Source: https://www.sec.gov/litigation/admin/34-48328.htm
Timestamp: 2019-04-23 11:59:04+00:00

Document:
In anticipation of the institution of these proceedings, Respondent has submitted an Offer of Settlement (the "Offer") which the Commission has determined to accept. Solely for the purpose of these proceedings and any other proceedings brought by or on behalf of the Commission, or to which the Commission is a party, and without admitting or denying the findings herein, except as to the Commission's jurisdiction over him and the subject matter of these proceedings, which Respondent admits, Respondent consents to the entry of this Order Instituting Public Administrative and Cease-and-Desist Proceedings Pursuant to Section 21C of the Securities Exchange Act of 1934 and Rule 102(e) of the Commission's Rules of Practice, Making Findings, and Imposing Remedial Sanctions and a Cease-and-Desist Order ("Order"), as set forth below.
Richard P. Scalzo was the PricewaterhouseCoopers LLP ("PwC") engagement partner for the audits of the financial statements of Tyco International Ltd. ("Tyco") for the company's fiscal years 1997 through 2001. In the course of those audits, Scalzo became aware of facts and events that provided him notice regarding the integrity of Tyco's senior management. By the end of the Tyco annual audit for its fiscal year ended September 30, 1998, if not before, those facts were sufficient to obligate Scalzo, pursuant to generally accepted auditing standards ("GAAS"), to reevaluate the risk assessment of the Tyco audits and to perform additional audit procedures, including further audit testing of certain items (most notably, certain executive benefits, executive compensation, and related party transactions). Scalzo did not take sufficient steps in these regards. Accordingly, Scalzo did not conduct those Tyco financial statement audits in accordance with GAAS. However, for each of the Tyco fiscal years from its fiscal year ended September 30, 1998, through its fiscal year ended September 30, 2001, PwC issued an audit report stating that PwC had conducted an audit of Tyco's financial statements "in accordance with auditing standards generally accepted in the United States of America." As the engagement partner for the PwC team auditing Tyco's financial statements, Scalzo was responsible for those statements, and, at the time those statements were made, Scalzo was reckless in not knowing that the Tyco audits had not been conducted in accordance with GAAS.
Richard P. Scalzo, age 46, was the PwC engagement partner for the firm's audits of the financial statements of Tyco, beginning with the Tyco fiscal year ended June 30, 1997, and continuing through Tyco's fiscal year ended September 30, 2002.3 He is currently licensed as a Certified Public Accountant by the Commonwealth of Massachusetts and has been so licensed since July of 1984. He resides in Massachusetts.
1. PricewaterhouseCoopers LLP is a limited liability partnership engaged in public accounting. It maintains its principal place of business in New York City. The firm was formed by the July 1, 1998, merger of Coopers & Lybrand, LLP and Price Waterhouse, LLP.
2. Tyco International Ltd. is a Bermuda corporation with its headquarters in Bermuda. Tyco is a manufacturing and service company involved in fire and safety systems, electronic security services, disposable medical products, packaging materials, flow control products, electrical and electronic components, and underwater telecommunications systems. The common stock of Tyco is registered with the Commission pursuant to Section 12(b) of the Exchange Act and is traded on the New York Stock Exchange.
3. L. Dennis Kozlowski was Tyco's Chairman of the Board, President, and Chief Executive Officer from 1997, and an Executive Officer of Tyco from 1992, until his resignation in June of 2002. Kozlowski had been affiliated with the company since 1975.
5. Frank E. Walsh, Jr. was an outside Director of Tyco from 1992 until February of 2002. In that capacity, Walsh served as the Chairman of the Board's Compensation Committee from 1998 through 2000 and as a member of the Board's Corporate Governance Committee and Lead Director in 2001.
For each of the Tyco fiscal years from its fiscal year ended September 30, 1998, through its fiscal year ended September 30, 2001, the PwC audit working papers continued to include schedules for the KELP accounts of Tyco employees. Although those schedules did not include Kozlowski activity line item descriptions, the schedules nevertheless continued to show Tyco's most senior officers utilizing the KELP with a frequency that is impossible to reconcile with the payment of taxes on the vesting of restricted stock. In fact, the rate of KELP activity for those officers was due to their use of the program as a revolving line of credit -- and should have led the PwC audit team to inquire further as to whether the loans could possibly be authorized.
