Adelphia Audit Partner Sanctioned - No Reliance On Prior Audits

Gregory M. Dearlove, AAER 2779

Time since appeal filed - 2 years, 4 months, 1 day.

Time since final brief filed - 2 years, 27 days.

Time since oral argument - 1 year, five months, 7 days.

Pages - 60

Footnotes - 168

Summary

This is a disciplinary proceeding against a CPA and arises from the Adelphia fraud. Respondent was formerly a partner at Deloitte & Touche and was the engagement partner for the audit of Adelphia for the 2000 audit of that firm. He was denied the privilege of appearing or practicing before the Commission with a right to reapply after four years.  He was also ordered to cease and desist violations of Exchange Act Section 13(a).  The ALJ had barred him from appearing before the SEC.

Adelphi filed for bankruptcy in June 2002 after disclosing related party transactions with the Rigas family that controlled the company.  As part of a settlement with the Department of Justice, Adelphia agreed to pay $715 million to a victims' restitution fund and the DOJ declined to file criminal charges.  In 2005 the Rigas settled civil charges brought by the Commission and consented to injunctive relief.  The Commission also brought an administrative action against Deloitte which the firm settled, among other things it agreed to a $25 million penalty and consented to findings it had "engaged in repeated instances of unreasonable conduct" concerning the 2000 audit of Adelphia.

This opinion contains a comprehensive discussion of the Generally Accepted Auditing Standards (GAAS) that apply to audits of public companies.  Among other things, "[u]nless and until an auditor obtains an understanding of the business purpose of material related party transactions, the audit is not complete."

Respondent argued that he should have been able to rely on the fact that the related party transactions had been subject to prior year audits.  The Commission rejected Dearlove's argument, stating "[W]e reject any suggestion that the conduct of prior auditors should be a substitute for the standards established by GAAS."  Further, it noted that rotation of auditors has long been required by the AICPA and federal law as a means of insuring impartiality. The Commission also rejected this defense on factual grounds, finding that the 2000 audit did not document how the prior audits were performed or what evidential matter supported those conclusions.  

Much of the opinion discusses highly technical accounting issues.  Those are summarized very briefly below.

The Commission noted that it was improper for Adelphia to net its related party receivables and payables.  Also, the company reflected a dramatic drop in the net figure, which the Commission found should have alerted the auditors to more carefully scrutinize this matter. Dearlove could not explain how the audit had tested this practice by the company.  The work papers do not reflect that the auditors gave any consideration to the propriety of this netting by the company.  The Commission found that Dearlove accepted the practice "primarily, if not solely" because the prior auditors had as well.

The ALJ rejected the Division of Enforcement's claim that Adelphia's treatment of various debt as a contingent, rather than a primary liability was wrong.  The Division did not appeal this finding.  Nevertheless, the Commission found that Dearlove's auditing of this was not in compliance with GAAS.  This is an important finding, accountants will be held liable for a GAAS violation even if the underlying accounting was appropriate.  Thus, getting to the right result is not a defense in a Rule 102(e) proceeding.  In support of this conclusion, the Commission noted that disclosures relating to the debt were not adequate.

Adelphia transferred debt from its subsidiaries to various Rigas controlled entities after the close of quarters, but nevertheless retroactively reflected the lesser debt amounts on the company's books. The Commission found this debt reclassification a violation of GAAP, even though there was no expert testimony that supported this conclusion.  The absence of expert opinion does not prevent the Commission from making findings as to the "principles of accounting."

The Rigas acquired Adelphia stock with funds borrowed jointly by themselves and Adelphia.  This debt was not recorded on Adelphia's books.  The Commission also found the auditors violated professional standards in their audit of these transactions.

The opinion contains a comprehensive discussion of the factors the Commission will consider when disciplining auditors.  It noted that auditors play a crucial rule in the system of public reporting as "[i]nvestors have come to rely on the accuracy of the financial statements of public companies when making investment decisions.  Because the Commission has limited resources, it cannot closely scrutinize every financial statement.  Consequently, the Commission must rely on the competence and independence of the auditors who certify, and the accountants who prepare, financial statements.  In short, both the Commission and the investing public rely heavily on accountants to assure corporate compliance with federal securities law and disclosure of accurate and reliable financial information."

It also noted that a negligent audit can inflict as much harm on investors as one that is conducted with an improper motive.  

The Commission found that it was appropriate to impose a cease and desist order against Dearlove for causing Adelphia's Exchange Act reporting violations.  In doing so it reiterated a three part test for "causing" liability namely: 1) a primary violation; 2) respondent contributed to the violation; and 3) respondent knew or should have known his conduct would contribute to the violations.  It further noted that negligence was sufficient to satisfy the knowledge requirement of the test.

