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SEC v. PRICE WATERHOUSE

July 29, 1992

SECURITIES AND EXCHANGE COMMISSION, Plaintiff, against PRICE WATERHOUSE, DANIEL W. JERBASI, BENJAMIN W. PERKS, and MICHAEL D. LeROY, Defendants.

Sprizzo


The opinion of the court was delivered by: JOHN E. SPRIZZO

SPRIZZO, D.J.:

 The Securities and Exchange Commission ("SEC" or "Commission") brings this action against defendants Price Waterhouse ("Price Waterhouse" or "PW"), Daniel W. Jerbasi ("Jerbasi"), Benjamin W. Perks ("Perks"), and Michael D. LeRoy ("LeRoy"), (collectively, the "PW defendants"), alleging (1) primary violations of Section 17(a)(1)-(3) of the Securities Act of 1933 ("the Securities Act"), 15 U.S.C. § 77q(a)(1)-(3) (1988), Section 10(b) of the Securities Exchange Act of 1934 ("the Exchange Act"), 15 U.S.C. § 78j(b) (1988) and Rule 10b-5 promulgated thereunder, 17 C.F.R. 240.10b-5 (1991), and (2) aiding and abetting violations of the aforesaid statutes and regulations and Section 13(a) of the Exchange Act, 15 U.S.C. § 78m(a) (1988), and Rules 12b-20 and 13a-1, 17 C.F.R. 240.12b-20 & 240.13a-1 (1991). The Commission seeks broad injunctive relief, to wit: a permanent injunction restraining and enjoining the defendants, and their agents, partners, servants, employees, attorneys and persons acting in concert with them, from violating the anti-fraud provisions of the securities laws.

 The Court having held a bench trial, seen and heard the witnesses, reviewed in detail the voluminous deposition transcripts and exhibits proffered by the parties, finds in favor of the defendants. Accordingly, for the reasons stated herein, judgment shall be entered for the defendants. The following shall constitute the Court's findings of fact and conclusions of law as required by Fed. R. Civ. P. 52. *fn1"

 BACKGROUND

 A. AM International, Inc.

 The fraud allegations in the complaint relate to an audit conducted by PW of AM International, Inc. ("AMI") in connection with its financial statements for the fiscal year ended July 31, 1980 ("FY 1980"). *fn2" AMI was a major producer of business equipment, such as systems and supplies for the reproduction and processing of information. See JPTO PP 4, 7. Its principal products included duplicators, imprinters, embossers, photocomposition systems, word processing, and engineering graphics equipment. See id. at 4, PP 7(b), 17(b) & 18. As of July 31, 1980, AMI had thirty wholly-owned divisions or subsidiaries, *fn3" conducted operations in nineteen countries including the United States, had facilities in twenty-two countries, and operated approximately thirty manufacturing, distribution and/or administrative facilities in the United States. See id. at 17, P 17(4)-(5).

 When Roy L. Ash became CEO of AMI in 1976, he decided to update the Company's products and acquire companies with the latest in electronic office equipment. *fn4" See Ex. 6; Tr. at 69-70; Gray Dep. at 59-60. Accordingly, he caused the company to purchase companies such as ECRM, Infortext, and Jacquard which manufactured state-of-the-art business equipment. See Ex. 6. Ash's business strategy to modernize the company was dependent upon the use of the company's more established divisions, such as the Multigraphics Division, to provide the cash needed to fund the early operations of the newly acquired high-tech companies. See Tr. at 69; Exs. 6, 7; Gray Dep. at 59-60; Kaufman Dep. at 46-48.

 However, the results were poor. The earnings and income of the more established divisions declined while the costs associated with the new companies increased. See Ex. 7; Gray Dep. at 59-60. As a consequence, the company began to suffer from a shortage of cash, increased its debt, and planned a public offering for securities which was supposed to take place in September of 1980. *fn5" See Ex. 62; Coo Dep. at 14-17; Pope Dep. at 99-103. That offering was postponed, however, based at least in part upon the reactions of the company's investment advisors to the company's 1980 financial statements. See Tr. at 975-80; Ross Dep. at 20-25; Gelles Dep. at 36-37.

