SECURITIES AND EXCHANGE COMMISSION Washington, D.C. SECURITIES EXCHANGE ACT OF 1934 Rel. No. 38183 / January 21, 1997 ACCOUNTING AND AUDITING ENFORCEMENT Rel. No. 871 / January 21, 1997 Admin. Proc. File No. 3-6776 _____________________________________________ : In the Matter of : : DAVID J. CHECKOSKY : and : NORMAN A. ALDRICH : _____________________________________________: OPINION OF THE COMMISSION ON REMAND RULE 2(e) PROCEEDINGS Ground for Remedial Action Improper Professional Conduct by Accountants Where accountants incorrectly interpreted Generally Accepted Accounting Principles and failed to comply with Generally Accepted Auditing Standards, held, accountants engaged in improper professional conduct within the meaning of Rule 2(e)(1)(ii) of the Commission's Rules of Practice, and have served suspensions from practice before the Commission for a period of two years. APPEARANCES: Geoffrey F. Aronow, Andrew T. Karron, and John C. Massaro, of Arnold & Porter, for David J. Checkosky and Norman A. Aldrich. Barry R. Goldsmith, Susan Ferris Wyderko, and Leo F. Orenstein, for the Commission's Office of the Chief Accountant. Remand received: August 15, 1994 Last brief filed: April 26, 1995 I. This proceeding under Rule 2(e) of our Rules of Prac- tice 1/ against David J. Checkosky and Norman A. Aldrich 1/ Although our Rules of Practice have been amended, Securities Exchange Act Release No. 35833, 60 Fed. Reg. 32,738 (June 23, 1995), these proceedings were instituted before the new rules were adopted. Thus, the old rules continue to apply. (continued...) ==========================================START OF PAGE 2====== ("Respondents") is here for the second time. On August 26, 1992, we issued an opinion and order finding that Respondents incorrectly interpreted Generally Accepted Accounting Principles ("GAAP") and did not comply with Generally Accepted Auditing Standards ("GAAS") 2/ in connection with a series of audits of Savin Corporation ("Savin"). 3/ We suspended Respondents from practice before us for a period of two years. 4/ On May 20, 1994, the United States Court of Appeals for the District of Columbia Circuit remanded this proceeding to us "for a more adequate explanation of [our] interpretation of Rule 2(e)(1)(ii) and its application to this case." 5/ II. Savin was a publicly traded company that, at the beginning of the 1980's, marketed liquid-toner copiers that were manufactured by Ricoh Company, Ltd. ("Ricoh"). Coopers & Lybrand ("C&L") was Savin's auditor. Checkosky was the engagement 1/(...continued) Former Rule 2(e)(1), which is the basis of this proceeding, is now 17 C.F.R.  201.102(e)(1). There were no substantive changes to this rule. 2/ GAAP constitutes a consensus of what accounting principles are considered "generally accepted." As one commentator observed, an accounting principle is considered generally accepted if it has "'substantial authoritative support' which may derive in turn from a respectable constituency of usage or from promulgation by competent authority." James F. Strother, The Establishment of Generally Accepted Accounting Principles and Generally Accepted Auditing Standards, 28 Vand. L. Rev. 201, 203 (1975). We have stated that we will consider principles, standards, and practices promulgated by the Financial Accounting Standards Board as having substantial authoritative support. Accounting Series Release No. 150 (December 20, 1973), 3 SEC Docket 275-76. The principles of GAAS set forth "the obligations of due and professional care which attend the independent auditor's examination and his report upon audited financial statements." Strother, supra, 28 Vand. L. Rev. at 208. GAAS is contained in 10 standards adopted by the American Institute of Certified Public Accountants ("AICPA"), describing the independent auditor's professional duties. AUDITING STANDARDS, AU  150.02, citing standard  110.02. 3/ David J. Checkosky and Norman A. Aldrich, 50 S.E.C. 1180 (1992). 4/ Respondents, who did not seek a stay, completed serving their suspensions in 1994. 5/ Checkosky & Aldrich v. SEC, 23 F.3d 452. ==========================================START OF PAGE 3====== partner and Aldrich was generally the audit manager 6/ on C&L's audits of Savin for Fiscal Years 1981 through 1984 and for the eight-month period from May 1 to December 31, 1984. 7/ In examining Savin's books, Respondents' responsibility was to determine, using GAAS, whether their client had adhered to GAAP in preparing its financial statements and to express an opinion on those financial statements. 8/ GAAS requires, among other things, the exercise of "due professional care" (General Standard No. 3) and independent judgment (General Standard No. 2), as well as possession of sufficient evidence to support the conclusions (Standards of Field Work No. 3). After their examination, Respondents were required to report whether Savin's financial statements were presented in conformity with GAAP. 9/ At issue is Respondents' treatment of Savin's expenditures in creating its own copiers, under Statement of Financial Accounting Standards No. 2 ("FAS 2"), promulgated by the Financial Accounting Standards Board ("FASB"). 10/ FAS 2 requires that all research and development costs be expensed as they are incurred. A. Savin's Decision to Develop Copiers. In the late 1970's, Savin was informed that Ricoh would not be renewing its distribution contract with Savin. Although it had not previously produced copiers, Savin decided to develop and manufacture its own line of high-speed, liquid-toner copiers, an effort that Savin called "Project X." It retained an engineer, Benzion Landa, to design a new photocopier, and purchased a subsidiary that could produce parts for its anticipated line. It also began construction of an assembly plant, and formed an Engineering and 6/ For the calendar year 1984 audit, Aldrich was the concurring partner. 7/ Savin's fiscal year ended on April 30 until 1984, when the ending date was changed to December 31. There were 2 sets of statements for 1984 -- the 12 months ending April 30, and the 8 months ending December 31 (referred to in this proceeding as the "Calendar Year 1984 audit"). 8/ Statement of Auditing Standards No. 1, promulgated by the AICPA, requires that an audit report state whether the financial statements are presented in accordance with GAAP. AUDITING STANDARDS, AU  326.01. See also United States v. Arthur Young & Co., 465 U.S. 805, 818 (1984). 9/ AUDITING STANDARDS, AU  150.02. Regulation S-X, 17 C.F.R.  210.2-02(b) also requires the auditor to state whether the audit was made in accordance with GAAS. 10/ See ACCOUNTING FOR RESEARCH AND DEVELOPMENT COSTS, Statement of Financial Accounting Standards No. 2, 53-56 (FASB 1974). ==========================================START OF PAGE 4====== Manufacturing Division ("E&M"), which eventually employed several hundred engineers and other workers. In early 1980, Landa delivered to E&M a model that demonstrated certain working components but did not produce copies, together with design drawings. E&M then began development of photocopiers based on the model and drawings. Savin recognized that the anticipated market for the new machine demanded a high degree of reliability. It therefore established specifications for the new copiers that required 60 copies per minute and a criterion for reliability permitting no more than 66 failures per million copies. 11/ Initially, Savin intended to create four models of copiers -- from a base model to one with multiple accessories. The anticipated models were assigned the code names, which were, in ascending order of cost and complexity, Diamond, Ruby, Sally, and Rhino (the "high-end" model). In August 1980, Savin's quarterly report on Form 10-Q stated that its development plans for the new line were on schedule and that Savin expected to introduce the line in early 1982. B. Savin's Accounting Policy. As costs of the copier project mounted, Savin sought to defer related expenses. In the fall of 1980, Savin's management informed Checkosky that Savin wanted to begin capitalizing the costs associated with the start-up of manufacturing. At that time, Checkosky knew that Savin's financial condition was deteriorating. After reading FAS 2 and a text on auditing, Checkosky con- cluded that Savin could defer the costs at issue, provided that the company had tangible evidence that research and development had ended. Checkosky recommended that Savin adopt a written policy of cost deferral to describe a start-up period after research and development during which costs would be deferred rather than expensed. He also suggested that completion of a working model of the machine that Savin committed to produce would provide a benchmark indicating the end of research and development. To assist Savin in drafting the policy, Checkosky requested that C&L's research unit provide information on other companies that deferred start-up costs relating to new facilities. 12/ 11/ A "failure" in this context was a problem that a customer could not fix. 23 F.3d at 474 (Randolph, J.). 12/ The response from C&L's research unit to Checkosky, dated January 26, 1981, states that the unit had been asked whether the company could defer certain start-up costs related to building a major manufacturing facility, rather than whether costs related to product development could be deferred. Nevertheless, in responding, the research unit attached four pages from a manual of another accounting firm (continued...) ==========================================START OF PAGE 5====== Savin adopted an accounting policy, dated May 1981, in which Checkosky concurred, that allowed deferral of funds expended on the copier project when Savin reached "a comfort level" of marketability and believed that "the product will satisfy the customer." 