The Commission rejected Dearlove's claim that the Commission's rule that set a deadline for trial judge to issue an opinion violates due process because here, a motion for a sixty day postponement of the trial was denied by the judge.   In rejecting this argument the Commission cited to the test set forth in Unger v. Sarafite, 376 U.S. 575 (1964) which noted that there is no mechanical test for deciding when denial of a continuance is so arbitrary as to violate due process.  The Commission noted that it has long articulated the test in terms of whether the denial "constituted 'an unreasoning and arbitrary insistence upon expeditiousness in the face of a justifiable request for delay.'"  In the past the Commission has rarely found a denial of due process when there were extraordinary circumstances for a postponement of trial, such as the respondent being left without counsel shortly before the hearing.  Here the judge's schedule allowed for 121 days between service of the order and completion of the hearing.  Further,  counsel was familiar with the matter as he had been involved in the matter for the two prior years when respondent's investigative testimony was taken.

Comment

The Commission's finding that Dearlove violated GAAS even though the accounting treatment of a debt item was appropriate is highly significant for auditors of public companies.  They can thus be held responsible for bad auditing practices even if the underlying accounting was valid.

Also noteworthy is the Commission's conclusion that it may make findings that accounting principles were not properly applied even absent expert testimony to support such a finding.  The Commission will make its own judgments about what constitutes proper accounting treatment of a transaction.

The Commission noted that under some circumstances "unreasonable conduct is not necessarily a less egregious disciplinary matter than either intentional or reckless conduct, or highly unreasonable conduct in circumstances warranting heightened scrutiny."

The Commission allowed respondent to reapply for reinstatement after four years. It stated, with little explanation, that it believed this sanction would encourage rigorous compliance with auditing standards, without being punitive.  This reversion to ipse dixit reasoning may cause the Commission issues before the court of appeals should an appeal be taken.

The Commission's finding that an auditor who signs an audit report after conducting an audit that does not comply with GAAS contributes to a violation of the reporting provisions is significant.

The Commission's ruling that there was no due process violation because the trial judge denied Dearlove's motion for a 60 day continuance after scheduling 121 days between the start of the proceedings and conclusion of the trial is one that practitioners should note.  This is another case where the Commission is clearly signaling that it will not interfere with scheduling or trial management decisions by its ALJs.  It pointed out that Commission rules specify such deadlines are not rigid and that the trial judge can petition the Commission to extend the deadline for rendering an initial decision.  Someone prone to sarcasm might note that the Commission took significantly longer than 121 days after oral argument to render its opinion, let alone the 300 days it allocated for the ALJ to conclude the trial and render an opinion.

Phlo Corp., et. al., Exchange Act Rel. 55562 (March 30, 2007)

Transfer agent, Issuer reporting violations

Time between appeal and decision – 12 months, 16 days
Time between last brief and decision – 9 months, 25 days
Pages – 28

Comment

Perhaps the most significant ruling in this case is the imposition of a cease and desist order against the company whose transfer agent registration was revoked and officer who was barred from transfer agent association because the cease and desist orders would serve the remedial purpose of encouraging [them] "to take their responsibilities more seriously in their future dealings with the clearance and transfer systems and the Commission." In justifying this sanction the Commission stated, "[w]e find that the record as a whole, especially the evidence with regard to the seriousness, recentness, and recurrent nature of the violations, the harm to the marketplace and the regulatory scheme, and the very high degree of scienter, establishes a sufficient risk that Respondents would commit future violations to warrant imposition of cease-and-desist orders. Based on all of these factors, we find cease-and-desist orders against Respondents to be in the public interest."

Also significant is the fact that the Commission increased the penalty against one respondent from $50,000 to $100,000. That respondent was responsible for the transfer agent violations and failed to cooperate with an SEC staff examination.

Finally, the Commission overturned the ALJ's sanction of revoking the issuer's registration because despite the egregious past violations, the company has devoted "significant resources to satisfying its reporting obligations," has become current with its periodic filings, and retained a consultant to improve its internal accounting functions. It did impose a cease and desist order against future filing violations. It is therefore clear that the Commission is reluctant to revoke the registration of a delinquent issuer that has become current and has taken other steps to make repeat violations less likely and will in the future be subject to a cease and desist order.