 AMI's consolidated financial statements for the fiscal year ended July 31, 1980, as to which PW audited and issued an unqualified opinion, reported revenues of $ 909,647,000 and pre-tax losses, before special items, of $ 1,540,000. See Ex. 455a (1980 Annual Report and Financial Statements) at 1, 36. The company also reported net income of $ 5,800,000, which was largely the result of tax credits and other non-recurring items, and total assets of $ 686,132,000. See id. However, notwithstanding these financial statements, which constituted a substantial decline from FY 1979, *fn6" AMI's management stated in the annual report that although profit from normal operations was below expectations, there was a distinct quarter-to-quarter improvement in operation performance during the year. This improvement, as well as their optimism for the newly acquired businesses, led management to be "confident that the most turbulent times are now behind us." That opinion proved to be ill founded, as the financial statements for FY 1981 demonstrate. *fn7"

 Since, as noted above, the company's fortunes declined, on February 20, 1981, Ash was forced to resign as CEO and was replaced by Richard Black. Black replaced many of the high level executives who had played important roles during FY 1980, including James H. Combes, the Chief Financial Officer. Shortly after Black's appointment as CEO, Jerbasi wrote a memorandum for Black identifying potential adjustments to AMI's financial statements. That memorandum, dated March 19, 1981, quantified approximately $ 25.7 million dollars in adjustments, see Ex. 125, which Jerbasi maintained that PW learned of after it concluded the audit for FY 1980. Moreover, because of AMI's financial difficulties in 1981, it was unable to issue its financial statements in September or October of 1981.

 As a consequence, the Board commissioned Arthur Andersen & Co. ("AA") to perform a review of the 1980 audit to determine if there were any adjustments which should have been entered in AMI's books and records for 1980. See Black Dep. at 56-57, 63. AA issued a draft document which stated that a large number of adjusting entries should have been recorded to the 1980 financial statements. *fn8" Finally, after several meetings with Black, Joseph Freeman (the new comptroller), representatives of AA, PW and AMI's attorneys, at which the draft document's conclusions were debated, AMI dismissed PW as its auditors and retained AA in December 1981. Ultimately, on April 13, 1982, AMI filed a voluntary petition for relief under Chapter XI of the Bankruptcy Code in the Northern District of Illinois.

 B. Price Waterhouse

 Price Waterhouse began serving as independent auditors for AMI prior to 1978, see JPTO at 3, P 2, and audited the company's books for the fiscal years ending July 31, 1978 through July 31, 1980. See JPTO at 3, PP 2-3; Tr. at 284-87. PW was retained to audit the fiscal year ending in July 31, 1981, but as noted above, was discharged in December 1981. See JPTO at 3, P 4. Price Waterhouse's Los Angeles office ("PW-LA") was responsible for the overall conduct of the FY 1980 audit. It coordinated the work done by other PW offices in the United States and PW firms in other countries.

 Defendant Jerbasi, a partner at PW-LA since July 1, 1970, served as the engagement partner on the examinations of the consolidated financial statements of AMI for FY 1979, FY 1980, and FY 1981 and the second partner on the FY 1978 examination. See JPTO at 6, P 12. Defendant LeRoy was a senior manager at PW-LA and served in that capacity on the examinations of AMI's consolidated financial statements for FY 1979, FY 1980, and FY 1981. *fn10" See JPTO at 7, P 14.

 Perks, also an individual defendant in this action, has been a partner of PW since July 1, 1978. He was the partner in PW's Chicago office ("PW-Chicago") responsible for the audit procedures performed at AMI's unincorporated divisions located in the Chicago area for the FY 1978, FY 1979 and FY 1980 examinations. See JPTO at 7, P 13. These divisions included Multigraphics, AM Addressograph, AM Bruning, AM Services, and AM Infortext. Moreover, he was the engagement partner for the examination of the financial statements of AMLC, which was an unconsolidated subsidiary of AMI on which PW issued a separate report. *fn11" See id.

