Document ID: s3://data.kl3m.ai/documents/govinfo/USCOURTS/USCOURTS-caDC-04-01047/USCOURTS-caDC-04-01047-0/pdf.json

Parties Involved:
James Thomas McCurdy
Petitioner
Securities and Exchange Commission
Respondent

Document Text:

United States Court of Appeals

FOR THE DISTRICT OF COLUMBIA CIRCUIT

Argued November 23, 2004 Decided February 8, 2005

No. 04-1047

JAMES THOMAS MCCURDY,

PETITIONER

v.

SECURITIES AND EXCHANGE COMMISSION,

RESPONDENT

On Petition for Review of an Order of the

Securities and Exchange Commission

Charles M. Carberry argued the cause and filed the briefs

for petitioner.

Michael A. Conley, Senior Special Counsel, Securities and

Exchange Commission, argued the cause for respondent. With

him on the brief were Giovanni P. Prezioso, General Counsel,

and Eric Summergrad, Deputy Solicitor. Mark R. Pennington,

Assistant General Counsel, entered an appearance.

Before: EDWARDS, SENTELLE, and RANDOLPH, Circuit

Judges.

Opinion for the Court filed by Circuit Judge RANDOLPH.

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RANDOLPH, Circuit Judge: The Securities and Exchange

Commission suspended James T. McCurdy for one year after

finding that he recklessly departed from generally accepted

auditing standards (“GAAS”) in his audit of a mutual fund’s

1998 financial statements. The case centered on the treatment

of a single receivable on the balance sheet of JWB Aggressive

Growth Fund, a diversified, open-end management investment

company. McCurdy’s arguments are that the Commission

improperly applied GAAS, that its finding of recklessness was

not supported by substantial evidence, and that it exceeded its

authority in imposing a one year suspension.

I.

John W. Bagwell founded JWB Aggressive Growth Fund

and registered it with the Commission in 1995. Bagwell served

as the fund’s chief executive officer and was a member of its

board of trustees. JWB Investment Advisory & Research, Inc.,

Bagwell’s sole proprietorship, was the investment advisor of the

fund, its only client. (We will refer to JWB Investment, in its

capacity as the fund’s advisor, as Bagwell.) At its height, the

fund had 60 investors and assets of $456,000. The fund is now

defunct.

When the fund began operations in 1996, Bagwell

voluntarily agreed to waive any management fees and to

reimburse the fund for its expenses exceeding 2.35% of the

fund’s assets. In the years that followed, the fund paid the

expenses when incurred and Bagwell reimbursed it at the end of

the year for the amount reported in the fund’s “Due From

Advisor” account. The arrangement was terminable at will, with

advance notice to the board of trustees. Until the year ending

December 31, 1998, Bagwell covered all such expenses. At the

end of 1997, the unpaid balance in the “Due From Advisor”

account was $3,783. During 1998, the fund’s expenses grew to

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approximately $100,000. By year end, the “Due From Advisor”

account had an outstanding balance of about $80,000, after an

approximately $20,000 offset for organizational expenses due to

Bagwell.

On November 20, 1998, Bagwell sent a letter to the board,

outlining a proposed repayment plan, with monthly payments of

at least $5,000 a month, beginning that month and continuing

until the receivable was repaid. At a meeting of the fivemember board on December 3, 1998, Bagwell gave notice of his

intention to withdraw from the reimbursement agreement. By

this time, Bagwell had already missed his proposed first

payment. He informed the board that it would be “extremely

difficult” for him to pay off the receivable by year’s end. The

four other board members reviewed Bagwell’s income statement

and balance sheet, which he had provided at the meeting.

Satisfied of his ability to pay, they agreed to allow him until

June 1999 to repay the $80,000 balance on the payment terms he

had proposed.

At the same meeting, the board followed Bagwell’s

recommendation and retained a new auditor, McCurdy &

Associates CPAs, Inc., an accounting firm specializing in

mutual funds. The firm’s founder, James Thomas McCurdy,

had been a certified public accountant licensed to practice in

Ohio since 1980. In light of the fund’s ongoing cost-cutting

efforts, McCurdy pledged in his engagement letter to keep fees

and expenses to a minimum in his audit of the year ending

December 31, 1998. 

McCurdy completed his field work on the audit in January

1999, and submitted a report dated January 25. By that time,

Bagwell had missed his first two payments under the boardapproved schedule and was at least $10,000 in arrears.

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McCurdy’s report accompanied the fund’s filings with the

Commission on March 8, 1999. 