Scalzo's own desk files contain at least one additional document that clearly reflects the KELP being used for purposes other than the payment of taxes on the vesting of restricted stock. The document, with marginalia in Scalzo's handwriting, relates to a series of transactions that took place over a three-day period in 1998 and involved an exercise of Tyco stock options by Kozlowski, Mark H. Swartz (then Tyco's Chief Financial Officer), and one other Tyco executive. The stock options were exercised by the executives borrowing, in the aggregate, in excess of $50 million from the KELP and then selling the shares received from their option exercise back to the company, through an off-shore subsidiary. The first two lines of the Scalzo desk file document states "17-Jul-98; LDK & MS & DB exercises [sic] options by borrowing cash from TYCO US; TYCO US forwards money to TIL."6 The document then lists the initial journal entries reflecting the transaction. The first three entries listed include debits to "Key Employee Loans [sic] DB"; "Key Employee Loan LDK"; and "Key Employee Loan MS."
These documents provided notice to Scalzo regarding the integrity of Tyco's most senior management. Specifically, the documents showed that his client was using the KELP for the improper benefit of its most senior officers, and, in any event, for purposes other than the only purpose stated in the notes to the company's financial statements -- the payment of taxes on the vesting of restricted stock.
The consistent refusal of Tyco's management to disclose non-interest-bearing "relocation" loans granted to Tyco executives provided notice to Scalzo regarding the nature of Tyco's management. Scalzo was aware of tens of millions of dollars of these non-interest-bearing loans to Tyco's top two officers. By the time of the fiscal year 1999 audit, Scalzo knew, for example, that Kozlowski had $35.5 million, and that Swartz had $8 million, of such loans. The loans ostensibly were granted under Tyco's relocation loan program and were to be used to assist with the purchase of real estate by Tyco employees who were required to relocate to Tyco's offices in New York City and Boca Raton, Florida. These loans were recorded on the books and records of the company and were reviewed as part of the audit process.
Pursuant to the firm's standard audit procedures, the PwC audit team for the Tyco audits recommended that Tyco disclose in its periodic reports the existence of these non-interest-bearing loans. When Scalzo raised the issue with the principal beneficiaries of the loans (Kozlowski and Swartz), Swartz told Scalzo that disclosure was not needed because the loans were not material to Tyco's financial statements, and Swartz refused to make the disclosure. The resistance to such disclosure, together with other facts and events discussed herein, provided notice to Scalzo regarding the character and integrity of Tyco senior management.
Two separate incidents, and one ongoing practice, in which management utilized post-period adjustments to negate the impact of unanticipated charges discovered post-period provided notice to Scalzo regarding the integrity of Tyco management. Most of those adjustments involved reversals of accruals. PwC had objected in prior periods to most of the accruals, and Tyco had refused in those periods to record the adjustments requested by PwC.
As noted above, during the course of the audit of Tyco's financial statements for its fiscal year ended September 30, 1998, the PwC audit team noticed a series of transactions from July 1998 in which Kozlowski, Swartz, and one additional Tyco executive exercised Tyco stock options, by borrowing from the KELP, and then sold the shares realized from their options exercises back to the company the next business day, along with additional shares previously held by the executives, through an off-shore Tyco subsidiary. Tyco then wrote a check to the executives, representing a net settlement of the stock buybacks, the KELP loans used to exercise the options, interest on those loans, and other unrelated KELP loans owed by the executives.7 After consulting with PwC national partners, the PwC audit team came to the conclusion that Tyco should include a compensation charge of approximately $40 million.
On October 15, 1998, when PwC first learned of the transactions, Tyco was within days of a scheduled October 22 earnings release and had already conditioned Wall Street analysts to expect earning numbers that did not include the previously unanticipated compensation charge. Taking an additional multi-million dollar compensation charge would have caused the company to report earnings per share that would have been several cents lower than those the Street was anticipating. Scalzo clearly knew the urgency of this issue at the time that he consulted with PwC's national partners. A Scalzo e-mail communication summarized the accounting issue for his partners and concluded by stating, "The potential impact to Tyco on this issue is significant."
One issue raised by the credits was the fact that $12.25 million of them resulted from Tyco's reversal of an "accrued restructuring reserve" into SG&A. That decrease of SG&A was accomplished by first reversing the accrued restructuring reserve against restructuring expense on the restructuring ledger and then debiting restructuring expense and crediting administrative expense on Tyco's general ledger. Scalzo was aware of the nature of these adjustments at the time they were made.10 Documents in Scalzo's handwriting show that Scalzo was also aware of an additional issue raised by the reversal of the restructuring reserve -- the fact that Tyco had suddenly decided that $12.25 million of the reserve would be reversed. Scalzo's notes made at the time that Tyco was attempting to resolve these issues contain a notation -- with the letters "SEC" printed to its left -- stating, "Why is this the right qtr to reverse restructuring vs prior periods." The Tyco controller's memorandum lists the justification for the reversal as the need "[t]o reverse certain restructuring items that have been resolved during the fourth quarter." Scalzo accepted this written representation from his client.