13/ Such subjective criteria had been considered and rejected by the FASB when it adopted FAS 2. Savin's management adopted an interpretation of FAS 2, which was accepted by Respondents, that the existence of a working prototype and release of blueprints to manufacturing were to be considered evidence of the conclusion of research and development. C. Fiscal Year 1981. In January 1981, there was no production line for the copiers. The E&M manufacturing facility was an "empty shell" that was still under construction. Checkosky testified, however, that he personally inspected a working model of a Savin photocopier in January 1981, and timed the machine at 60 copies per minute. There is no record in his workpapers of either his visit or his observations. Even if his testimony were accepted, there is no evidence that Checkosky ascertained whether the machine satisfied Savin's functional specifications (including whether it met the requirements for reliability) or was ready for manufacture. During this period, minutes of a meeting of Savin's Board of Directors reported that Savin had been unable to develop a toner that would permit the high-speed quality copies required by Savin's specifications. The workpapers, moreover, refer to E&M's incurring costs for "development and production of copiers." Respondents did not test to determine whether the costs were generated by activities that were in fact research and development. Instead, they tested to determine whether the activities were directed to the copier project. Nonetheless, during the Fiscal Year 1981 audit, they authorized Savin to begin deferring costs relating to Project X "after completion of [the] first successful prototype" in November 1980. D. Fiscal Year 1982. Design of the copiers proved difficult. During Fiscal Year 1982, contemporaneous engineering reports described "advanced development" efforts on the optical system, the "complete design of paper path fixture," and the "stripper finger," as well as substantial work with the toner and "fuser." Respondents saw a working model of a prototype of the Ruby copier and were told that most of the drawings for Ruby and 12/(...continued) describing product research and development. See n. 33, infra. 13/ Savin's accounting policy defined research and development to include "[d]esign, construction and testing or [sic] pre-production prototypes and models" and "[p]rototype pre-manufacturing activity." ==========================================START OF PAGE 6====== Diamond had been released to manufacturing. Respondents, however, were aware that substantial development work remained on the toner and fuser and that there were issues concerning reliability. Moreover, they were informed that Ruby, as well as the Diamond and Sally models, would not be introduced into manufacturing until Fiscal Year 1983 and that Rhino would not be introduced until Fiscal Year 1984. Although Respondents had seen a Ruby prototype, they did not determine whether the prototype met Savin's specific functional and economic criteria. Respondents nonetheless concluded that Ruby was "past the prototype stage and deferral (and continued deferral) was appropriate." Respondents did not test to determine whether the activities that were generating the deferred costs were research or development. E. Fiscal Year 1983. Production did not begin as planned. In June 1982, the company announced that it was postponing the anticipated introduction date for its new photocopier line to January 1983. Savin's engineers kept redesigning every aspect of the machine. By summer 1982, Savin had built between 15 and 20 copiers, but those machines were unreliable. There were continuing problems with the fuser, toner, stripper, sorter, and paper path. During the summer, Landa provided a new liquid toner that was expected to produce clearer copies, but needed further development work. Moreover, E&M engineers discovered that the new toner was incompatible with the existing fuser. Attempts to modify the existing fuser to accommodate the new toner resulted in fires within the copier, and attempts were made to develop a new fuser. In addition, the failure rate was well in excess of 1,000 failures per million copies, and rose to 1,919 failures per million in mid-November 1982. Savin displayed several copiers at the National Office Machine Dealers Association convention in July 1982. The dis- played models did not use the new toner because a compatible fuser was not ready. The copiers also produced copies that smudged. By September 1982, Savin's Board of Directors was informed that the production run would be deferred until September 1983. The Board was also informed that the copy quality generated by the Savin machines was "not as good as dry toner machines." As 1982 drew to a close, the copiers still had not met the product specifications written by Savin's engineers. Contemporaneous engineering reports noted "critical problems" (i.e., problems that would preclude marketability) that had not been overcome with the fuser, toner, and copier reliability, among other things. Savin concluded that it had missed the window of opportunity for marketing less expensive copiers and abandoned ==========================================START OF PAGE 7====== Project X. 14/ At this time, E&M dismissed half of its 500 employees. In January 1983, Savin informed the C&L audit staff that it would "redesign" one of the models to create a marketable, high-end machine, which it called "Pegasus," or the "8000 Series." Although the Pegasus was to be an improvement of the Rhino model, the Rhino had not been reduced to a working prototype and the C&L workpapers stated that Rhino had not passed out of research and development. In fact, the optics, photoconductor, stripper finger, developer, and fluid and paper handling systems were redesigned for the Pegasus. 15/ In early 1983, Savin hired McKinsey and Company ("McKinsey"), a management consultant, to study the business viability of continuing with the Pegasus project. McKinsey reported in April 1983 that, to be marketable, the copier had to be capable at introduction of producing 70 copies per minute, with no more than 62 failures per million copies. McKinsey also described the fuser as an "untested concept." McKinsey projected that Savin would have to design, test, and redesign the copier subsystems and prototypes, and that development and testing of the copier would last through June 1984 -- well past the end of Fiscal Year 1984. In recommending that production be pursued, McKinsey assumed that Savin would be able to begin to market its copier by July 1984. Respondents knew that the machines were experiencing a high number of failures and that the fuser and toner would involve new technology. They were aware that the engineers were working on prototypes. They nonetheless concluded that Savin did not have to write off its deferred costs because the Pegasus would employ the "same basic technology" as the Rhino. F. Fiscal Year 1984. Engineers in E&M devoted all their time throughout 1983 and 1984 to designing, constructing, and testing prototypes in an attempt to meet Savin's specific functional and economic requirements and to get the copier ready for manufacture. 16/ The minutes of Savin's Board of 14/ In Fiscal Year 1983, as a result of the decision to reconfigure the copier, and at Respondents' insistence, Savin wrote off $5.7 million of deferred start-up costs attributable solely to the lower-end models. 15/ For example, the Project X copiers had had one or two paper trays. Pegasus was to have four paper trays. The entire mechanism was to be rotated 90 degrees around the drum. While the original copiers were tabletop machines, the Pegasus was designed to be a full-size console model. 16/ In September 1983, the staff of our Division of Corporation Finance wrote to Savin seeking detailed justification for its inclusion of deferred start-up costs as an asset for Fiscal Year 1983 and the three months thereafter. In (continued...) ==========================================START OF PAGE 8====== Directors' meeting in November 1983, which are included in Respondents' workpapers, reported "continuous design change throughout the prototype build." In February 1984, Arthur D. Little, Inc., a management consultant, submitted a review of Pegasus to Savin. The report stated that production was scheduled to start in late 1984 and that Savin claimed to have two complete engineering models, subject to preliminary testing. However, the author reported seeing only a skeletal frame of a prototype, which lacked most components. The author further had not seen an operational or completed copier, or copies made by a Pegasus copier. In March 1984, the Pegasus copiers were still experiencing from 700 to over 1,000 failures per million copies. Respondents were aware that no drawings had been released for manufacture. Respondents also had access to Savin engineering reports written during May 1984 that cited continuing problems, such as transfer jams, toner leakage, and motor overheating. 