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With the attention to the Securities and Exchange Commission's accounting-fraud probes is new evidence that there are advantages for accountants contesting administrative charges. Following a three-year battle royal over an in-house accountant's role in his employer's financial fraud, this Spring an ALJ issued a cease and desist order(2) based on negligent conduct which caused violations of the securities laws. However, he rejected (a) knowing, reckless or conscious intent allegations, (b) willfulness assertions, (c) aiding and abetting charges, and (d) the SEC's prayer for a five-year bar.

The lesson is that an accountant's bad judgment made in good faith is sufficient to establish negligence, but not scienter or willfulness. The decision includes a rare financial materiality finding without a numerical benchmark analysis.

Background

From 1993-95, Sensormatic Electronics Corporation improperly recognized revenue on shipments made outside the appropriate accounting period in order to manipulate its quarterly revenue and earnings to meet analysts' projections.

A. Glenn Yesner was its controller, director of business controls, had a reporting responsibility to the audit committee, and was told to report impermissible GAAP practices to the committee. He was not an "officer." He had only fragmented awareness that the out-of period shipments were inconsistent with GAAP and written company policy. He was told the amounts were immaterial, but did not quantify the revenue prematurely reported. Yesner had no responsibility for the preparation of financial statements, corporate filings, or press releases, and only a limited duty for the accuracy of books. He failed to report what he knew of the deviations from GAAP to the audit committee.

OIP Charges

The SEC's employed a shoot-for-the-moon enforcement approach. It charged virtually every securities law violation available against an in-house accountant and sought a crippling remedial sanction.

The 1998 OIP alleged that Yesner knew of and participated in improper accounting practices and therefore willfully violated Securities Exchange Act of 1934 Rules 13b2-1 and 13b2-2, caused and willfully aided and abetted violations of Sections 13(b)(2)(A) and 13(b)(2)(B) of the '34 Act, and caused Sensormatic's violations of Section 17(a) of the Securities Act of 1933, Section 10(b) and 13(a) of the '34 Act and Rules 10b-5, 12b-20, 13a-1 and 13a-13 thereunder. The OIP also alleged improper professional conduct within the meaning of Rule 102(e) of the SEC's Rules of Practice.

ALJ Decision

ALJ Robert G. Mahoney dismissed the severe charges, but found violations stemming from negligent failure to report the out-of-period shipments to the audit committee. He issued a C&D order. By ignoring the SEC's plea for a bar, the decision sustains the consensus that challenging the SEC pays off.(3)

Materiality Findings

The proceeding focused on the inclusion of out-of-period shipments in reported revenues when Sensormatic's financial statements were issued. Provocative are the materiality conclusions which were a prerequisite to any finding against Yesner.(4)

The 1993-95 revenue practices were the subject of (a) an inquiry by Ernst & Young, Sensormatic's auditors, (b) an audit committee investigation, (c) an independent expert report, and (d) a three year SEC investigation. Then, Sensormatic voluntarily restated only its unaudited report for the third quarter of 1995. E&Y concurred in that determination. The SEC did not require Sensormatic to restate any quarter or annual period. Yet, in the OIP the SEC alleged seven quarterly reports in 1994-95, and the 1994 annual report, were materially misstated.(5)

Brushing aside Yesner's argument that the quarterly misstatements did not exceed established percentage materiality tests or violate GAAP, Judge Mahoney found the financial statements included material misstatements. He made no numerical analysis. Indeed, he afforded "no weight" to either experts' testimony "insofar as they rely solely on numerical benchmarks to determine the materiality of the alleged misstatements." He concluded that E&Y's acquiescence that Sensormatic restate only one quarter was "not determinative of the issue of materiality." He said E&Y's "conclusion regarding whether . . . to restate previously issued financial statements does not address the impact of the alleged misstatements when made." He added that "(m)isstatements of quarterly earnings do not become immaterial just because profits for the year are unaffected by the misrepresentation."

Relying on Basic(6) and Ganino(7), and without citing SAB 99(8) , the ALJ's materiality finding was premised on conclusions that the company's reports falsely represented to analysts and investors a continuous growth rate for over 30 quarters, fulfilled investor expectations, and promoted shareholder confidence. Equally relevant was a finding that the revenue practices violated GAAP and deviated from the company's stated revenue recognition policy.