Part of the $19.2 million in adjustments was a $2 million credit resulting from Tyco's partial reversal of its "corporate general reserve." In fact, during the previous fiscal year, PwC had noted on its Summary of Unadjusted Differences ("SUD") that the reserve was per se impermissible and should be reversed completely.12 At that time, Tyco had declined to reverse the reserve in any amount, and, at the time of the post-period adjustments off-setting the impact of the $40 million compensation charge, Tyco only reversed $2 million of that reserve -- leaving the remainder of the accrual available for future use.
The facts point to Scalzo's knowledge of the process whereby Tyco arrived at $40 million in adjustments to negate the impact of the compensation charge. The notes in Scalzo's handwriting, which make sense only if they date from some point in time prior to the final "resolution" of the matter, set forth, near the bottom of one page, three line items reading, "13M reverse restricted stock award; 14M reverse I/C hit; 13M restructuring reversal." The line items aggregate $40 million. Moreover, they closely resemble the types of post-period adjustments that eventually were made on Tyco's books.13 All of these issues provided further notice to Scalzo regarding the integrity of Tyco's management. Moreover, the very next fiscal year the post-close fire-drill reoccurred.
During the annual audit for Tyco's fiscal year ended September 30, 1999, the PwC team auditing Tyco's Flow Control division came to the conclusion that $10.6 million in expenses at the division's Earth Tech subsidiary had been improperly charged against purchase accounting accruals.14 Scalzo, once informed of the findings, told the client that these errors were "black and white" and had to be reversed.
Scalzo continued to witness Tyco's use of general unallocated reserves to off-set unexpected expenses throughout Tyco's fiscal years 1998-2001. For example, the PwC Discussion Outline for the Tyco fiscal quarter ended June 30, 2001, notes "[g]eneral reserves of $26m recorded through post-close entries; Increase is allocated to various Corporate accrual and reserve accounts, but intention is primarily to off-set possible (but unidentified) under accruals at a divisional level."
On three occasions over one calendar year, the company's treatment for certain executive bonuses provided notice to Scalzo regarding the integrity of Tyco senior management.
In July 2000, Tyco successfully completed an initial public offering ("IPO") of approximately fourteen percent of the outstanding common stock of its previously wholly-owned subsidiary, TyCom Ltd., which served as the holding company for Tyco's undersea fiber optic cable communications business. The TyCom IPO generated a one-time gain of approximately $1.76 billion on the books of Tyco. In early September 2000, Kozlowski decided to grant bonuses to fifty-one Tyco officers, managers, and employees, ostensibly for their contributions to the gain from the TyCom IPO. On November 30, 2000, Scalzo received a facsimile transmission of a memorandum purportedly written by Swartz and dated September 29, 2000. The memorandum noted the TyCom IPO bonuses and stated that selected employees would receive their bonuses in the form of cash, forgiveness of relocation loans, and/or Tyco stock under Tyco's restricted stock program. The memorandum also stated that the bonus payments are not in lieu of a normal year-end bonuses but instead represented an incremental payment to reward selected employees for the successful TyCom IPO.
The relocation loan forgiveness, and other components of the bonuses, aggregated $95,962,653, of which Kozlowski and Swartz received $49,586,754. According to a Tyco report on Form 8-K, filed with the Commission on September 10, 2002, an internal Tyco investigation found that Tyco had classified $44,642,065 of the $95.9 million as a TyCom offering expense, with the remainder charged against previous overaccruals of general and administrative expense and against an accrual for federal income taxes.
In October 2000, Tyco sold its ADT Automotive business for approximately $1 billion in cash, with a net gain on the sale of approximately $400 million. In November 2000, Kozlowski used the ADT Automotive divestiture as a vehicle for the payment of almost $56 million in bonuses to Tyco officers and managers, in the form of cash bonuses, relocation loan repayments, and grants of restricted stock.18 Although the bonus recipients were almost exclusively Tyco corporate headquarters personnel, Swartz directed that the $56 million in charges be netted against the gain on the divestiture, and that all but the restricted stock components be classified as "direct selling costs" associated with the ADT Automotive divestiture.
A January 15, 2001, draft of PwC's Discussion Outline for the Tyco quarter ended December 31, 2000, lists, as one of nine "Key Items," an issue relating to "[c]harges recorded against gain on sale of businesses."19 The "Corporate" section of the draft Discussion Outline cites the ADT Automotive issue more explicitly. Discussing a "$(410.4)m gain on disposal of businesses," the Outline states, "Calculation of gain nets a number of additional charges against the mechanical gain calculation (proceeds less net assets) of $548.1m, including: Management bonuses of $61.5m - documentation of these bonuses is that they are direct and incremental costs of the sale of ADT Automotive."20 The "Key Item" language and the "Corporate" language appear in identical form in another document from Scalzo's desk files, a document entitled "Audit Committee Discussion Outline - March 26, 2001." Scalzo received a representation from Swartz that the bonuses were direct and incremental costs of the transaction. 21 While Scalzo brought the bonuses to the attention of the audit committee, he did not disclose to the committee that Kozlowski and Swartz were recipients of the bonuses.