17/ Respondents asked that Savin have McKinsey update its earlier study of Pegasus' marketability. Early versions of the McKinsey update show editorial modifications made by Checkosky and by Aldrich to delete or modify references to technical problems associated with the development of the copier. Many of their changes were incorporated in the final version of the updated report. The final version of the update, dated July 13, 1984, focused on delays caused by organizational, rather than technological problems. Even as modified, however, the McKinsey update stated that no working model of Savin's copier had yet been built, and that "the key technical risks that remain center on achieving the overall reliability goal of less than 62 [failures per million copies] before introduction." G. Calendar Year 1984. By the end of 1984, the copier still leaked considerable amounts of liquid toner on the floor and produced excessive heat. One Savin engineer testified that the copier "could have been used as a furnace as well as a copy machine, because that's what it was." Concerns arose that the excessive heat emissions might violate Occupational Safety and Health Administration standards. Fusing the liquid toner to paper produced toxic vapors, which caused severe eye irritation and headaches for users. Reliability of the machines continued 16/(...continued) December 1983, our Division of Enforcement wrote an extensive follow-up letter. 17/ These reports and the early drafts of the McKinsey update were discovered in C&L's files and produced by C&L while our prior opinion was on appeal. See 23 F.3d at 457-58 n. 5 (Silberman, J.). ==========================================START OF PAGE 9====== to be a problem, and many of the manufacturing drawings for Pegasus were defined as "NOT STARTED" or in redesign. Savin abandoned its plans to develop a new copier in late 1985. The company had failed to design any machines that achieved its goals for commercial production. Savin's financial statements, filed as part of its Forms 10-K for Fiscal Years 1981 through 1984 and Calendar Year 1984, carried "deferred start-up costs" as an asset. This capitalization of Savin's expenses related to copier programs totalled $68 million by the end of 1984. We found in our prior opinion that $37 million of that amount were research and development costs, which should have been expensed and not deferred. As a result, Savin's assets and stockholders' equity were materially overstated, and its net losses materially understated. 18/ The audit reports for Fiscal Years 1981 through 1983 repre- sented that the audits were conducted according to GAAS and that, in the auditors' opinion, Savin's financial statements conformed without exception to GAAP. The audit reports for Fiscal Year and Calendar Year 1984 contained the auditors' opinion that the financial statements complied with GAAP, subject to the recovery of Savin's deferred start-up costs. 19/ 18/ The following chart, taken in part from our prior opinion (50 S.E.C. at 1186 n. 13), shows the amounts of deferred start-up costs (in millions) found to have been improperly capitalized for each year and, cumulatively, Savin's net loss and stockholders' equity for each period, and the improperly capitalized amounts as a percentage of the net loss and stockholders' equity for each period: FY 81 FY 82 FY 83 FY 84 CY 84 Improperly deferred start-up costs 1.8 8.8 9.1 11.7 5.6 Cumulative amounts 1.8 10.6 19.7 31.4 37.0 Net loss 2.2 32.2 21.1 58.8 13.8 Stockholders' Equity 100.4 103.1 116.1 85.9 72.2 Start-up costs as % of net loss 81.8 27.3 43.1 19.9 40.6 Cum. Start-up costs as % of Stock. Eqty. 2.2 10.3 16.9 36.5 51.2 19/ In November 1985, pursuant to a settlement with the Commission in which Savin neither admitted nor denied the Commission's allegations, Savin was enjoined from violations of Sections 13(a) and 13(b)(2) of the Securities Exchange (continued...) ==========================================START OF PAGE 10====== III. A. As discussed above, the Court of Appeals remanded this proceeding to us for further explanation of our interpretation of Rule 2(e)(1)(ii) and its application to the facts before us. Each of the three opinions accompanying the court's order expresses differing views on certain of the issues. All three opinions, however, recognize our authority to sanction accountants pursuant to Rule 2(e)(1)(ii) of our Rules of Practice. All three further agree that our findings that Respondents did not properly interpret GAAP and failed to act in accordance with GAAS are supported by substantial evidence. 20/ B. We previously found that Respondents engaged in improper professional conduct and that their conduct was reckless. 21/ We begin by explaining our reasons for this conclusion and why we continue to find their conduct reckless. 22/ As accountants and auditors, Respondents are required to comply with professional standards. 24/ At issue here is 19/(...continued) Act of 1934 ("Exchange Act") and Rules 13a-1 and 13a-13 thereunder, and agreed to restate its annual reports on Form 10-K for Fiscal Year 1983, Fiscal Year 1984, and Calendar Year 1984 to write off certain deferred start-up costs related to development of the copiers. Litigation Release No. 10928 (November 12, 1985), 34 SEC Docket 920. 20/ To the extent that Respondents' arguments may be viewed as addressing these issues, the court's opinions resolving them are the law of the case. Under that doctrine, once a court decides an issue that decision binds all future proceedings in the same case. Key v. Sullivan, 925 F.2d 1056 (7th Cir. 1991); City of Cleveland v. Federal Power Commission, 561 F.2d 344 (D.C. Cir. 1977). 21/ Checkosky, 50 S.E.C. at 1197. 22/ 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.'" SEC v. Steadman, 967 F.2d 636, 641-42 (D.C. Cir. 1992). 24/ Every profession must set high standards for the quality of its work because people who rely on that work are usually unable to judge its quality for themselves. Clearly, it is neither possible nor desirable to relieve auditors . . . of their (continued...) ==========================================START OF PAGE 11====== Respondents' determination to concur in the capitalization of certain costs associated with Savin's copier program, specifically costs associated with research and development. FAS 2 provides definitions and examples of those costs that should properly be expensed as research and development. "Research" includes investigation to discover knowledge useful in development of a new process or technique or in creating a significant improvement to an existing product or process. 25/ "Development" is the translation of research findings or other knowledge into a plan or design for a new product or process or for a significant improvement to an existing product or process whether intended for sale or use. It includes the conceptual formulation, design, and testing of product alternatives, construction of prototypes, and operation of pilot plants. 26/ Among the activities that exemplify research and development are: (f) Design, construction, and testing of pre-production prototypes and models. . . . (i) Engineering activity required to advance the design of a product to the point that it meets specific functional and economic requirements and is ready for manufacture. 27/ 24/(...continued) professional responsibility by establishing detailed rules of conduct . . . . Auditing standards, in the broadest sense, are guidelines for performing professionally responsible audits. . . . They set the minimum level of quality that auditors are expected, by their clients and the public, to achieve. (Jerry D. Sullivan, et al., Montgomery's Accounting, 10th edition, (1985) 48-49). The level of accepted professionalism that the accounting and auditing professions have set for themselves is GAAS and GAAP. 25/ "Research" is planned search or critical investigation aimed at discovery of new knowledge with the hope that such knowledge will be useful in developing a new product or service. FAS 2 8(a). 26/ Development does not include routine or periodic alterations to existing products, production lines, manufacturing processes, and other on-going operations, although those alterations may represent significant improvements. Development further does not include market research or market testing activities. FAS 2 8(b). 27/ FAS 2 9(f) and (i). These examples may be contrasted with FASB examples of activities that are not considered (continued...) ==========================================START OF PAGE 12====== Respondents ignored numerous indicia that should have caused them to question Savin's accounting treatment. The first was Savin's financial condition. 28/ During Fiscal Year 1981, Respondents knew that Savin experienced a net operating loss for the first time. Had Savin not improperly deferred $1.8 million as start-up costs, its operating loss would have further risen. Checkosky characterized this information as a red flag, warranting a heightened scrutiny of Savin's figures. Moreover, Respondents did not require that Savin adopt a cost deferral policy that adhered to the standards of FAS 2. 29/ Instead, Savin's policy, which was adopted with 27/(...continued) research and development: (a) Engineering follow-through in an early phase of commercial production. . . . (d) Routine, on-going efforts to refine, enrich, or otherwise improve upon the qualities of an existing product. . . . (h) Activity, including design and construction engineering, related to the construction, relocation, rearrangement, or start-up of facilities or equipment other than (1) pilot plants . . . and (2) facilities or equipment whose sole use is for a particular research and development project . . . . 