With all that said, it was not surprising there was a determination that Sensormatic acted with scienter by intentionally violating GAAP, making no effort to quantify the GAAP deviations, ignoring the company's revenue policy, meeting analysts' growth projections by premature recognition of revenue, and withholding documents from E&Y which would show out-of-period shipments.

Yesner Did Not Cause Antifraud Violations

After the determinations against Sensormatic, the charges against Yesner were ripe for consideration.

The OIP alleged that Yesner "caused" the company's violations of the antifraud provisions because he knew or should have known that revenue was improperly recognized for inclusion in filed reports. At the heart of the claim that Yesner caused those violations was an SEC created "materiality analysis" of what misrepresented revenue he might have known. The ALJ recognized the analysis as a compilation of "cherry picked" numbers, based on unsupported assumptions, that "might" relate to revenue recognition practices known by Yesner--without any evidence of what he "might" have known. The analysis had no relationship to GAAP. Judge Mahoney found it was speculative and "entitled to no weight."

He held Yesner did not act with scienter and that his conduct was not extremely unreasonable because he did not make revenue decisions or prepare financial statements. Yesner relied on the assertions of individuals with more familiarity with the practice, who represented that it was immaterial. He thought they were the "experts." As to the charge that Yesner acted with scienter because he knew documents were withheld from E&Y, the Judge found reasonable Yesner's inference that E&Y received the requested documents because it signed off on the audit.

Yesner's Failure to Act Caused Filing Violations

Employing a negligence standard, it was held that Yesner's failure to report the accounting practices to the audit committee resulted in the conduct proscribed by Sections 17(a)(2) and 17(a)(3) of the '33 Act, and that he "caused" Sensormatic's primary violations of those Sections. Yesner's silence was found unreasonable and negligent.

Likewise, it was found that Yesner caused the reporting/filing violations of Section 13(a) of the '34 Act and Rule 12b-20, 13a-1, and 13a-13 thereunder. Although not responsible for the financial statements or filings, he was found negligent in not acting when "he knew of the revenue recognition practices and was responsible for assessing the processes and practices of the company and reporting to the audit committee."

Split Decision on Books and Records Violations

The SEC alleged that Yesner "caused" and "aided and abetted" books and records and internal controls violations of Sections 13(b)(2)(A) and 13(b)(2)(B) of the '34 Act -- the accounting provisions of the Foreign Corrupt Practices Act of 1977--"by knowing about and not reporting the practice or misdating documents that resulted in the falsifications of books and records."

Judge Mahoney found Sensormatic violated Section 13(b)(2)(A) because its books were not maintained in reasonable detail or to satisfy prudent officials in their own affairs. However, he held the company did not violate the internal control provisions of Section 13(b)(2)(B) because its controls were adequate, but merely "intentionally overridden and circumvented." With no primary violation of Section 13(b)(2)(B), the related causing and aiding and abetting charges against Yesner were dismissed.

As to "aiding or abetting" the Section 13(b)(2)(A) books and records violations, while the SEC portrayed Yesner at the center of the Sensormatic universe, the ALJ found the evidence did not support a conclusion that he knowingly, recklessly or consciously intended to substantially assist the primary violations through silence, or that by inaction, he possessed the requisite degree of scienter. The Judge held there was no evidence that Yesner threw "in his lot with the primary violators."

To bolster its argument that Yesner "caused" those Section 13(b)(2)(A) violations, the SEC successfully stressed that Yesner was a CPA with duties as controller and director of business controls. It argued Yesner remained silent when he had a duty to speak. Judge Mahoney concurred, and held Yesner's failure to report the practice to the audit committee unreasonable and that he "caused " the Sections 13(b)(2)(A) violations.

No Liability for Undermining Financial Reporting

The OIP alleged Yesner "willfully" violated '34 Act Rule 13b2-1 because he was responsible for the accuracy of book and records, and allowed the misdating of documents and knew of premature revenue recognition. The OIP also alleged Yesner "willfully" violated Rule 13b2-2 because he participated in the withholding of documents and information from E&Y, and never disclosed the out-of-period shipments to the auditors. Each allegation was rejected.