On June 22, 2001, Tyco acquired 15 million shares of FLAG Telecom for $11,421,810 in cash and 5,580,647 shares of common stock in Tyco's subsidiary, TyCom Ltd.22 Tyco reported a $79,364,700 gain associated with its swap of TyCom shares for the FLAG Telecom equity. Kozlowski and Swartz directed bonuses to a handful of Tyco corporate headquarters officers and managers, again ostensibly to reward the officers and managers for their role in creating the $79 million gain. At the end of its fiscal third quarter ended June 30, 2001, when it was still not clear what form these bonuses might take, Tyco established a $15 million accrual for management bonuses and netted the accrual against the gain on the FLAG Telecom transaction. During its fiscal fourth quarter, Tyco management decided to take the bonuses in the form of accelerated vestings of restricted stock. The officers and managers sold those shares back to Tyco, through a Tyco off-shore subsidiary, and the proceeds were then wired to their personal accounts. The aggregate cost of those bonuses was $15,378,700, of which $12,329,475 went to Kozlowski and Swartz. Kozlowski and Swartz then awarded themselves a tax gross-up on their FLAG Telecom bonuses, in the form of approximately $9.6 million in additional restricted stock. The tax gross-up was charged against a corporate income tax account on Tyco's balance sheet. Accordingly, neither Kozlowski's and Swartz' initial FLAG Telecom bonuses nor their tax gross-up affected Tyco's operating expense.
Finally, in early December 2001, during the financial statement audit for Tyco's fiscal year 2001, Scalzo was informed by the PwC team auditing Tyco's Tyco Capital Corporation subsidiary that the team had noticed a $20 million finder's fee paid to Frank E. Walsh, Jr., then a Tyco outside Director, in connection with Tyco's 2001 acquisition of The CIT Group, Inc. (Tyco Capital Corporation, later renamed CIT Group Inc., was formed as a result of Tyco's acquisition of The CIT Group, Inc.) The Tyco Capital Corporation audit team especially wanted Scalzo to know that the $20 million fee consisted of a $10 million payment directly to Walsh and a $10 million contribution by Tyco to a charitable foundation chosen by Walsh.25 By the time that the Tyco Capital Corporation audit team informed Scalzo about the finder's fee, the PwC audit team under Scalzo had already interviewed Tyco management regarding the existence of related party transactions for Tyco's fiscal year 2001 and had been told that there were no such transactions to report.26 Therefore, Tyco management had given the audit team false information. Once again, Scalzo was faced with facts that raised serious questions about the integrity of Tyco management.
These facts and events -- repeated and consistent -- provided notice to Scalzo, by the end of the PwC audit for Tyco's fiscal year 1998, if not before, regarding the character and integrity of Tyco management. So informed, and as the engagement partner for the PwC Tyco audits, Scalzo faced certain obligations under GAAS.
As an initial matter, in order for an audit to be conducted in accordance with GAAS, the auditor must plan the audit "to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud." AU § 316.01. The auditor's obligations regarding assurance, however, do not end there. The auditor is directed to also perform the audit in a manner calculated to obtain such assurances. AU § 316.01. Thus, "the assessment of the risk of material misstatement due to fraud is a cumulative process and one that should be ongoing throughout the audit." AU § 316.35. Because this process is a cumulative one, "[a]s the auditor performs planned procedures, the evidence obtained may cause him or her to modify the nature, timing, and extent of other planned procedures." AU § 316.33. Thus, "conditions may be identified during fieldwork that change or support a judgment regarding the [risk] assessment," including "[t]ransactions not recorded in a complete or timely manner or improperly recorded as to amount, accounting period, classification, or entity policy" or "[l]ast-minute adjustments by the entity that significantly affect financial results." AU § 316.25 (emphasis added). Statements on Auditing Standards make clear that one of the ways that "procedures may need to be modified" in response to facts uncovered during an audit is that "[t]he nature of audit procedures performed may need to be changed to obtain evidence that is more reliable or to obtain additional corroborative information." AU § 316.28.
Risk assessments, and, accordingly, any reevaluations of risk assessments, should be made with consideration of applicable risk factors. See AU § 316.12, .14. Thus, the auditor's response to a risk assessment "is influenced by the nature and significance of the risk factors identified as being present." AU § 316.26. One of the principal categories of "[r]isk factors that relate to misstatements arising from fraudulent financial reporting" is "[m]anagement's characteristics and influence over the control environment." AU § 316.16. Those factors "pertain to management's abilities, pressures, style, and attitude relating to internal control and the financial reporting process." AU § 316.16 (emphasis added).27 One of the examples of the risk factors from another principal category, that of risk factors relating to operating characteristics and financial stability, is "[s]ignificant related-party transactions not in the ordinary course of business" AU § 316.17 (emphasis added).
