTES --------- -[1]- Information available at the time contradicts the stock having a value of $4,687,500: the shares were restricted and could not be sold for at least two years; AAC stock was thinly traded; the shares constituted a material 21% increase in AAC's outstanding stock; and AAC had negative retained earnings of $488,536 and had never reported a profit. iv -------------------- BEGINNING OF PAGE #v ------------------- produced a single Penetrator, a "proof of concept" version, that would be disassembled and analyzed at the completion of test flights. v -------------------- BEGINNING OF PAGE #vi ------------------- AAC's auditor told Moody that the prototype costs were expenses and AAC initially recorded the prototype costs as expenses when incurred. Moody, however, contended that AAC's prototype costs were assets. AAC's auditor, acceding to Moody's belief, instructed AAC's bookkeeper to adjust AAC's accounting records and financial statements to capitalize the prototype's cost as inventory for fiscal years 1990 and 1991. By the end of fiscal 1991, AAC's assets included $2,512,388 in pre-production prototype costs. AAC improperly reported these prototype development costs as inventory assets in its Forms 10- K and 10-Q for fiscal years 1990 and 1991. Furthermore, as a result of capitalizing these costs, AAC materially understated net losses for fiscal years 1990 and 1991 by $948,618 and $1,563,770 respectively. D. MOODY VIOLATED THE FEDERAL SECURITIES LAWS 1. Antifraud Violations: Section 10(b) of the Exchange Act and Rule 10b-5 Thereunder Section 10(b) of the Exchange Act and Rule 10b-5 thereunder make it unlawful for any person, in connection with the purchase or sale of any security, to employ any device, scheme, or artifice to defraud, to make any untrue statement of a material fact, to omit to state a material fact, or to engage in any act, practice or course of business which operates or would operate as a fraud or deceit upon any person through the means or instruments of interstate commerce or the mails. Information is material if there is a substantial likelihood that a reasonable investor would consider it important to an investment decision. See Basic Inc. v. Levinson, 485 U.S. 224, 231-32 (1988); TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976). Scienter is required to establish a violation of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. See Aaron v. SEC, 446 U.S. 680, 701-02 (1980). Scienter is "a mental state embracing intent to deceive, manipulate or defraud." Ernst & Ernst v. Hochfelder, 425 U.S. 185, 194 n.12 (1976). Recklessness satisfies the scienter requirement. Hollinger v. Titan Capital Corp., 914 F.2d 1564 (9th Cir. 1990), cert. denied, 499 U.S. 976 (1991). Recklessness is "an extreme departure from the standards of ordinary care, and which presents a danger of misleading [investors] that is either known to the defendant or is so obvious that the actor must have been aware of it." Id., 914 F.2d at 1569. Moody violated the antifraud provisions of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder by publicly disseminating and filing with the Commission materially false and misleading financial statements. Specifically, Moody overstated the value of certain aircraft designs, falsely reported as assets certain R&D costs and understated net losses in AAC's financial statements. Moody also acted with scienter. In general, Moody knew or was reckless in not knowing that AAC did not have sufficient accounting expertise to properly report its financial condition. Moody also knew, or was reckless in not knowing that the Designs were materially overvalued in AAC's financial statements. Moody knew that he had virtually no monetary investment in the Designs. Moody should have realized that AAC's acquisition of the Designs vi -------------------- BEGINNING OF PAGE #vii ------------------- was a part of the AAC-Phalanx reverse acquisition. The Designs, therefore, as part of the reverse acquisition, should have been valued at Moody's basis, which was zero. Moody also admitted that the Designs should have a zero value because they could not be objectively valued. vii -------------------- BEGINNING OF PAGE #viii ------------------- Moody also knew or was reckless in not knowing that the tooling and prototype costs were R&D and should have been expensed. AAC's auditor told Moody that these costs were R&D and should be charged to expense. Moody also signed management representation letters to AAC's auditor stating that the tooling was properly capitalized because the projects related to the tooling were beyond the R&D stage at the same time that AAC's Forms 10-K, which Moody also signed, reported that AAC had not completed development of any of its proposed products. This fraudulent conduct also occurred in connection with the purchase or sale of securities. AAC released the fraudulent financial statements, included in its Forms 10-Q and 10-K, to the public. AAC's stock was publicly traded through NASDAQ. See SEC v. Texas Gulf Sulphur Co., 401 F.2d 833, 860-61 (2nd Cir. 1968) ("in connection with" requirement satisfied when issuer makes public announcements while its stock is publicly traded), cert. denied, 394 U.S. 976 (1969). 