The opinion of the court was delivered by: GURFEIN
This is an action in which the Securities and Exchange Commission (SEC) has charged that Keller Industries, Inc. (Industries), its President Henry A. Keller (Keller), and its chief financial officer Norman C. Edelcup (Edelcup) knowingly disseminated false and misleading interim financial statements in violation of the Securities Exchange Act of 1934 and the Securities Act of 1933. The SEC now moves for a preliminary injunction against the defendants enjoining them "from further violations of the Securities Exchange Act of 1934," and for other and further relief.
The motion is supported by an affidavit of Morris Lafferman, a senior staff accountant of the SEC, and is accompanied by exhibits. The defendants have countered with extensive affidavits and exhibits, and the SEC has tendered reply affidavits. The SEC has also supplied voluminous "investigation files," consisting of interviews with various people, including the individual defendants. Issues of fact arise from the affidavits and interviews as we shall see.
The investigation covered the period from November 1969 to June 1970. The complaint was not filed until January 1971. This motion for a preliminary injunction was not filed until July 28, 1971, and was adjourned to October 19, 1971. No application for a temporary restraining order was made.
The complaint is in five counts and seeks an order enjoining the defendants from violating Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, from issuing and filing false and misleading registration statements that may be required to be filed under Section 6(a) of the Securities Act, and from issuing false and misleading annual, semiannual and other periodic reports and proxy statements required to be filed under Sections 13, 14 and 15 of the Exchange Act. The motion for the preliminary injunction relates to the Exchange Act, however, and not specifically to the Securities Act.
The complaint charges that certain quarterly and semiannual reports including interim earnings figures of Industries, whose stock was registered and listed on the New York Stock Exchange, were false and misleading and affected transactions in the stock. Though the complaint alleges violations not only of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, but also of Section 13(a) & (b) of the Exchange Act and Rule 13a-13 thereunder as well as of Section 17(a) of the Securities Act, I find that the strongest allegations relate to the 10b-5 charge which concerns the first quarter report of fiscal year 1969. For reasons that will appear, there is no need to consider the relatively weaker charges made by the SEC, at this time.
Industries is a Florida corporation with principal offices in Miami. Keller is, and for almost 21 years with one interruption has been, its President and Board Chairman. Edelcup is and has been a financial officer of Industries since August 1968.
The company manufactures and distributes a number of products made from aluminum, and fabric for the building industry and for consumers, such as lawn furniture, windows, rugs, ladders and the like. It has approximately one hundred subsidiaries, of which thirty are manufacturing subsidiaries and seventy are sales warehouses. The business of certain subsidiaries is seasonal to some degree, with one-third of sales occurring in the first half of the fiscal year and two-thirds in the second half.
The fiscal year begins in August and ends in July. Each of its hundred subsidiaries depends completely upon the Miami office for all its accounting services and sends to Miami virtually all its business records. The company has for some years published and distributed to its shareholders, to the Dow Jones Service and to the New York Stock Exchange unaudited quarterly reports of earnings which are consolidated statements purporting to reflect on a consolidated basis the earnings of all the hundred subsidiaries.
Industries, on about December 16, 1968, mailed to its shareholders, to the New York Stock Exchange and to others its first quarter report of fiscal 1969 for the three months ending October 31, 1968. This report contained a "Consolidated Comparative Statement of Income" for the quarter. The reported net income was $1,378,000 or $.82 per share, compared to $1,164,000 or $.71 per share for the same period in the prior year. The SEC contends that income was arbitrarily increased for the quarterly period by an adjustment of $2,209,369, compared to a similar adjustment of $894,410 for the same period of the prior year.
The adjustment was defended as principally a deferral of current expenses to future periods of the same fiscal year in order to reflect more accurately the true earnings of the interim period.
There is no dispute that if the actual revenues and expenses for the quarter are considered in isolation, the amount attributable to the adjustment is the figure of $2,209,369. It is also not in dispute that the adjustment was made by journal entry. And although both sides agree that it was Keller who determined the journal entry in question, the parties disagree from this point on.
The SEC argues that the adjustment, which had the effect of substantially increasing earnings for the quarterly period, was made without adequate support and was not based upon sound accounting principles. The defendants, on the other hand, argue that an adjustment was necessary, in view of the seasonal character of the sales of several subsidiaries, to avoid distortion of the true earnings for the period. They contend further that this type of adjustment -- the deferral of part of the expenses to a later period when sales will be greater -- should not be based on rigid formulae, but rather on the judgment of the principal operating officer, Keller, who had been at the helm for twenty years and was best able to exercise a value judgment.
The accountants involved have furnished conflicting affidavits. The SEC accountants point to the fact that there are no worksheets to support the disputed adjustment and that proper accounting methods require an objective approach based on books and records which can serve as the basis for a consistent accounting method. The accountants for the company, while not in disagreement, stress the argument that the accounting profession, while recognizing the validity and, indeed, the necessity for deferrals in seasonal businesses, has never formulated governing rules for the deferral technique as far as interim reports are concerned.
The emphasis, in their view, is properly on business judgment rather than on purely objective criteria.
The SEC points to several facts as indicating that Keller was reckless. First, it argues that by his method he could control quarterly earnings as he wished with no measurable yardstick. Second, that his admitted method of deferring operating losses of his subsidiaries rather than using an actual allocation of expenses to revenues creates a fictitious earnings figure. Third, that Keller, by his own concession, included not only seasonally affected subsidiaries, but others with no seasonal problems at all, in his adjustments. Fourth, that Keller admitted that he had eliminated a $305,000 loss of one subsidiary in the first quarter, possibly the result of theft, from the first quarter figure because he "hoped" that the loss would be made up later in the year. ...