The fund’s audited financial statements showed $340,484

in assets, of which $83,399 represented the “Due From Advisor”

receivable. In light of the fact that twenty-five percent of the

fund’s assets depended on the collectibility of this related-party

account, McCurdy recognized that the receivable was material

and would require special scrutiny. In analyzing the probability

of collecting the receivable, he relied on the board’s decision to

allow Bagwell time to repay his obligation. He read the minutes

of the meeting. He also spoke to the fund’s attorney, who was

present at the meeting. But he did not speak with any board

member or with Bagwell (except to confirm that the receivable

existed), and he neither examined nor tested the financial data

Bagwell presented to the board. McCurdy also relied on the

February 1999 renewal of the fund’s bond by Gulf Insurance

Company, although he took no steps to ascertain the basis for

the company’s decision. And he considered Bagwell’s history

of making timely payments in previous years, as well as the fact

that the receivable could no longer continue to grow because the

reimbursement arrangement had terminated. On the basis of this

information, McCurdy concluded that the receivable was

probably collectible and that it properly could be treated as an

asset under generally accepted accounting principles.

The Commission charged McCurdy with improper

professional conduct in violation of Rule 102(e) of the

Commission’s Rules of Practice, citing his failure to obtain

sufficient competent evidence to support his conclusion

regarding the receivable, his failure to render an accurate report,

and his lack of professional skepticism and due professional

care. After an evidentiary hearing, an administrative law judge

concluded that while McCurdy’s audit of the receivable did not

comport with GAAS, his conduct did not constitute reckless or

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highly unreasonable behavior. The Commission disagreed,

finding McCurdy’s audit both reckless and highly unreasonable.

It therefore suspended McCurdy from practicing before the

Commission for one year.

II.

Information is the lifeblood of the market. For the market

to operate efficiently -- indeed, for it to operate at all --

information must have some measure of reliability. Investor

confidence is bolstered by the knowledge that public financial

statements have been subjected to the rigors of independent and

objective investigation and analysis. See, e.g., AMERICAN

INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS (“AICPA”),

CODE OF PROFESSIONAL CONDUCT § 53, available at

http://www.aicpa.org; VINCENT M. O’REILLY ET AL.,

MONTGOMERY’S AUDITING 13-14 (11th ed. 1990). Independent

auditors therefore must exercise reasonable diligence in

reviewing financial statements. See AICPA, CODIFICATION OF

STATEMENTS ON AUDITING STANDARDS (“AU”) § 230.01

(1998). Because it is not possible to give each transaction the

fullest scrutiny, professional auditing standards have come to

recognize, through decades of experience, particular factors that

arouse suspicion and call for focused investigation. These

factors are the so-called “red flags” for which all auditors are

trained to remain alert. See Howard v. SEC, 376 F.3d 1136,

1149 (D.C. Cir. 2004) (citing Graham v. SEC, 222 F.3d 994,

1006 (D.C. Cir. 2000), and Wonsover v. SEC, 205 F.3d 408, 411

(D.C. Cir. 2000)). 

Among transactions calling for close inspection are relatedparty transactions, including transactions between a company

and its officers or directors. Such dealings are viewed with

extreme skepticism in all areas of finance. See, e.g., 17 C.F.R.

§ 210.4-08(k)(1) (one of many disclosures of related-party

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transactions required by the Commission in the securities

context); Gordon v. Comm’r, 85 T.C. 309, 326-27 (1985)

(explaining “heightened” skepticism of the form related-party

transactions). The reason for this is apparent: Although in an

ordinary arms-length transaction, one may assume that parties

will act in their own economic self-interest, this assumption

breaks down when the parties are related. A company that

would perform a thorough credit-risk assessment before

extending a loan might not do so if the loan were to one of its

officers or directors. Accordingly, GAAS explicitly recognize

the need for particular care in the auditor’s examination of

material related-party transactions. AICPA, AU § 334. 

In response to the inherently suspicious nature of such

transactions, the AICPA has identified particular sources of

information to which an auditor should turn for assurance

regarding material outstanding balances associated with relatedparty transactions: “audited financial statements, unaudited

financial statements, income tax returns, and reports issued by

regulatory agencies, taxing authorities, financial publications, or

credit agencies.” AICPA, AU § 334.10(e). McCurdy took no

steps to obtain or consult any of these sources with regard to this

receivable. The question then is whether, in view of the

information upon which he did rely, the Commission was

warranted in finding that he lacked sufficient information to

form a reasoned judgment about the receivable’s collectibility.

A.