 C. The Planning and Scope of the 1980 Audit of AMI

 Jerbasi, LeRoy and Steven W. Bills, a PW-LA manager on the engagement, began preparing for the audit of FY 1980 in early 1980. See Tr. at 286-87. Based upon discussions amongst themselves and with AMI officials, and their experiences as auditors, including prior audit experience with II, the three prepared a series of detailed planning memoranda for the audit. See Tr. at 286-89; Ex. 119; Exs. AX, B, C, D. These memoranda included specific instructions to each of the offices of the United States PW firm and the various foreign PW firms that were to perform some of the necessary auditing procedures and identified specific areas which Jerbasi and LeRoy felt warranted additional attention. Most prominent among theme were accounts receivable, inventories and sales. See Ex. 119 at 28-29. The instructions also requested that all of the PW offices and/or firms involved provide PW-LA with an inter-office report or in some cases a full scale memorandum on examination summarizing their findings and raising issues which required resolution at the corporate level. See JPTO at 16, P 3.

 This expansion of time spent on the audit caused it to be unprofitable for PW. The amount of fees for the audit was fixed by an agreement negotiated in 1977 by Walton W. Kingsbery, a PW partner then at the Cleveland, Ohio office. *fn12" That agreement provided that PW would receive $ 480,000 *fn13" for the 1980 examination, which included a $ 100,000 discount, based upon an estimate of 18,100 hours for the audit, with some provision for additional fees for uncontemplated work. See Tr. at 298-99; Ex. 305. However, because of AMI's growth and poor internal controls, PW was forced to expend large amounts of additional time on the FY 1980 audit for which it would not be compensated. *fn14" See Tr. at 303; Exs. 78, 135. At trial, Jerbasi testified that at all times he instructed other PW personnel to expend whatever hours were necessary to carry out a thorough examination without regard to fees. See Tr. at 297, 303; see also Tr. at 499; LeRoy Dep. at 1460. The Court accepts this testimony as credible.

 THE COMMISSION'S CONTENTIONS

 The SEC commenced this action on June 20, 1985 by filing a complaint for permanent injunctive relief against PW, Jerbasi, LeRoy, and Perks as well as seven former officers or divisional employees of AMI ("the AMI defendants"). *fn15"

 The Commission's complaint, as amended, *fn16" asserts that in issuing an unqualified opinion on AMI's FY 1980 financial statements, the PW defendants made the following misrepresentations of material fact: (1) that the company's financial statements for the fiscal year ended July 31, 1980 were prepared in accordance with generally accepted accounting principles ("GAAP") consistently applied and (2) that their examination of those financial statements was conducted in accordance with generally accepted accounting standards ("GAAS"). *fn17" See Amended Complaint against PW Defendants P 22. The PW defendants are also alleged to have violated the securities laws and aided and abetted AMI personnel in violating the securities laws through their assistance in preparing financial statements which the SEC contends misrepresented AMI's financial position as of July 31, 1980 and inflated income in order to portray the company as experiencing a financial "turnaround."

 These claims center upon the following alleged accounting and audit defects which will be addressed in detail below: (A) Multigraphics' treatment of so-called "MIP" leases as sales upon shipment of the equipment to a customer and AMI's recognition of revenue from those transactions at that time on its consolidated financial statements; (B) AMLC's treatment of the MIP transactions as direct-financing leases; (C) an alleged understatement of the allowance for doubtful accounts for AMLC; (D) an alleged failure to expand the scope of the audit sufficiently to examine irregularities in AMI's accounting for the change in year end for foreign subsidiaries; (E) an allegedly improper examination of unreconciled differences in the intercompany accounts between AMLC and certain product divisions; (F) failure to require disclosure of certain accounting changes allegedly having a material effect upon AMI's financial statement; and (G) allegedly improper concessions to AMI management on issues of audit adjustments which resulted in the company booking a lesser amount of adjustments than originally proposed by PW. *fn18"

 A. Multigraphics' Treatment of the Multigraphics Introductory Program

 During FY 1979, Multigraphics instituted a program known as the Multigraphics Introductory Program ("MIP") in order to sell some of its larger pieces of duplicating equipment, which consisted of an offset duplicator, a master imager, and in some cases a collator. See JPTO at 18, P 1; Exs. SE ("Multigraphics Duplicator Model TCS/4"), SF ("Multigraphics Duplicator Model TCS/5"). Pursuant to this program Multigraphics would ship the aforesaid equipment to a customer, and would record a sale to AMLC on its books. The customer would then enter into a lease agreement with AMLC and would make nominal rental payments for the first ninety days. During that time, AMLC would hold the transaction in a "leases in progress" account. See Affidavit of Clarence W. Houghton ("Houghton Aff.") P 8; Ex. 284.