10(a), (d), and (h). 28/ We have judged auditors' performance in light of the "total audit environment." Ernst & Ernst, 46 S.E.C. 1234, 1262 (1978). Thus, in Ernst & Ernst, we concluded that, among other things, the auditors failed to demonstrate "due professional care" when confronted with "a very large and extraordinarily profitable transaction" concluded three days before the end of the accounting year and were aware of management's desire to generate earnings. Id. See also Touche Ross & Company, 45 S.E.C. 469, 472 (1974) (auditor aware that management was aggressively seeking income and increasingly dependent on small number of complex transactions) (settlement). 29/ Respondents claim that they reasonably understood that "research and development" for purposes of FAS 2 ended when there was a working model of the new product that incorporated and demonstrated the new technology that had been pursued through research and development. Respondents' (continued...) ==========================================START OF PAGE 13====== Checkosky's advice and concurrence, permitted deferring development costs when Savin reached "a comfort level" of marketability and when it "believe[d] that the product will satisfy the customer." As discussed above, this type of subjective standard was explicitly considered and rejected by the FASB when it adopted FAS 2. 30/ Respondents also acceded to Savin's view that the existence of a working prototype and release of drawings for manufacture meant that Savin was no longer engaging in research and development. However, these benchmarks were not necessarily indicia that a product had reached the "specific functional and economic requirements" described in FAS 2 or that there would not be continued design, construction, or testing of other prototypes. Respondents were further aware that the copiers would have to meet certain reliability standards to be marketable. Checkosky claims that he personally inspected a working model of a Savin photocopier in January 1981, and that this was evidence supporting deferral. It does not appear, however, that Checkosky ascertained that the machine met Savin's functional and economic specifications. In fact, throughout 1981 and 1982, Savin's engineers struggled to correct problems with fundamental components of the copier, including the fuser and the toner, as well as the copier's unreliability. In the meantime, Savin's deferred costs kept rising. The indications that Respondents should question Savin's policy of deferral mounted. In Fiscal Year 1983, Savin abandoned Project X and began work on Pegasus. Although Respondents assert that Pegasus was a refinement of the Rhino model, they knew that there had been no prototype of Rhino and no release of drawings. Indeed, C&L workpapers describe Rhino as remaining in research and development. Respondents were aware that the timing of market entry and copier reliability were critical to the success of Pegasus. They knew that the staff of E&M had been drastically reduced in December 1982. They were also aware that substantial re- engineering was being done to major components of Pegasus. Difficulties and continuing delays are described in engineering reports and in minutes of the Savin Board of Directors. Respondents further learned during the fall of 1983 that our 29/(...continued) contention that FAS 2 is aimed only at the production of "new technology" was rejected by the law judge, by us, and by the Court of Appeals. As Judge Randolph observed, the design of a model and its testing are considered research and development under FAS 2. 23 F.3d at 477. 30/ 23 F.3d at 456-57 (Silberman, J.), citing ACCOUNTING FOR RESEARCH AND DEVELOPMENT COSTS, Statement of Financial Accounting Standards No. 2, 53, 54 (FASB 1974). ==========================================START OF PAGE 14====== staff was seeking detailed justification from Savin for its inclusion of deferred start-up costs as an asset. The first McKinsey report, in outlining what would be required for successful marketing of the Pegasus project, recommended strict production and completion benchmarks. Those benchmarks were not met in Fiscal Year 1983 or Fiscal Year 1984. Nor were the difficulties minor. By the end of 1984, for example, the copiers still leaked liquid on the floor and generated excessive heat. Respondents apparently relied on management's view that none of the costs deferred with respect to the Pegasus project were research and development. Instead of assessing Savin's activities to determine whether costs associated with the project had passed out of research and development, Respondents merely verified the amounts of project costs and that Savin had incurred the costs in connection with the Pegasus project. Although each projection for production passed unfulfilled and no copier progressed beyond the prototype stage, Respondents failed to question Savin's continuing practice of deferring increasingly higher amounts. Moreover, there is nothing in the workpapers that suggests that, in the face of all the contrary evidence that they amassed over this period, Respondents ever reconsidered the merits of their decision to permit deferral. Moreover, even under the much lower standards of Savin's accounting policy, Savin's expenditures should not have been deferred. Respondents claim that they applied two benchmarks in their Fiscal Year 1981 and 1982 audits to determine whether Savin's project had passed out of research and development: whether Savin had developed the actual machine that it would produce and whether blueprints had been released from engineering to manufacturing. 31/ Yet, in 1982, many of the blueprints had not in fact been released. The accounting policy standards were apparently abandoned completely for the succeeding audits. There were neither completed Pegasus blueprints nor any successful working prototype of the Pegasus at the time of the 1983 or 1984 audits. Thus, over a period of years, Respondents were aware of functional and economic problems that resulted in Savin's repeatedly postponing introduction of copier models. By the Fiscal Year 1983 audit, Respondents knew of the cancellation of development of the original designs, lay-off of a significant number of employees, and attempts to develop a reconfigured design. The new design attempts were unsuccessful, resulting in prototypes that leaked toner, generated very excessive heat, and were unreliable. These events, coupled with Savin's financial condition and the accelerating deferred costs, should have alerted them to the need for "heightened vigilance" in 31/ 50 S.E.C. at 1191. ==========================================START OF PAGE 15====== determining whether the deferrals were proper. As described above, Respondents did not make such efforts. Respondents' lack of independent judgment is underscored by their involvement with the 1984 McKinsey update report. Before the law judge and in their initial appeal to us, Respondents cited this update as evidential matter supporting their audit work. As described above, however, Respondents made editorial modifications to the 1984 update. Their changes struck out phrases that suggested that Savin was in the "design phase" or had incurred "development costs" and minimized the preliminary nature of the copier project. 32/ Many of their changes were incorporated in the final version of McKinsey's report. Such involvement is a complete deviation from the requirement that auditors bring professional skepticism to their work. Respondents argue that, even if we did not accept the testimony of their expert witnesses who concurred with Respondents' interpretation of FAS 2, these experts' testimony shows that Respondents' conclusions were not unreasonable, and certainly not reckless. 33/ In our prior opinion, we found 32/ For example, "[t]he technical risks of an unproven copier project" was changed to "the risks of a new copier project," and "the development team" to "the engineering team." And the following section was marked in the draft: A year ago, the major risk was whether the basic technical concept was sound. The fuser concept had not been demonstrated and no subsystems were even under test. Given the high reliability and copy quality benchmarks, there were major concerns as to whether the product was feasible. With prototypes now under test . . . . In the final McKinsey update report, this language was replaced with: As of March 1983 the major risk on the program was whether the 8000 concept as a system could meet the high reliability and copy quality benchmarks that were established as the requirements for commercial success. No working models incorporating all of the planned modifications to the earlier generation of machines (i.e., Diamond/Ruby) has as yet been built. Now, as it has been explained to us, with prototypes having been tested . . . . 33/ Respondents also claim to have consulted the Price Waterhouse manual in 1981, which lent support to the (continued...) ==========================================START OF PAGE 16====== that Respondents' expert witnesses were satisfied with the Respondents' actions because the experts were unaware of the seriousness of the designs' deficiencies, or that the designs had not progressed to manufacture. 