One of the cardinal principles of GAAS is that "[d]ue professional care is to be exercised in the planning and performance of the audit and the preparation of the [audit] report." AU § 230.04 (emphasis added). Statements on Auditing Standards note that "[d]ue professional care requires the auditor to exercise professional skepticism," AU § 230.07, and "[i]n exercising professional skepticism, the auditor should not be satisfied with less than persuasive evidence because of a belief that management is honest," AU § 230.09. In fact, one of the ways in which a reevaluation of risk assessment may affect the audit is in the increased application of professional skepticism. See AU § 316.27. "Some examples demonstrating the application of professional skepticism in response to the auditor's assessment of the risk of material misstatement due to fraud include (a) increased sensitivity in the selection of the nature and extent of documentation to be examined in support of material transactions, and (b) increased recognition of the need to corroborate management explanations or representations concerning material matters -- such as further analytical procedures, examination of documentation, or discussion with others within or outside the entity." AU § 316.27.
The auditor's obligation of ongoing risk assessment does not end once the fieldwork is complete. "At the completion of the audit, the auditor should consider whether the accumulated results of audit procedures and other observations [for example, conditions arising during fieldwork] affect the assessment of the risk of material misstatement due to fraud he or she made when planning the audit." AU § 316.33. "Such an accumulation may provide further insight into the risk of material misstatement due to fraud and whether there is a need for additional or different audit procedures to be performed." AU § 316.33. Moreover, "[w]hen audit test results identify misstatements in the financial statements, the auditor should consider whether such misstatements may be indicative of fraud." AU § 316.34.
As noted, if risk assessment is reevaluated properly, GAAS may well lead an auditor to the conclusion that he or she is required to take additional audit steps. In addition, an auditor's identification of certain types of transactions or events may also trigger the need to take specific, additional actions. For example, during the course of an audit, the auditor may become aware of reportable conditions, that is, "matters coming to the auditor's attention that, in his judgment, should be communicated to the audit committee because they represent significant deficiencies in the design or operation of internal control, which could adversely affect the organization's ability to record, process, summarize, and report financial data consistent with the assertions of management in the financial statements." AU § 325.02. One example of a reportable condition is "[e]vidence of significant or extensive undisclosed related party transactions." AU § 325. Similarly, "[w]hen the auditor, as a result of the assessment of risk of material misstatement due to fraud, has identified risk factors that have continuing control implications (whether or not transactions or adjustments that could be the result of fraud have been detected), the auditor should consider whether these risk factors represent reportable conditions relating to the entity's internal control that should be communicated to senior management and the audit committee." AU § 316.39 (emphasis added). Additional matters encountered during the course of the audit may also need to be brought to the attention of the audit committee, AU § 380, including, for example, "audit adjustments," or proposed corrections "of the financial statements that, in the auditor's judgment, may not have been detected except through the auditing procedures performed." AU § 380.09.
A principal vehicle of executive compensation and related party transactions at Tyco was the KELP loans to its senior officers.31 Nevertheless, the PwC audit team did not pursue troublesome facts regarding KELP. The PwC working papers contained documents that contradicted the KELP financial statement footnote they were ostensibly intended to support. Scalzo knew, and documents contained in his own desk files showed, that KELP loans had been used to exercise tens of millions of dollars worth of stock options rather than to pay taxes on the vesting of restricted stock. Failing to reevaluate audit risk in this area, Scalzo took no further steps. He did not perform, nor did he direct PwC personnel to perform, any audit steps to determine whether KELP loans made to Tyco's top officers, in fact, were consistent with the program purpose stated in the financial statement footnote. He did not inform the audit committee of Tyco's Board of Directors that Tyco's most senior officers had used KELP loans for non-program purposes.
Another principal area of Tyco executive compensation and related party transactions was that of non-interest-bearing loans extended to Tyco's senior management. Here, also, the audit team failed to respond to troublesome facts and events. Scalzo was aware of tens of millions of dollars in non-interest-bearing loans to Tyco's top two officers. For each of the Tyco fiscal years 1999-2001, PwC's recommendation that these loans be disclosed was rejected. Scalzo raised the issue with the principal beneficiaries of the loans: Kozlowski and Swartz. Swartz told Scalzo that disclosure was not needed because the loans were not material to Tyco's financial statements. Scalzo considered that statement and the impact of non-disclosure on the financial statements.32 Scalzo did not reevaluate audit risk in this area, and he took no additional audit steps regarding the propriety and disclosure of the loans or their authorization, other than to review and consider management's draft financial statements. He did not review the PwC working papers on the use of the loans. He did not insist on separate disclosure of the loans in Tyco's financial statements, and he did not inform the audit committee of the existence of the non-interest-bearing loans.