Key points

• The Commission considered as evidence a statement in a responpondent's Wells submission that she contradicted in her oral trial testimony.
• "'The prompt and accurate clearance and settlement of securities transactions, including the transfer of record ownership . . . , are necessary for the protection of investors and persons facilitating transactions by and acting on behalf of investors.' Failure to comply jeopardizes the efficacy of the Congressionally-mandated national system for the prompt and accurate clearance and settlement of transactions in securities." (footnotes omitted).
  A transfer agent is required to keep records demonstrating that it has complied with the turn-around rule.
• "A willful violation of the securities laws means merely 'that the person charged with the duty knows what he is doing.' Wonsover v. SEC, 205 F.3d 408, 414 (2000) (quoting Hughes v. SEC, 174 F.2d 969, 977 (D.C. Cir. 1949)). There is no requirement that the actor 'also be aware that he is violating one of the Rules or Acts.' Id. (quoting Gearhart & Otis, Inc. v. SEC, 348 F.2d 798, 803 (D.C. Cir. 1965))
• The aiding and abetting scienter requirement can be satisfied with proof of actual knowledge or reckless disregard.
• Incomplete response by transfer agent to staff request for documents and to conduct physical examination for 2 ½ months violates the obligation to make required records available for inspection by the SEC staff.
• The person who delayed the transfer agent's response and submitted an incomplete response to the staff document request was an aider and abetter of the violations and a cause.
• There is no scienter requirement to establish a violation of the periodic reporting requirements of Exchange Act Section 13.
• Corporate officer who "engaged in acts and omissions that he knew or should have known would result in [the company's] reporting violations was a cause of those violations.
• The fact that the ALJ denied respondents request for a postponement of the hearing did not establish that the ALJ was biased against respondents and should have withdrawn from the proceeding.
• Revocation of transfer agent registration was appropriate as the failure to transfer items occurred for a three month period that the Commission characterized as egregious, recurrent, and prolonged.
• The fact that the company no longer acts as a transfer agent is irrelevant in considering sanctions as there is an opportunity for future violations because it could in the future resume that role.
• Despite revocation of the transfer agent's registration and a bar from association with a transfer agent for an individual, a cease and desist order was in the public interest in order to "serve the remedial purpose of encouraging [them] to take their responsibilities more seriously in their future dealings with the clearance and transfer systems and the Commission."
• A $25,000 penalty was imposed for each month respondent aided and abetted transfer agent violations and another $25,000 for failure to comply with staff inspection requests.
• Because the company only had revenues of $1,544 and was in financial difficulty, and had a going concern qualification of its financial statements, the penalty of $100,000 against the company imposed by the ALJ was overturned as not in the public interest.
• Because the proceedings against one respondent were instituted only under Sections 12(j) and 21C of the Exchange Act, no penalty was appropriate and the penalty imposed by the ALJ against that respondent was also overturned.

Summary

Phlo Corp. manufactured beverages and acted as its own transfer agent (and was so registered with the Commission) for its publicly traded securities. James Hovis was executive vice presidenet of the company and Anne Hovis was the company's general counsel. The initial decision found that Phlo willfully violated transfer agent turnaround requirements and failed to make documents available for inspection by SEC staff. It also found that A. Hovis aided and abetted and caused the transfer violations and failure to provide records for examination. The ALJ also found that Phlo failed to timely file periodic reports with the SEC from March 2003 through November 2005 and that J. Hovis aided and abetted and caused those violations. The ALJ ordered civil penalties of $100,000 against Phlo, $25,000 against J. Hovis and $50,000 against A. Hovis, revoked Phlo's transfer agent registration, barred A. Hovis from associating with any transfer agent and imposed cease and desist orders on all respondents.

The initial decision was upheld in all respects, except that the penalty for A. Hovis was increased to $100,000 and no penalties were imposed against the company and J. Hovis.

Exchange Act rules require that registered transfer agents turn around 90 percent of routine items within three business days. Reports sent to Phlo by its Depository Trust Corp. showed that for three months in 2003 Phlo failed to meet the three day turnaround rule for fifty-four items. Phlo did not offer evidence that it had met the three day requirement and there was no evidence the items were non-routine. A. Hovis also was notified by DTC staff of the failure to turn around items. A. Hovis also explicitely refused to transfer items to Cede & Co.(DTC's nominee). She claimed that DTC had no legal right to insist that securities be registered in the name of Cede. The SEC staff told A. Hovis Phlo was required to transfer to Cede if instructed to do so by DTC despite her claim that this was facilitating naked short selling in Phlo stock. During a heated conversation with SEC staff A. Hovis refused to provide a legal basis for her position. When the hearing in this matter began in September 2005, a number of the transfers had still not been completed. Indeed, at the time of the oral argument on appeal, some of the transfers were still pending.

SEC staff pursuant to the Commission's inspection authority requrested various documents from Phlo in late October 2003. The documents were never provided and at one point the staff visited the registered location of the transfer agent, which was locked. Despite a request from the SEC staff, A. Hovis never contacted the staff to arrange a date for an inspection of that registered location. Finally, in mid-January 2004, A. Hovis provided some, but not all of the requested documents. The remaining documents have never been produced.

Because the Division of Enforcement met its initial burden of showing turn around violations by proof that all fifty-four items received by Phlo in June through August 2003 were still outstanding in early September 2003, the burden then shifted to Phlo to refute that evidence. Further, Phlo failed to respond to a request for documents that sought the required logs which document a transfer agent's compliance with the turn around rule.

A. Hovis aided and abetted the transfer agent violations and Phlo's failure to provide requested documents to the SEC staff. A. Hovis was a cause of the violations as well.

Between March 2003 and November 2005 Phlo failed to timely file three annual reports and eight quarterly reports with the SEC (the delinquencies ranged from three days to twenty months). Six of the eleven filings were more than a year late. During this time the company had four auditors.

J. Hovis admitted he was responsible for overall management of the company. He signed the company's annual and quarterly reports. He was found to be a cause of Phlo's reporting violations.

It was appropriate under the Steadman factors to revoke Philo's transfer agent registration and bar A. Hovis from associating with a transfer agent. It is appropriate to impose cease and desist orders against Phlo and A. Hovis for transfer agent violations despite the revocation and bar to "serve the remedial purpose of encouraging [them] to take their responsibilities more seriously in their future dealings with the clearance and transfer systems and the Commission."