A basic guideline of field work requires auditors to form

their opinions on the basis of “[s]ufficient competent evidential

matter,” “obtained through inspection, observation, inquiries,

and confirmations.” AICPA, AU § 326.01. In considering the

evidence upon which McCurdy relied, the Commission properly

disregarded what was not competent. The Commission found,

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for instance, that Gulf Insurance Company’s renewal of the

fund’s bond in February 1999 could not support a reasonable

judgment that the receivable was collectible. The bond covered

“Uncollectible Items,” with a limit of liability of $25,000. The

record does not establish whether, at the time, Gulf was aware

of the status of the receivable. The Commission believed that

Gulf had only the fund’s 1997 financial statements, apparently

because the 1998 financial statements listing the receivable were

not filed with the Commission until March. In re McCurdy,

Exchange Act Release No. 34-49182, 2004 WL 210606

(“Comm’n Op.”), at *4, *6 (Feb. 4, 2004). In any case,

McCurdy could not have known whether Gulf investigated the

receivable in deciding to renew the bond. He did not contact

Gulf or otherwise attempt to ascertain the reason for Gulf’s

decision; his inference of support for the collectibility of the

receivable amounted to pure speculation.

 

The Commission also properly rejected McCurdy’s reliance

on the size of the receivable. McCurdy viewed $83,399 as not

“inherently large.” Id. at *7. As compared to what? Bagwell

must have thought it a large sum; at the board meeting, he told

the trustees that it would be “extremely difficult” for him to

come up with that amount of money by the end of 1998. What

matters under GAAS is that the receivable comprised a quarter

of the fund’s assets, which made it important for an independent

auditor to examine carefully whether Bagwell could and would

repay the balance on time. For similar reasons, the Commission

refused to give any credit to McCurdy’s assertion that the

receivable was probably collectible because it would not get any

larger in 1999. Id. Like the Commission, we cannot see how

this makes it more likely that the fund would collect the balance

remaining at the end of 1998.

After discounting this evidence, two sources of support for

McCurdy’s conclusion remain: Bagwell’s history of payment

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in prior years, and the decision of the board of trustees to extend

Bagwell’s repayment period. Bagwell’s previous payments are

only minimally instructive, in light of the fact that the 1998

receivable dwarfed the prior balances. In addition, as the

Commission stated, “[w]hile a history of default would have

been a source of concern, the lack of such a history does not

establish probable collectibility on these facts.” Id. That leaves

the decision of the board, to which McCurdy gave “substantial”

weight in forming his opinion. Id. at *5. The most glaring

problem with McCurdy’s reliance on this fact is that he

considered only the vague and narrow snapshot offered by the

official minutes of the December 3 meeting, which consisted of

the following two sentences:

The Board then questioned Mr. Bagwell at length

concerning the financial condition of the Adviser, the

Adviser’s ability to pay off the account in a reasonable

time period, and the sources of income available to the

Adviser to pay off such sums. The Adviser presented a

balance sheet and income statement to the Board and

demonstrated, to the satisfaction of the Board, that the

Adviser would be able to pay off the account not later

than June of 1999.

Neither the reliability of Bagwell’s balance sheet nor his

financial condition at the time can be gleaned from these

statements. Collection of the debt depended on both. Yet

McCurdy took no steps to investigate. The Commission

determined, with ample support in the record, that the evidence

McCurdy had before him at the conclusion of his audit was

insufficient to support his conclusion that the receivable was

probably collectible. 15 U.S.C. § 78y(a)(4); Steadman v. SEC,

450 U.S. 91, 97 n.12 (1981).

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B.

McCurdy maintains that his actions fell within the bounds

of auditor judgment as contemplated by GAAS. He points to

AU § 326.22, which states that the “amount and kinds of

evidential matter required to support an informed opinion are

matters for the auditor to determine in the exercise of his or her

professional judgment after a careful study of the circumstances

in the particular case.” Speaking of judicial discretion, Chief

Justice Marshall observed that such choices are not left to a

court’s “inclination, but to its judgment; and its judgment is to

be guided by sound legal principles.” United States v. Burr, 25

F. Cas. 30, 35 (C.C. Va. 1807). To paraphrase, an auditor must

exercise, not his “inclination,” but his “professional judgment”

and that judgment must be “guided by sound” auditing

principles, among which are a “thorough . . . search for

evidential matter,” AU § 326.23, and an “attitude that includes

a questioning mind and a critical assessment of audit evidence,”

AU § 230.07. The Commission’s conclusion that McCurdy was

derelict in performing these and other auditing functions is

amply supported. 