Scalzo also failed to reevaluate audit risk when confronted with the issues raised by the bonuses granted in connection with the TyCom IPO, the ADT Automotive divestiture, and the FLAG Telecom transaction. Scalzo discussed the TyCom IPO bonuses with Swartz, a primary beneficiary of the bonuses, and was told that the bonuses were not material. Scalzo considered Swartz' representation and accepted the lack of disclosure of the bonuses in the context of the financial statements. Scalzo accepted management's representation that the bonuses were direct and incremental costs of the TyCom IPO. He did not reevaluate audit risk. He did not insist that the bonuses be separately disclosed in the financial statements, and he did not report to the audit committee that Kozlowski and Swartz received the bonuses.
Faced with the accounting treatment for the ADT Automotive executive bonuses, Scalzo again accepted a management representation that the bonuses were direct and incremental costs of the transaction and allowed the accounting treatment to stand. He listed the bonuses on the audit committee Discussion Outline along with a notation that there was documentation that the bonuses were direct and incremental costs of the sale. More important for the violations discussed herein, he did not reevaluate audit risk. Accordingly, he undertook no additional audit procedures or testing. He did not direct the audit team to ascertain whether the bonuses were authorized by Tyco's Board of Directors. Although he discussed the bonuses with the audit committee, he did not identify the recipients of the bonuses to the audit committee and did not require the bonuses to be separately disclosed in the financial statements.
Moreover, during the fiscal year 2001 audit, Scalzo learned that Tyco management had not voluntarily informed the PwC audit team about the Walsh CIT finder's fee, and in fact had told the audit team that there were no related party transactions to report for that fiscal year. After another PwC audit team found, and informed Scalzo of, the fee, Scalzo discussed it with Tyco management and was told that the fee was not material for purposes of separate financial statement disclosure. Although his client had given the audit team false information regarding related party transactions, Scalzo did not reevaluate audit risk for such transactions. Accordingly, he did not perform, or direct PwC personnel to perform, any additional audit steps. Moreover, without the benefit of any such additional steps, Scalzo reached a determination that the payment was not material for purposes of separate financial statement disclosure. Scalzo did not inform the audit committee about the fee.
In sum, it is important to note that Scalzo was exposed to all of these facts and events -- not just those of a single fiscal year and not just those of a single type of transaction. Nevertheless, at no point during the course of his work as engagement partner for the Tyco audits did Scalzo reassess the level of audit risk with regard to executive compensation or related party transactions. For Scalzo, it was only exposure to these facts, and not the assessment of audit risk that was "a cumulative process."
Because of these repeated failures, PwC, under Scalzo's direction, for each of Tyco's fiscal years ended September 30, 1998; September 30, 1999; September 30, 2000; and September 30, 2001, failed to conduct an audit of Tyco's financial statements in accordance with GAAS. Nevertheless, for each of those fiscal years, PwC issued an audit report falsely stating that the firm had conducted its audit of Tyco's financial statements "in accordance with auditing standards generally accepted in the United States of America." Scalzo, as the PwC engagement partner for those Tyco audits, was responsible for the false statements. At the time those statements were made, Scalzo was reckless in not knowing that the Tyco audits had not been conducted in accordance with GAAS, and, therefore, that the statements were false.
Scalzo recklessly allowed PwC to issue an audit report containing the false statement in Tyco's annual report on Form 10-K for each of its fiscal years ended September 30, 1998; September 30, 1999; September 30, 2000; and September 30, 2001. Accordingly, as a result of the false statement contained in the PwC audit reports, Tyco filed with the Commission, and distributed to investors, false and misleading annual reports that misrepresented whether Tyco's financial statements had, in fact, been submitted to an audit in accordance with GAAS.
Section 10(b) of the Exchange Act of 1934 and Exchange Act Rule 10b-5 prohibit a person, in connection with the purchase or sale of a security, from making an untrue statement of a material fact or from omitting to state a material fact necessary to make statements made, in light of the circumstances under which they were made, not misleading. "[T]o fulfill the materiality requirement [of these provisions] `there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the "total mix" of information made available.'" Basic Inc. v. Levinson, 485 U.S. 224, 231-32 (1988) (citation omitted). Few matters could be more important to investors than that of whether an issuer's financial statements, contained in its filings with the Commission, had, in fact, been subjected to an annual audit conducted in accordance with GAAS in all material respects. To violate Section 10(b) or Rule 10b-5, a defendant must act with scienter, Aaron v. SEC, 446 U.S. 680, 695, 701-02 (1980), which the Supreme Court has defined as "a mental state embracing intent to deceive, manipulate, or defraud," Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 n.12 (1976). Such scienter encompasses knowing or intentional misconduct, or recklessness. See, e.g., IIT v. Cornfeld, 619 F.2d 909, 923 (2d Cir. 1980); Lanza v. Drexel & Co., 479 F.2d 1277, 1306 (2d Cir. 1973) (en banc). By means of the conduct set forth above, Scalzo violated Section 10(b) and Rule 10b-5.