34/ Moreover, we are uncertain whether any of these experts reviewed the after-disclosed evidence, including the edits to the McKinsey update report and the Savin staff 1984 engineering reports. We do not know, therefore, how that evidence would have affected their views. The facts that Respondents qualified their opinions on the Fiscal and Calendar Year 1984 audits and that Savin expensed certain copier-related costs beginning in 1981 do not change our conclusion that they recklessly failed to account for all such costs properly. The qualified opinions raised questions regarding Savin's ability to bring its product to the market on a timely basis and to recover its costs. They did not raise questions about Respondents' opinion that it was proper for Savin to book as assets costs that should have been expensed, particularly after years of Savin's failures to manufacture a copier. 35/ 33/(...continued) standards adopted in Savin's policy statement. As Judge Randolph observed, the law judge did not indicate whether she credited Checkosky's testimony that he had read the materials sent by the research unit. Moreover, we do not agree that the Price Waterhouse manual supports Respondents' position. The manual observes that research and development activities are undertaken with the goal of bringing new products to a "technologically feasible status where they are ready to be produced, utilized, or offered." The manual includes examples of charges that should be expensed, such as "translation of research output into a new product concept" and "designing a new product." 34/ 50 S.E.C. at 1195. 35/ Respondents cite certain inquiries to the FASB staff made by our staff as supporting the position that their inter- pretation of FAS 2 was reasonable. The inquiries and their responses are quite general, and at least one response notes that the FASB staff did not provide interpretations as to specific situations. It appears, moreover, that the majority of these responses dealt with a company that was "working on" or making alterations to existing products, a situation not applicable here. One of the responses also observes that, in determining whether an activity is research or development, "It may be significant that the enterprise is continuing in its attempts to find a commercially successful application of the developed technology rather than merely attempting to adapt an existing, commercially successful product to a broader market." ==========================================START OF PAGE 17====== IV. Respondents assert that any finding that Respondents acted recklessly fails to satisfy due process and administrative notice requirements because the Office of the Chief Accountant did not allege that Respondents acted with scienter. Respondents rely, in part, on In re Ruffalo. 36/ Ruffalo had been charged with attorney misconduct. At the hearing, the state board added a different charge based on Ruffalo's testimony before it, and gave Ruffalo a continuance to defend the new charge. The board ultimately dismissed the original charges and disbarred Ruffalo based on the charge added at the hearing. The Supreme Court held that, despite the continuance, Ruffalo was deprived of procedural due process because he had a right to know of the charges against him before the hearing commenced. 37/ Unlike Ruffalo, we are not dealing with an uncharged offense, nor alleged misconduct predicated on the unwitting testimony of a respondent. Respondents understood the charge against them. The Order Instituting Proceedings alleged that Respondents engaged in improper professional conduct. 38/ As discussed infra, we have found improper professional conduct committed under circumstances evidencing a variety of mental states. Throughout this proceeding, Respondents have argued that they must be found to have acted with scienter if their conduct is to be adjudged improper. As Respondents have urged, we have evaluated their conduct against GAAS and GAAP and considered the degree of their deviations from those standards. 39/ V. 36/ 390 U.S. 544 (1968), modified on other grounds, 392 U.S. 919. Compare also 23 F.3d at 481-82 (Randolph J., agreeing with Respondents' assertion) with 23 F.3d at 460-62 (Silberman, J., disagreeing). 37/ 390 U.S. at 552. 38/ See, e.g., Aloha Airlines, Inc. v. CAB, 598 F.2d 250, 262 (D.C. Cir. 1979) (discussing sufficiency of notice under the Administrative Procedure Act). 39/ Respondents complain that our consideration of the issue has somehow been waived. However, Rule 17(g) of our former Rules of Practice (which govern this proceeding) authorizes this Commission, with notice to the parties, to raise and determine matters that it deems material. We asked the parties here to address (1) what constitutes recklessness for purposes of Rule 2(e)(1)(ii); and (2) what facts, if any, in the record demonstrate that Respondents did or did not act recklessly or negligently. See David J. Checkosky and Norman A. Aldrich, Securities Exchange Act Release No. 34983 (November 14, 1994), 58 SEC Docket 19. ==========================================START OF PAGE 18====== We have explained above why we find Respondents' conduct to be reckless. As noted, however, the Court of Appeals unanimously directed that we generally supply a "more adequate explanation" of our interpretation of Rule 2(e)(1)(ii). The opinions of the panel focus on the mental state required for improper professional conduct. Rule 2(e)(1) governs the conduct of professionals -- including accountants, attorneys, engineers, and geologists -- who appear before us. In light of the different roles of each of these professionals, we hold "those professionals who practice before us to generally recognized norms of professional conduct . . . . To do so upsets no justifiable expectations, since the professional is already subject to those norms." 40/ In the case of accountants, those standards include GAAS and GAAP. Accountants' audit reports publicly represent that "the code of conduct embodied in the statements of auditing standards promulgated by the AICPA has been followed." 41/ As Judge Randolph observed, [c]ompliance with these requirements gives credibility to financial statements. It promotes the use of financial statements as the [Securities Exchange Act of 1934 ("Exchange Act")] intended them to be used: to assess the financial health of a company; to compare one company's performance with another's; and to evaluate any single company's progess over several accounting periods. 42/ Improper professional conduct by accountants encompasses a range of conduct. We agree that improper professional conduct by an auditor includes the "auditor who certified financial statements despite realizing his lack of independence from the reporting company, or who knowingly assisted in the filing of materially false statements with the Commission. Such individuals cannot be trusted and neither can their reports." 43/ We have not hesitated to sanction auditors for such conduct. 44/ However, it has equally been our experience 40/ William R. Carter, 47 S.E.C. 471, 508 (1981). 41/ Carter, 47 S.E.C. at 478. 42/ Checkosky, 23 F.3d at 471-72. 43/ Id. at 471. 44/ See, e.g., Myron Swartz, 41 S.E.C. 53 (1961) (sanctioning accountant who certified financial statements when no examination was made of books and records, failed to disclose falsity of such statements while continuing to perform accounting services for the company, prepared false and misleading financial statements for filing with this Commission, and testified falsely to Commission staff about these matters). ==========================================START OF PAGE 19====== that "[a]n incompetent or unethical practitioner has the ability to inflict substantial damage on the Commission's processes, and thus the investing public." 45/ Our conclusions about the propriety of particular professional conduct are driven by the impact on Commission processes of the specific facts presented in a given proceeding before us. We have, for example, disciplined an auditor who employed a discredited accounting principle; 46/ an auditor who failed to bring healthy skepticism to management's repre- sentations in the face of indications that those representations should be questioned; 47/ an auditor who expressed an opinion without sufficient basis; 48/ and an auditor who failed to perform required minimum audit procedures. 49/ We believe 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. 50/ Unlike Rule 2(e)(1)(iii), 45/ Carter, 47 S.E.C. at 475, quoting Keating, Muething & Klekamp, 47 S.E.C. 95, 120 (1979) (Chairman Williams, concurring). 46/ F.G. Masquelette & Co., Accounting Series Rel. No. 68, [1937-1982 Accounting Series Releases] Fed. Sec. L. Rep. 72,087 (July 5, 1949) (using the "now thoroughly discredited device of employing par value as a representation of value for financial statement purposes."). 47/ Ernst & Ernst, 46 S.E.C. at 1262 (criticizing accountants' failure to bring "healthy skepticism" to management representations when aware of management's willingness to "stretch a point" and conceal material information); Touche, Ross & Co., 45 S.E.C. at 472 (observing that failure to question management's representations delayed discovery of "pattern of manufacturing profits"). 48/ Barrow, Wade, Guthrie, & Co., Accounting Series Rel. No. 67 [1937-1982 Accounting Series Releases] Fed. Sec. L. Rep. (CCH) 72,086 (April 18, 1949) (auditor acquiesced in decision of management not to take a physical inventory of work in process yet certified that there was "no reason to believe" that inventories were "unfairly stated."). 