 After ninety days passed, the customer had the option to pay cash for the equipment, return the equipment, or continue the lease agreement with AMLC for twenty-four months, with an option to renew the lease for an additional twelve months. The accounting for these options was as follows: (1) if the customer chose to pay cash for the equipment, AMLC would cancel the lease and transfer the cash to Multigraphics through an inter-company account; (2) if the customer chose to return the equipment, AMLC would return the equipment to Multigraphics and would record a payable from Multigraphics on its books; and (3) if the customer chose to continue the lease, Multigraphics would continue to treat it as a sale to AMLC, while AMLC would record the transaction as a direct financing lease under Financial Accounting Statement 13 ("FAS 13"). *fn19" See Declaration of Peter S. Dye ("Dye Decl.") PP 59-60; Affidavit of Samuel Gunther ("Gunther Aff.") PP 9-10; Houghton Aff. PP 8-9; Ex. 122 at PWC 0384-85; Ex. 188 at PW 2495-96, Ex. GB, Ex. GO; Tr. at 936-938. Since Multigraphics recognized sales revenue at the time the MIP equipment was initially shipped to a customer it also booked a reserve for estimated returns.

 Richard R. Kilgust, now a PW partner, was a manager in PW's Chicago office assigned to the 1979 examination of AMI's Reprographics group, which included the Multigraphics, Addressograph and Infortext divisions. *fn20" The Court accepts as true his testimony that he was first confronted with the issue of whether AMI could properly recognize revenue on the MIP transactions in the fashion described above in connection with his work on the 1979 examination. See Tr. at 786-801; Kilgust Dep. at 345-66, 441. At that time he reviewed a MIP agreement, learned about the type of equipment involved in the program, and spoke to AMI officials about the MIP plan. See Tr. at 788-95; Kilgust Dep. at 366-67. He also spoke to Edward J. Keller, the PW-Chicago manager involved in the examination of AMLC to ascertain how AMLC recorded the transactions. *fn21" See Tr. at 789-95; Kilgust Dep. at 442-49.

 Kilgust testified that AMLC's treatment of the MIP leases was germane to his inquiry because if AMLC treated the MIP leases as "direct financing leases," where the customer chose the lease option, it would be consistent with Multigraphics' treatment of the transaction as a sale, because the economic substance of a direct financing lease is that there is a transfer of the risk of ownership from AMLC to its lessee which in turn requires that Multigraphics have transferred that risk to AMLC. See Tr. at 792-93; Kilgust Dep. at 441-42. Keller advised him that once the customer elected the lease payment option AMLC did treat the MIP leases as direct financing leases. Accordingly, based upon this investigation and his assessment of the economic substance of the MIP leases, Kilgust concluded that the MIP leases were, in fact, sales and that revenue recognition upon shipment was appropriate provided that Multigraphics made an adequate allowance for potential returns in the event that the customer chose to return the equipment to Multigraphics. See Tr. at 789; 796-801; Kilgust Dep. at 441-42; see also Tr. at 801-02. He testified that he discussed this conclusion with Perks, see Kilgust Dep. at 462-63, and, although it was never specifically raised with Jerbasi or LeRoy, see Tr. at 194-96, 510; Jerbasi Dep. at 923-25, this conclusion is included in the 1979 memorandum on examination for the Reprographics group. *fn22" See Tr. at 794; Ex. GE at PWC 10249; see also Ex. GB. Moreover, the PW-Chicago auditors had no doubt that AMI's accounting treatment of those transactions was correct and therefore did not specifically seek Jerbasi or LeRoy's input as to the correctness of that conclusion. See Tr. at 194-96, 336, 510; see also Ex. GB.