Those Rules are intended to promote compliance with the '34 Act's accounting provisions by making individuals directly liable for conduct that undermines the reliability of financial information or the integrity of an audit.

The Judge found that, as controller and director of business controls, Yesner was not responsible for Sensormatic's compliance with the books and records provisions of the '34 Act. As controller, he did not supervise the revenue recognition department. As director of business controls, he only evaluated practices, policies and procedures and reported his finding to the audit committee.

Rule 13b2-2 prohibits "directors and officers" from making or causing false statements or omitting any material fact to any accountant in connection with an audit or filing. Rule 3b-2 includes within the definition of "officer" a "comptroller" or any "person routinely performing corresponding functions." Few financial personnel so charged escape this dragnet provision--Yesner did.

Judge Mahoney said that as "controller," Yesner was never considered an "officer," and that his duties were not so significant he should be considered an "officer." His duties and responsibilities were limited; he did not prepare or verify financial statements, never signed corporate filings, never made a representation to the SEC, never made or acquiesced in ultimate accounting decisions, and was not a primary contact for E&Y. As "director of business controls," Judge Mahoney held Yesner did not perform corresponding functions to a principal financial/accounting officer. He did not supervise the accounting department or have any decision-making authority as to accounting treatment decisions. Therefore, Yesner did not willfully violate Rule 13b2-2.

No Improper Professional Conduct

The OIP alleged Rule 102(e)(1) violations because of improper professional conduct in connection with Yesner's role in premature revenue recognition, materially false filings, failure to report the company's conduct, and willfully aiding and abetting violations of the securities laws. Judge Mahoney used a "intentional or knowing conduct, including reckless conduct," standard to determine if there were violations of the professional standards. Given that no willful misconduct was found, only negligence, and that Yesner had no role in the preparation of financial statements, the Rule 102(e) allegations were rejected.

No Lip Service to Bar Plea

As a remedial sanction, the SEC sought to destroy Yesner's CPA career. It asked that he be denied the privilege of appearing or practicing as an accountant before the SEC for five years - the equivalent of a professional death sentence. Reference to the SEC's bar-request does not appear in the decision. Judge Mahoney did not even accord it lip service.

As difficult as defending SEC charges may be when a professional's career is threatened by draconian charges and sanctions, settlement is not a viable alternative. The stigma of a consented settlement often dooms a CPA's career. Consequently, the risk of litigation is minimal. Integrity and professional standing require an aggressive defense.

Given the SEC's increasing number of financial fraud probes, if the enforcement staff continues making shoot-for-the-moon charges against professionals, its litigation calendar will expand exponentially.

(1) The author, a D.C. and N.Y. securities attorney, represented Yesner in the administrative proceeding.

(2) In the Matter of Albert Glenn Yesner, CPA, Initial Decision Rel. No. 184, May 22, 2001, See, www.sec.gov/litigation.

(3) ;See Eugene I. Goldman and Douglas G. Edelschick, SEC ALJ's Resist Requested Sanctions, Insights, Sept. 2000, at 15; Joseph A. Slobodzian, Challenging the SEC Pays Off, Nat'l L.J., Aug. 7, 2000, at B-1; Karen Donovan, SEC Has No Home-Court Advantage, Nat'l L.J., Oct. 12, 1998, at B-1.

(4) In 1998, Sensormatic and five officials settled with the SEC, without admitting or denying the allegations. So, there were no contested findings of fraud against the company for the SEC to rely upon in its OIP against Yesner.

(5) If the SEC believed the OIP allegations, it ignored its duty to investors by permitting Sensormatic to continue to publish false reports. After the 1998 OIP, the SEC permitted the company to publish 1998-00 financial reports which included comparative financial information from 1993-95 reports --which the SEC attacked as materially misleading in its charges against Yesner. Thereby, the SEC espoused a double standard for judging the materiality of financial information.

(6) Basic Inc. v. Levinson, 485 U.S. 224 (1988).

(7) Ganino v. Citizens Utils. Co., 228 F. 3d 154 (2d Cir. 2000).

(8) Staff Accounting Bulletin No. 99, Materiality, Rel. No. SAB 99, 1999 SEC LEXIS 1599 (Aug. 12, 1999).

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