49/ See, e.g., Harmon R. Stone, 41 S.E.C. 532, 535 (1963). 50/ Respondents make certain arguments based on the recognized inherent powers of an administrative agency to discipline attorneys and the mental state required for such action. However, while we have such inherent powers, we do not agree with Respondents' arguments that those powers mandate a bad faith finding. Respondents rely on Roadway Express, Inc. v. (continued...) ==========================================START OF PAGE 20====== Rule 2(e)(1)(ii) does not require that the conduct be "willful." Nor do we believe that Respondents are correct that the overall structure of the securities laws mandates that scienter is an element of Rule 2(e)(1)(ii). Respondents observe that Section 10(b) of the Exchange Act requires scienter. 51/ However, other provisions of the securities laws that can involve accountants do not. The Office of the Chief Accountant directs our attention to Section 11 of the Securities Act of 1933, which imposes civil liability on auditors in the absence of scienter. Moreover, other provisions of the Exchange Act that may impose liability based on audited financial reports filed with us, such as Sections 15(c)(3) and 13(a), similarly do not contain a scienter requirement. 52/ Moreover, we have found improper professional conduct where an auditor was negligent or acted while mentally and physically 50/(...continued) Piper, 447 U.S. 752, 767 n. 13 (1980), which dealt with the issue of whether courts had the inherent powers to assess attorneys' fees as a sanction for bad-faith conduct. That opinion, while recognizing that state courts had sanctioned attorneys for negligent conduct, specifically limited its holding to the issue of bad-faith conduct before it. With respect to this case, the Court of Appeals noted, in any event, that Section 2(e)(1)(ii) was enacted pursuant to our broad rulemaking authority under Section 23(a)(1) of the Exchange Act. Checkosky, 23 F.3d at 455-56 (Silberman, J.), 23 F.3d at 469-72 (Randolph, J.), 23 F.3d at 493-94 (Reynolds, J.). 51/ We previously expressed the view that the standards for fraud or for injunctive relief "have no bearing" on Rule 2(e)(1)(ii) proceedings. Checkosky, 50 S.E.C. at 1197 n. 38. 52/ Respondents assert that Section 15(b) of the Exchange Act authorizes this Commission to discipline broker-dealers and their associated persons for willful conduct. However, certain provisions of Section 15(b) do not require willfulness. See, e.g., Section 15(b)(4)(E) (failure to provide reasonable supervision). Moreover, courts have construed "willfully" under Section 15(b) as "intentionally committing the act which constitutes the violation." Tager v. SEC, 344 F.2d 5, 8 (2d Cir. 1965). Respondents also cite the recent amendments to the securities laws that authorize imposition of director and officer bars. However, the fact that this particular remedy may be imposed only for a scienter-based violation is not apposite to the question of what constitutes improper professional conduct. ==========================================START OF PAGE 21====== exhausted; 53/ "failed to fulfill [its] responsibilities of serving as" an independent accountant; 54/ "failed to give this professional undertaking the degree of care and inquiry it demanded," (conduct that we found "so deficient" as to warrant disciplinary action); 55/ or behaved in a manner that was "manifestly unethical, improper, and unprofessional." 56/ While the acts in each case demonstrated varying degrees of care or mental state, we concluded in each that the accountant had improperly certified that financial statements complied with the applicable auditing requirements and that the resulting financial statements could not be relied upon. Respondents argue that our opinion in Carter mandates that scienter must be established to demonstrate improper professional conduct. In Carter, two attorneys were charged both with improper professional conduct (Rule 2(e)(1)(ii)) and with aiding and abetting their client's violations of the antifraud and disclosure provisions (Rule 2(e)(1)(iii)). Carter, however, dealt with a limited issue -- the responsibilities of an attorney acting as an adviser to a client on disclosure matters where the reasonable lawyer "must conclude that his advice is not being followed, or even sought in good faith, and that this client is involved in a continuing course of violating the securities laws." 57/ The particular question we confronted was what 53/ Barrow, Wade at 62,176. Consistent with then-current procedures, Barrow, Wade was instituted as a private proceeding. Under those procedures, among other things, the name of the respondent was not disclosed unless an adverse judgment was entered against the respondent. Although, as Respondents note, we dismissed the case against the Barrow, Wade respondents, this Commission adopted the recommendation of the hearing examiner that we identify the respondents and publish a statement detailing the basis for our findings that these respondents engaged in improper professional conduct. 54/ Ernst & Ernst, 46 S.E.C. at 1271. 55/ Haskins & Sells, Accounting Series Rel. No. 73 [1937-1982 Accounting Series Releases] Fed. Sec. L. Rep. (CCH) 79,092 (October 30, 1952). 56/ Myron Swartz, 41 S.E.C. at 57. 57/ Carter, 47 S.E.C. at 511-12. We made clear that our opinion was: directed only to the narrow range of lawyers engaged in a federal securities practice, to the specific factual context of an ongoing disclosure program of a corporate client, and to the limited question of when it is appropriate for a lawyer to make further efforts within (continued...) ==========================================START OF PAGE 22====== further steps the lawyer had to take "to avoid the inference that he has been co-opted, willingly or unwillingly, into the scheme of non-disclosure." 58/ In Carter, we further acknowledged that, at that time, no generally recognized professional norms provided guidance to attorneys faced with this difficult situation. 59/ For that reason, we issued an interpretation, applicable after the date of the opinion, as to what constituted improper professional conduct in that instance. 60/ In contrast, here Respondents are not being held to account for advice to a client that the client refused to follow. Indeed, Respondents concurred in management's desire to defer 57/(...continued) the corporation to forestall continuing violative conduct. Id. at 476. 58/ Id. at 511. Respondents make much of the fact that we refer to the attorney's awareness of the client's violation. The attorney's knowledge of the violations was the precise problem we were facing in Carter. We did not suggest that "awareness" was somehow an element of improper professional conduct. 59/ Id. at 508. 60/ We expressed the opinion that the lawyer was "in the best position" to evaluate the correct course of action. We suggested, as possibilities, approaches to the board of directors or individual officers or directors. We also observed that resignation was not the only permissible course under these facts. We concluded that, as long as the attorney was exerting reasonable, good faith efforts, the attorney would be found to have met his or her professional obligations. Id. at 512. In this regard, we distinguished efforts that might on their face appear reasonable (e.g., continuing to counsel disclosure) but are not in good faith (i.e., the attorney knows that the client is disregarding the advice and using the attorney as a shield.) Id. at 511-12. This observation is consistent with our opinion in Haskins & Sells. We found that the auditors there acted in good faith but failed to give their "undertaking the degree of care and inquiry it required" in a manner which was "so deficient" that it warranted discipline. Haskins & Sells at 62,197. Similarly, in Ernst & Ernst, we found that the auditors failed in their "responsibility to perform audits" in accordance with GAAS although we recognized that they "were victims of management's fraud and deception." 46 S.E.C. at 1272. We have found that work done either in bad faith or incompetently adversely impacts our processes. Compare nn. 44, 56 with n.53. ==========================================START OF PAGE 23====== Savin's research and development costs. Moreover, we have found improper Respondents' failures to comply with GAAS and to apply properly GAAP, and there is a recognized professional standard that applies to the issue, FAS 2. The Carter opinion separately analyzed the alleged improper professional conduct and the aiding and abetting claims against the attorneys. Although Respondents here are not charged with aiding and abetting Savin's violations, they cite the aiding and abetting section of the Carter opinion to support their assertions that Carter held that the "element of intent" distinguishes professionals who should be disciplined from those who committed "errors of judgment or have been careless." However, as is clear from the remainder of the paragraph from which this quotation is drawn, we stated only that, absent wrongful intent, a lawyer will not be found to be an aider and abettor merely because he gives incorrect advice. 