2. Reporting Violations: Section 13(a) of the Exchange Act and Rules 12b-20, 13a-1 and 13a-13 Thereunder Section 13(a) of the Exchange Act and Rules 13a-1 and 13a- 13 thereunder require issuers with securities registered pursuant to Section 12 of the Exchange Act, such as AAC, to file with the Commission quarterly reports on Form 10-Q and annual reports on Form 10-K. An issuer violates these provisions if it files Forms 10-Q or 10-K that contain materially false or misleading information. SEC v. Falstaff Brewing Corp., 629 F.2d 62, 72 (D.C. Cir. 1980); SEC v. Savoy Industries, Inc., 587 F.2d 1149, 1165 (D.C. Cir. 1978), cert. denied, 440 U.S. 913 (1979). Rule 12b-20 under the Exchange Act requires that these reports contain any material information that is necessary to ensure that the statements made are not, under the circumstances in which they are made, materially misleading. AAC materially overstated assets and/or understated expenses and net losses in its Forms 10-Q and 10-K for the period from February 29, 1988 through November 30, 1991, in violation of Section 13(a) of the Exchange Act and Rules 12b-20, 13a-1 and 13a-13 thereunder. Moody was a cause of AAC's violations of the reporting provisions. Moody, as the head of AAC's management, was responsible for the fair presentation of AAC's financial statements in conformity with GAAP and knew that no one at AAC could competently prepare AAC's financial statements. Moody also admitted that the Designs should have had a zero value because they could not be objectively valued, yet he allowed them to be reported as assets at $4,687,500 before amortization and merely relied on AAC's auditor's judgment that they were properly valued. Finally, Moody insisted to AAC's auditor that the tooling and prototype costs were assets even after AAC's auditor told him the R&D should be expensed, eventually persuading AAC's auditor to acquiesce. 3. Record Keeping Violations: Section 13(b)(2)(A) of the Exchange Act and Rules 13b2-1 and 13b2-2 Thereunder Section 13(b)(2)(A) of the Exchange Act requires an issuer filing reports with the Commission to make and keep books and records that accurately and fairly reflect the issuer's transactions. Rule 13b2-1 provides that "no person shall, directly or indirectly, falsify or cause to be falsified, any viii -------------------- BEGINNING OF PAGE #ix ------------------- book, record or account subject to Section 13(b)(2)(A)." Rule 13b2-2 prohibits any officer or director of an issuer from, among other things, omitting to state any material fact to an accountant in connection with any required audit of the issuer's financial statements or the preparation of a report required to be filed with the Commission. AAC did not properly account for the Designs and for R&D expenses in its books, records and accounts from fiscal 1988 through fiscal 1991, in violation of Section 13(b)(2)(A) of the Exchange Act. Moody was a cause of AAC's violations of the books and records provisions of Section 13(b)(2)(A) and violated Rule 13b2-1 thereunder. As AAC's President and CEO, Moody was ultimately responsible for assuring that AAC properly recorded and reported its transactions in conformity with GAAP and was on notice that AAC did not have competent accounting expertise. He similarly doubted the valuation of the Designs but did nothing to ensure that they were correctly reported other than to merely rely on AAC's auditor. Moody also persuaded AAC's auditor to agree that AAC could report the R&D costs as assets even after AAC's auditor told Moody that such costs should be expensed. Moody also violated Rule 13b2-2 under the Exchange Act. In management representation letters to AAC's auditor concerning AAC's fiscal 1990 and 1991 financial statements, Moody falsely represented that AAC had progressed beyond the R&D stage concerning the Penetrator and other projects and was properly capitalizing the related tooling costs. Moody's representation contradicted AAC's disclosure in its fiscal 1990 and 1991 Forms 10-K that it had not completed development of its Penetrator project. 4. Internal Control Violations: Section 13(b)(2)(B) of the Exchange Act Section 13(b)(2)(B) of the Exchange Act requires every issuer that has securities registered pursuant to Section 12 of the Exchange Act, such as AAC, to devise and maintain a system of internal accounting controls sufficient to reasonably assure, among other things, that transactions are executed in accordance with management's general or specific authorization and that transactions are recorded as necessary to permit preparation of financial statements in conformity with GAAP. AAC had inadequate internal controls to assure that it correctly accounted for the Designs and the R&D costs. Indeed, AAC did not even employ a person with a competent level of accounting expertise to correctly account for these transactions. As a result, AAC relied on its outside auditor, AAC's auditor, to account for these transactions. AAC had no internal system or procedure to check or verify AAC's auditor's entries. Moody was also a cause of AAC's violations of the internal control provisions. As AAC's President and CEO, Moody was ultimately responsible for assuring the adequacy of AAC's internal accounting controls. Again, Moody also knew that AAC did not have competent accounting expertise at AAC to develop and maintain a system of internal accounting controls. E. CONCLUSION ix -------------------- BEGINNING OF PAGE #x ------------------- Based on the foregoing, the Commission finds that Moody violated or caused violations of Section 10(b) of the Exchange Act and Rules 10b-5, 13b2-1 and 13b2-2 thereunder and caused violations of Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act and Rules 12b-20, 13a-1, 13a-13 thereunder. x -------------------- BEGINNING OF PAGE #xi ------------------- III. Based on the foregoing, the Commission deems it appropriate to accept the Offers of Settlement of Moody and accordingly, IT IS HEREBY ORDERED, pursuant to Section 21C of the Exchange Act, that: Moody cease and desist from committing or causing any violations and any future violations of Section 10(b) of the Exchange Act and Rules 10b-5, 13b2-1 and 13b2-2 thereunder and from causing any violations and any future violations of Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exhange Act and Rules 12b-20, 13a-1, 13a-13 thereunder. By the Commission. Jonathan G. Katz Secretary xi