Rule 102(e)(1)(ii) of the Commission's Rules of Practice allows the Commission to deny, temporarily or permanently, the privilege of appearing or practicing before it to any accountant who the Commission finds has engaged in improper professional conduct. According to the records of the Massachusetts Board of Public Accountancy, Scalzo is currently licensed by Massachusetts as a Certified Public Accountant and has been so licensed since July 1984. Rule 102(e)(1)(iv) provides, in relevant part, that "[w]ith respect to persons licensed to practice as accountants, `improper professional conduct' under [Rule 102(e)(1)(ii)] means: (A) Intentional or knowing conduct, including reckless conduct, that results in a violation of applicable professional standards."
The Commission has recently noted that it adopted the recklessness standard set forth in Rule 102(e)(1)(ii)(A) "to highlight that reckless conduct is not merely a heightened form of ordinary negligence, but rather a lesser form of intent." Michael J. Marrie, CPA, and Brian L. Berry, CPA, Exchange Act Release No. 48246 (July 29, 2003). "The question is not whether an accountant recklessly intended to aid in the fraud committed by the audit client, but rather whether the accountant recklessly violated applicable professional standards." Marrie and Berry. Scalzo's conduct set forth above constitutes reckless violations of applicable professional standards, and, accordingly, Scalzo engaged in improper professional conduct. "An auditor who skips procedures designed to test a company's reports or looks the other way despite suspicions is a threat to the Commission's processes." Marrie and Berry.
Based on the foregoing, the Commission finds that Scalzo committed and caused violations of Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder.
Based on the foregoing, the Commission finds that Scalzo engaged in improper professional conduct pursuant to Rule 102(e)(1)(ii) of the Commission's Rules of Practice.
In view of the foregoing, the Commission deems it appropriate to impose the sanctions agreed to in Respondent Scalzo's Offer.
Scalzo shall cease and desist from committing or causing any violations and any future violations of Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder.
Scalzo is denied the privilege of appearing or practicing before the Commission as an accountant.
The Commission may . . . deny, temporarily or permanently, the privilege of appearing or practicing before it . . . to any person who is found . . . to have engaged in . . . improper professional conduct.
3 The present-day Tyco was formed by the July 1997 merger between Tyco International Ltd. and a wholly-owned subsidiary of what was formerly called ADT Limited. ADT Limited had a fiscal year-end of December 31, while former Tyco had a year-end of June 30. The new Tyco adopted a year-end of September 30. The June 30, 1997, and September 30, 1997, audits of Tyco's financial statements were conducted by a predecessor firm of PwC, Coopers & Lybrand, LLP.
4 In the note for the fiscal year ended September 30, 2001, the words "under Former Tyco's Restricted Stock Ownership Plans" became "under our Restricted Share Ownership Plans." The purpose stated in these notes was, in fact, the only authorized purpose for Tyco KELP loans.
5 Other line items are nearly as explicit in setting forth purposes other than the payment of taxes on the vesting of restricted stock: For example, another line item reads "KENSHIRE GAL," three read "UTILITIES," and four read "LIVING SPACE." In fact, apart from one item that reads "LOAN VESTING," and perhaps another that reads "IRS," none of the descriptions bear an apparent tie to the payment of such taxes.
6 "DB" was another Tyco executive; "TIL" is Tyco International Ltd.
7 The description set forth here mirrors that contained in a document, found in the fiscal year 1998 working papers, that discusses the transactions. The description coincides, therefore, with the understanding documented by the Tyco PwC audit team after their review of the transactions.
8 The memorandum is contained in PwC's fiscal year 1998 working papers.
9 The referenced "executives" were Kozlowski and Swartz -- the same two executives selling the lion's share of the stock bought back by the company in the transactions underlying the $40 million compensation charge.
10 Scalzo's desk file contains several pages of handwritten notes made at the time that Tyco was attempting to resolve issues raised by the unanticipated $40 million compensation charge. One of those pages contains the following notation: "Any credits should go to the right place -- ie in restructuring reserves."
11 Tyco had already conditioned the Street to expect earnings that did not include any of these post-period adjustments. If Tyco, prior to the discovery of the $40 million compensation charge, had intended to take the additional $40 million in credits to SG&A, then Tyco inexplicably had conditioned the Street to anticipate earnings $40 million lower than the earnings that Tyco, in fact, expected to announce.