61/ Respondents further assert that Carter observed that paragraphs (ii) and (iii) of Rule 2(e) serve the "same function" and must therefore mandate the same degree of scienter. Again, we believe that they misconstrue Rule 2(e) and our opinion. In Carter, we observed that all three sections of Rule 2(e) have the same goal and seek to effectuate the same policies: [I]f a [professional] violates ethical or professional standards, or becomes a conscious participant in violations of the securities laws, or performs his professional function without regard to the consequences, it will not do to say that because the [professional's] duty is to his client alone, this Commission must stand helplessly by while the [professional] carries his privilege of 61/ Carter, 47 S.E.C. at 504. Nor, as Respondents hypothesize, does our analysis mean that the improper professional conduct standard in Rule 2(e)(1)(ii) has engulfed the wilfulness standard in Rule 2(e)(1)(iii). We have continued to bring proceedings under Rule 2(e)(1)(iii). See, e.g., Davy v. SEC, 792 F.2d 1418 (9th Cir. 1986) (affirming findings that respondent should be permanently denied the privilege of practicing before this Commission both for improper professional conduct and violations of the antifraud provisions of the securities laws). Similarly, we continue to bring proceedings under all three sections of 17(a) of the Securities Act of 1933 although the Supreme Court has held that Section 17(a)(1) requires scienter to establish a violation, while Sections 17(a)(2) and (3) do not. Aaron v. SEC, 446 U.S. 680, 696 (1980). See, e.g., Jay Houston Meadows, Securities Exchange Act Rel. No. 37156 (May 1, 1996), 61 SEC Docket 2444, 2453 n. 16, appeal filed, No. 96-60328 (5th Cir.) ==========================================START OF PAGE 24====== appearing and practicing before the Commission on to the next client. 62/ Rule 2(e)(1)(i), which is not at issue here, permits us to discipline those who do "not . . . possess the requisite qualifications to represent others." Rule 2(e)(1)(i) does not require any level of intent. If a person is not properly admitted or qualified in the appropriate professional capacity and nonetheless seeks to appear before us, that professional is subject to discipline under Rule 2(e). The fact that this section does not require scienter does not mandate any conclusion with respect to whether Rules 2(e)(1)(ii) or (iii) should be construed in the same way. Each paragraph addresses a different potential harm to our processes. 63/ Respondents also claim that our opinion in Kenneth N. Logan, 64/ supports their position that an auditor cannot be found to have engaged in improper professional conduct if the auditor acted in good faith. In Logan, an auditor improperly certified that he was independent, although eight percent of his and his family's net worth was invested in the client's securities. We held that Logan's conduct was "grossly improper." 65/ However, we observed, in dicta, if the evidence showed that Logan in good faith held himself out as an independent accountant, we should not hold him to be lacking in character or integrity or to have engaged in improper and unethical professional 62/ Carter, 47 S.E.C. at 478. 63/ Thus, in Carter, 47 S.E.C. at 478, we observed, Not every violation of law, however, may be sufficient to justify invocation of the sanctions available under [Rule 2(e)(1)(iii)]. 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. 64/ 10 S.E.C. 982 (1942). 65/ Id. at 998. Logan had argued that he was unfamiliar with a Commission rule and release that made clear that an accountant who had a substantial interest in a client would not be viewed as independent with respect to that client. We rejected his assertion of good faith, noting that both the rule and release were in effect at the time he made the subject certifications. ==========================================START OF PAGE 25====== conduct merely by reason of the fact that he was found to be not in fact independent. 66/ When Logan was issued in 1942, we and the accounting profession were attempting to determine what constituted independence on the part of accountants. 67/ In 1959, we rejected a second claim that an auditor had certified mistakenly, but in good faith, that he was independent. 68/ We conceded that the accountant had made no effort to deceive us and that the accuracy and completeness of the audit were not questioned. We nonetheless concluded that the accountant had engaged in improper professional conduct, evidenced by "a careless and unprofessional attitude with respect to a most fundamental concept under both the [federal securities laws] and Accounting Standards." 69/ 66/ Id. at 985. We note that Logan dealt not simply with whether the auditor had engaged in improper professional conduct, but whether he was "lacking in character or integrity" or had engaged in "improper and unethical professional conduct." (emphasis added). Respondents have asserted that, "[a]side from the reference to 'improper professional conduct,'" the remaining phrases in Rule 2(e)(1)(ii) "suggest wrongdoing, dishonesty, immorality or other instances of moral turpitude." 67/ One year before our decision in Logan, we noted that we had found that "conscious falsification . . . or lack of care and of proper verification in going over accounts, or uncritical acceptance of the orders of an officer of the registrant may cast grave doubts on the independence of an accountant." A. Hollander & Son, Inc., 8 S.E.C. 586, 612 (1941) (citations omitted). Beginning in 1937, and on several occasions thereafter, we issued statements as to whether particular facts could affect an accountant's independence. See, e.g., Accounting Series Rel. No. 81, [1937-1982 Accounting Series Releases] Fed. Sec. L. Rep. 72,103 (Dec. 11, 1958) (summaries of staff opinions as to whether, given a particular set of facts, an accountant was independent). 68/ The accountant's partner was also an officer, director, and the majority shareholder of an issuer. The partner prevailed on the accountant to audit the issuer in his "individual" capacity. The accountant claimed that he had reviewed an AICPA rule which did not specifically deal with the issue of whether one partner's lack of independence would be imputed to others in the firm. He also consulted the issuer's counsel, who was, in addition, an officer and director of the issuer. We held that the accountant was obligated to acquaint himself with our and the AICPA's rules and opinions respecting independence. Bollt and Shapiro, 38 S.E.C. 815, 820-21 (1959). 69/ Id. at 823. ==========================================START OF PAGE 26====== We wish to make clear, however, that the fact that GAAP and GAAS are professional standards against which we examine the conduct of accountants does not mean that every deviation from GAAP or GAAS is improper professional conduct warranting discipline under Rule 2(e)(1)(ii). Our processes are not necessarily threatened by innocent or even certain careless mistakes. 70/ At times, we have found improper professional conduct by accountants who engage in several deviations of GAAS or GAAP, 71/ or who deviated from GAAS or GAAP in more than one audit, 72/ or with more than one client. 73/ However, isolated failures may be so serious as to warrant discipline. 74/ Thus, as explained above, we concluded that a single misrepresentation, which we characterized as "careless and unprofessional," by an auditor that he was independent warranted discipline. We concluded that the importance of independence by the auditor is "a most fundamental concept under [the securities laws] and Accounting Standards." 75/ VI. Respondents urge that we dismiss this proceeding, alleging that they at most engaged in isolated instances of negligent behavior in the early 1980's. As discussed in detail above, we disagree both that their failures were isolated or merely negligent. We previously suspended Respondents from appearing before us for a two-year period. Those suspensions were 70/ Thus, in Carter, we observed that a lawyer did not risk being held to have violated Rule 2(e)(1)(ii) if he or she failed "to correct every isolated disclosure action or inaction" the attorney believed varied from "applicable disclosure standards." 47 S.E.C. at 511. 71/ See, e.g., Myron Swartz, 41 S.E.C. at 58; Haskins & Sells, at 62,184 (various failures in valuing intangible assets). 72/ See, e.g., Touche Ross & Co., 47 S.E.C. 965 (1983) (improper professional conduct with respect to financial statements covering five years). 73/ See, e.g., Peat, Marwick, Mitchell & Co., 45 S.E.C. 789 (1975) (relating to the examination of financial statements of National Student Marketing Corporation, Talley Industries, Inc., Penn Central Company, Republic National Life Insurance Company, and Stirling Homex Corporation.) 74/ See, e.g., Carter, 47 S.E.C. at 511 ("There may be isolated disclosure failures that are so serious that their correction becomes a matter of primary professional concern."). 75/ Bollt and Shapiro, 38 S.E.C. at 823. ==========================================START OF PAGE 27====== concluded in September 1994. 76/ We do not believe vacating this order would be in the public interest. An appropriate order will issue. 