 Since Kilgust had determined that revenue recognition was appropriate only if Multigraphics created an adequate reserve to provide for possible returns, he then focused his attention upon determining what an appropriate reserve should be. See Tr. at 802. Kilgust therefore considered the guidance provided by Statement of Position 75-1 ("SOP 75-1") issued by the Accounting Standards Division of AICPA, *fn23" as well as his own knowledge of accounting practices and experience as an auditor. See Tr. at 802-63; Kilgust Dep. at 468. In implementing those guidelines he and his staff accountants considered the past experience of MIP returns, using records from Multigraphics' sales administration division. See Tr. at 803; Kilgust Dep. at 536. Based upon this work, they proposed a $ 220,000 reserve for MIP returns, which was included in the 1979 memorandum on examination. See Ex. GE at PWC 10250.

 Having resolved the issue of whether revenue recognition was appropriate in connection with the 1979 audit, Kilgust did not see the need to re-examine that issue in 1980. See Tr. at 803. However, since the number of MIP transactions had increased dramatically during the 1980 fiscal year, Kilgust and the staff accountants under his direction expended substantial efforts to determine an appropriate reserve for returns for that year. See Tr. at 803-04. They therefore first ascertained the relationship between the number of sales cancelled and returned during the ninety day trial period and those that were not. See Fritzche Dep. at 289-92. Based upon their analysis of the returns of MIP equipment since the inception of the program, they determined that the average amount of cancellations was twenty-three percent (23%). See Fritzche Dep. at 289-92; Kilgust Dep. at 708; Ex. 188 at PWM 2498. They then applied that figure to the gross profit margin for machines (1) shipped and billed but not installed or cancelled; (2) still in the test period; or (3) past the test period, where the customer's option had not yet been received. See Ex. 188 at PWM 2498. Accordingly, they recommended an allowance for MIP returns of $ 2,097,000. *fn24" See Ex. 122 at PWC 374, 384; Ex. 188 at PWM 2495. This reserve figure also included $ 610,000 representing the gross profit on $ 1,000,000 in MIP sales that had already been cancelled by the customer and billed back by AMLC, but not yet credited by Multigraphics. See Tr. at 808-09; Ex. 122 at PWC 384.

 The Court finds that PW's accounting treatment of the MIP transaction was consistent with GAAP and that the reserves proposed by PW for future returns constituted a reasonable estimate of those future returns in conformity with GAAS. It follows that the Court must reject the Commission's contention that the aforesaid accounting and audit procedures were so defective as to permit a rational inference of fraud. See infra pp. 57-67. In support of that conclusion, the Court specifically finds the testimony of PW's expert witnesses, Gunther and Houghton, that the MIP transactions were in substance sales even though they had the appearance of operating leases, credible, persuasive, and well supported by the reasons advanced for their conclusions. See Tr. at 754-60, 922-26; Houghton Tr. at 15, 21-25, 67-68; Houghton Aff. PP 21-23; see also Tr. at 801.

 Indeed, those opinions and the judgment of the PW auditors, reflect a most basic principle of accounting, i.e. that the nature of a transaction be determined by its economic reality and not by its form. By contrast, the Commission and its experts appear to have concluded that the HIP transactions should have been treated as leases largely because they were called "leases" and the payments made were denominated "rental payments." The Court therefore rejects as neither credible nor persuasive the Commission's experts with respect to that issue. *fn25" It follows that the Court also rejects the Commission's contentions that the PW auditors were guilty of fraudulent conduct because they looked to SOP 75-1 rather than to the criteria set forth in FAS 13 in determining the appropriate accounting treatment for the MIP transactions.

 Since FAS 13 deals with leases, the Commission and its expert witnesses, in asserting that FAS 13 had to be complied with, assumed the very fact which had to be determined, i.e. that the MIP transactions were leases and not sales. Such circular reasoning commends itself neither to logic nor good sense. A more rational approach was that taken by PW and its experts, i.e. to examine the economic substance of the HIP transactions and to determine if either the amount of the lease payments, here virtually nominal during the ...


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