McCurdy’s departures from GAAS fell into two basic

categories. He formed an opinion on the basis of insufficient

evidence, and he failed to obtain additional evidence that might

properly have supported an opinion. In reaching its finding of

recklessness, the Commission focused on errors of the latter

type. Under SEC Rule 102(e), recklessness is “not merely a

heightened form of ordinary care,” but rather an “extreme

departure from the standards of ordinary care, . . . which

presents a danger of misleading buyers or sellers that is either

known to the [actor] or is so obvious that the actor must have

been aware of it.” 63 Fed. Reg. 57,164, 57,167 (Oct. 26, 1988)

(quoting SEC v. Steadman, 967 F.2d 636, 641 (D.C. Cir. 1992)).

McCurdy contends that the Commission ignored this scienter

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requirement. The record is otherwise. The Commission

properly applied the standard, noting at the outset of its

recklessness analysis that McCurdy “knew that the Receivable

was ‘very material’ to the Fund; he also recognized that it

represented a related party transaction.” Comm’n Op. at *8.

The Commission so stated in order to highlight the danger

signals apparent to McCurdy. He knew that the receivable

presented a significant risk of misleading the public if it were

reported as an asset and yet not probably collectible. His actions

in response fell short of GAAS requirements, but did they

constitute an extreme departure?

The Commission’s finding of recklessness rested on a

combination of the suspicious nature of the receivable, and the

stunning lack of skepticism and investigatory initiative

McCurdy displayed. Upon entering into his engagement with

the fund, McCurdy was confronted by a surfeit of red flags

surrounding the receivable. The receivable was nearly ten times

the amount of the GAAS-dictated materiality threshold, which

McCurdy calculated at the outset of the engagement. The

related-party interest underlying the transaction was not minor:

Bagwell was the founder and CEO of the fund, a trustee, and its

investment advisor. As if this were not enough, the arrangement

that gave rise to the receivable also was described by the board’s

counsel as, “under normal circumstances, . . . illegal.” Comm’n

Op. at *2. Not only a professional auditor charged with a duty

of skepticism, but any rational observer, should have been

highly suspicious in the face of these facts. See AICPA, AU

§ 230.07. 

In short, investigating and classifying this receivable was

McCurdy’s single most important task in performing his audit.

Yet his actions in response to this duty were perfunctory at best.

As this court recently held, “an extreme departure occurs, for

instance, when an auditor ‘skips procedures designed to test a

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company’s reports or looks the other way despite suspicions.’”

Marrie v. SEC, 374 F.3d 1196, 1206 (D.C. Cir. 2004) (quoting

In re Marrie, 2003 WL 21741785, at *11-*12 (July 29, 2003)).

In defense of his complete failure to seek firsthand corroboration

of Bagwell’s financial situation, McCurdy asserts that GAAS in

fact prefer independent evidence to records in the control of the

audited company. We do not understand the point. The fund --

not Bagwell -- was McCurdy’s client, and the subject of the

audit. The records in question related to Bagwell in his capacity

as the fund’s advisor, and those records were under Bagwell’s

control, not the fund’s. McCurdy’s rationale also does not

explain his failure to contact the other trustees, whom McCurdy

repeatedly describes as “independent” in justifying the weight

he gave their decision. See Brief for Petitioner at 34-38. As the

Commission noted, GAAS required these inquiries. Had

McCurdy made them, it would have added little additional cost

to the audit, but would have offered the possibility of significant

additional insight -- such as, for example, the fact that, by the

time McCurdy completed his audit report, Bagwell had not

made any of his agreed-upon payments. McCurdy’s failure to

take these simple steps amply supports the Commission’s

finding of recklessness. We therefore need not reach the

Commission’s alternate finding of highly unreasonable conduct.

C.

The Commission may impose sanctions for a remedial

purpose, but not for punishment. See SEC Rule 102(e)(1)(iv);

Johnson v. SEC, 87 F.3d 484, 490 (D.C. Cir. 1996). McCurdy

contends that because the Commission based its suspension

solely on his past conduct, the order was ultra vires and should

be set aside. It is difficult to imagine how any suspension,

remedial or not, could be based on anything but past actions. At

all events, the Commission here began its order by stating that

“it is in the public interest for [McCurdy] to be denied the

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privilege of appearing or practicing before the Commission,”

Comm’n Op. at *1, and later specifically noted that “McCurdy

has significant experience in audit work,” which “makes his

failure to conduct the audit in accordance with applicable

professional standards particularly troublesome,” id. at *9. It is

troublesome, the Commission continued, because the

Commission “anticipate[d] that he will continue to conduct

audits of public companies.” Id. The purpose of the sanction

thus was not to punish McCurdy, but rather to protect the public

from his demonstrated capacity for recklessness in the present,

and presumably to encourage his more rigorous compliance with

GAAS in the future. The Commission acted within the bounds

of its authority in issuing this order.

 Accordingly, the petition for review is denied.

So ordered.

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