77/ By the Commission (Chairman LEVITT and Commissioner HUNT); Commissioner JOHNSON dissenting, and Commissioner WALLMAN not participating. Jonathan G. Katz Secretary 76/ Respondents recently filed a notice suggesting that Johnson v. SEC, 87 F.3d 484 (D.C. Cir. 1996) was applicable to these facts. In Johnson, the Court of Appeals ruled that the statute of limitations contained in 28 U.S.C. 2462 prohibited this Commission from imposing a censure and a supervisory suspension in an administrative proceeding because that proceeding had been initiated more than five years after the entire conduct at issue. Respondents assert that, since the first decision to defer Savin's costs was made more than five years before this proceeding was instituted, claims based on their subsequent conduct within the period are somehow barred. In the alternative, they urge that we remand this proceeding for a new hearing limited to the conduct within the five-year period. Respondents concede that the majority of their conduct is within the five-year period. As described above, they persisted in their determination to permit Savin to defer its costs in the face of Savin's repeated, unsuccessful attempts to develop copiers. Even if the initial conduct were time-barred, such conduct can be considered as evidence of motive, intent, or knowledge. See, e.g., Fed. R. Evid. 404(b). Respondents further contend that the court in Johnson determined that Commission sanctions were not remedial. We do not understand the court in Johnson to hold that the Commission may not impose sanctions for conduct that is not time-barred. Respondents also make various arguments about whether the suspensions would serve a prophylactic purpose. Since these suspensions are concluded, we believe those arguments are moot. See also Checkosky, 50 S.E.C. at 1197, n.38. 77/ All of the arguments 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 in this opinion. ==========================================START OF PAGE 28====== Commissioner JOHNSON, dissenting: Having reviewed the record in this proceeding, the earlier opinion of this Commission, and the opinions of the United States Court of Appeals for the District of Columbia Circuit in this matter, I respectfully dissent from the majority's opinion. My disagreement with the majority relates to two important issues. The first is the mental state that should be considered necessary to trigger professional discipline under Rule 2(e)(1)(ii). 1/ The second is the appropriateness of disciplining the respondents considering the age of this proceeding. The majority opinion concludes that professionals may be sanctioned under Rule 2(e)(1)(ii) based on conduct that is merely negligent. I disagree. I think that this Commission's processes can be protected sufficiently by disciplining professionals under Rule 2(e)(i)(ii) only when it is demonstrated that they acted with scienter. The success of our system of truthful and accurate disclosure relies in large part on the work of talented, well- trained professionals. Thus, I agree with former Chairman Williams' statement that we would be unable to administer effectively the securities laws if those "involved in the capital raising process were not routinely served by professionals of the highest integrity and competence, well-versed in the requirements of the statutory scheme Congress has created." 2/ I am of the view, however, that this Commission's mandate for determining who may no longer "practice" before us under Rule 2(e) is a limited one and that we should continue to exercise an appropriate degree of self-restraint in this area. 1/ Former Rule 2(e), which is the basis for this proceeding, is now 17 C.F.R. 201.102(e). There are no substantive differences between the two rules. 2/ Keating, Muething & Klekamp, 47 S.E.C 95, 120 (1979) (concurring opinion of Chairman Williams). The United States Court of Appeals for the Second Circuit also recognized the importance of the role served by accountants and attorneys: By the very nature of its operations, the Commission, with its small staff and limited resources, cannot possibly examine, with the degree of close scrutiny required for full disclosure, each of the many financial statements which are filed. Recognizing this, the Commission necessarily must rely heavily on both the accounting and legal professions to perform their tasks diligently and responsibly. Touche, Ross & Co. v. SEC, 609 F.2d 570, 580-81 (2d Cir. 1979). ==========================================START OF PAGE 29====== 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. 3/ 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 judgement . . . [the professional] must have the freedom to make innocent -- or even, in certain cases, careless - - mistakes without fear of [losing] the ability to practice before" us. 4/ The majority's position will impair the relationships between professionals and their clients. Such an adverse impact will damage our ability to rely on these professionals to enhance compliance with the securities laws. I share the view expressed by the Commission in the William R. Carter case that professionals "motivated by fears for their personal liability will not be consulted on difficult issues." 5/ The professional owes a duty to serve the interests of his clients. To discharge this duty, the professional requires the cooperation and trust of the client. As Judge Randolph observed: [W]ithout a scienter requirement, lawyers would slant their advice out of fear of incurring liability, and management therefore would not consult them on difficult questions. I cannot see why this sort of reasoning would not apply as well to auditors. I recognize that although companies need not retain outside counsel, they are legally compelled to "consult" independent accountants. . . . This creates an obligation on the part of management to cooperate with and provide information to the auditor. . . . There are, however, degrees of cooperation. Encouraging management to be completely candid with its auditor about difficult accounting issues may be just as desirable as encouraging 3/ Thus, Judge Randolph observed: "The complexity of generally accepted accounting principles and generally accepted auditing standards is belied, and perhaps obscured, by their familiar acronyms." Accounting principles must be interpreted. Judgments must be made about specific transactions. "[R]easonable preparers of financial statements"-- often management --"and auditors can disagree about those interpretations and judgments." Checkosky v. SEC, 23 F.3d 452, 479 (D.C. Cir. 1994) (citations omitted). 4/ William R. Carter, 47 S.E.C. 471, 504 (1981). 5/ Id. ==========================================START OF PAGE 30====== management to consult candidly with outside lawyers, and for similar reasons. 6/ Thus, I believe that this Commission should not hold a professional liable for improper professional conduct under Rule 2(e)(1)(ii), absent a finding of scienter. Accountants and attorneys are members of "ancient professions," regulated according to rigorous ethical rules enforced by professional societies and, in the case of accountants, state licensing boards. As Judge Silberman observed, disciplining an accountant for every violation of GAAS or failure correctly to construe GAAP puts the Commission at risk of engaging in "a de facto substantive regulation of the profession. . . ." 7/ 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. That is not an appropriate role for this Commission. Difficult ethical and professional responsibility concerns are generally matters most appropriately dealt with by professional organizations or, in certain cases, malpractice litigation. Nor do I believe that mere misjudgments or negligence establishes either professional incompetence warranting Commission disciplinary action or the likelihood of future danger to the Commission's processes. My concern with imposing a negligence standard on accountants under Rule 2(e)(1)(ii), as set forth above, compels me to refrain from joining in the majority opinion. Moreover, assuming respondents had acted with scienter, as the majority finds, I would still dissent. This proceeding involves audits that took place at the beginning of the 1980s. As described in Commissioner Roberts' dissent to the earlier Commission opinion, this proceeding was brought several years after the initial audit and took several more years to work its way through the administrative process. It was then considered by the Court of Appeals and returned to us. Even if, technically, there is no legal impediment to continuing this proceeding, given the age of the conduct at issue, I believe that dismissal is the appropriate remedy. In light of these factors, I would dismiss this proceeding. 6/ Checkosky v. SEC, 23 F.3d at 485 (Randolph, J.) 7/ Checkosky, 23 F.3d at 459 (Silberman, J.). UNITED STATES OF AMERICA before the SECURITIES AND EXCHANGE COMMISSION SECURITIES EXCHANGE ACT OF 1934 Rel. No. 38183 / January 21, 1997 ACCOUNTING AND AUDITING ENFORCEMENT Rel. No. 871 / January 21, 1997 Admin. Proc. File No. 3-6776 _____________________________________________ : In the Matter of : : DAVID J. CHECKOSKY : and : NORMAN A. ALDRICH : _____________________________________________: ORDER AFFIRMING FINDINGS AND DENYING RESPONDENTS' MOTION TO DISMISS On the basis of the Commission's Opinion issued this day, it is ORDERED that the findings of improper professional conduct made against David J. Checkosky and Norman A. Aldrich ("Respondents") in this proceeding under Rule 2(e) in the Commission's opinion dated August 26, 1992 (50 S.E.C. 1180), be, and they hereby are, affirmed; and it is further ORDERED that the Respondents' request that this proceeding be dismissed be, and it hereby is, denied. By the Commission. Jonathan G. Katz Secretary