12 Generally accepted accounting principles ("GAAP") prohibit the use of "reserves for general contingencies." Financial Accounting Standards Board ("FASB") Statement No. 5, Accounting for Contingencies, ¶ 14.
13 The adjustments actually made included a $7.8 million reversal of restricted stock expense, a $14 million reversal of a balance sheet credit into intercompany charges, and a $12.25 million reversal of restructuring expense.
14 Tyco acquired The Earth Technology Corporation or "Earth Tech" in the first quarter of calendar 1996.
15 A copy of the memorandum was maintained in a "Post-Close" folder in the PwC working papers for the Tyco fiscal year 1999 audit.
16 One of the Mueller Company's principal products was fire hydrants. Hence, the code name "Dog Leg."
17 "Direct and incremental costs" meant that the costs were direct costs of the transaction and that the bonuses were incremental to the usual and ordinary bonuses the executives would receive.
18 Of the approximately $56 million in Tyco corporate ADT Automotive bonuses, approximately $25.5 million was paid to Kozlowski, and an additional $12.8 million was paid to Swartz.
19 The draft Discussion Outline was produced to the staff as part of Scalzo's desk files. Moreover, a typed list of "PwC Notes" for a March 2001 meeting with the Tyco audit committee contains, next to the bullet-point "[c]ertain charges recorded against gain on sale of businesses," a note in Scalzo's handwriting stating "ie ADT Auto."
20 The difference between the $61.5 million cited on the Discussion Outline and the $56 million that Swartz directed be taken against the gain on the divestiture of ADT Automotive is $5.5 million that was designated as "ADT Auto Bonuses" -- as opposed to "Tyco Cash Bonuses" or "Tyco Restricted Stock Bonuses" -- and actually may have gone to individuals at ADT Automotive.
21 In fact, the PwC audit team received an early indication that Tyco might attempt to net bonuses against the gain on the sale of ADT Automotive. An item on a draft PwC Discussion Outline for the Tyco quarter ended June 30, 2000, (and therefore drafted well ahead of the October transaction) noted, under the "Corporate" section, "$2.2m to defer ADT Automotive retention bonuses through to date of sale; Plan to recognize as direct cost of sale; If employees are involved in revenue producing activities then should period [sic] expenses." (emphasis added).
22 FLAG is an acronym formed from "Fiberoptic Link Around the Globe."
23 A $79 million gain on the stock issuance, less $15 million for "bonuses," would net $64 million.
24 In addition to repeatedly classifying certain executive bonuses in a manner calculated to keep them from affecting its operating expenses, Tyco regularly failed to clearly disclose the existence of those same bonuses in its proxy statements or in its annual reports on Form 10-K, as either compensation or as related party transactions.
25 Scalzo was told by Tyco management that the payment would be disclosed in Tyco's proxy statement, and in fact it was so disclosed.
26 The finder's fee paid to Walsh constituted a related party transaction. See AU § 334; FASB Statement No. 57, Related Party Disclosures.
27 Examples of such risk factors, and indicators of such risk factors, include "[a]n excessive interest by management in maintaining or increasing the entity's stock price or earnings trend through the use of unusually aggressive accounting practices," "[a] failure by management to display and communicate an appropriate attitude regarding internal control and the financial reporting process," "[d]omination of management by a single person or small group without compensating controls such as effective oversight by the board of directors or audit committee," and "[m]anagement failing to correct known reportable conditions on a timely basis." AU § 316.17.
28 "As a result of the interaction of quantitative and qualitative considerations in materiality judgments, misstatements of relatively small amounts that come to the auditor's attention could have a material effect on the financial statements." AU § 312.11.
29 "In such circumstances, the auditor should reevaluate the assessment of the risk of material misstatement due to fraud and its resulting impact on (a) the nature, timing, and extent of the tests of balances or transactions, (b) the assessment of the effectiveness of controls if control risk was assessed below the maximum, and (c) the assignment of personnel that may be appropriate in the circumstances." AU § 316.34.
30 In fact, the PwC audit team under Scalzo not only failed to consider whether additional audit testing was required for related party transactions, it also regularly failed to undertake some of the basic audit procedures in connection with related party transactions. AU § 334.08. Moreover, once an auditor has identified related party transactions, "the auditor should apply the procedures he considers necessary to obtain satisfaction concerning the purpose, nature, and extent of these transactions and their effect on the financial statements." AU § 334.09. "The procedures should be directed toward obtaining and evaluating sufficient competent evidential matter and should extend beyond inquiry of management." AU § 334.09. As noted, such extended inquiry specifically did not occur during the Tyco audits conducted under Scalzo's direction.
31 Generally, loans between an entity and the entity's executive officers constitute related party transactions. See AU § 334; FASB Statement No. 57, Related Party Disclosures. At Tyco, as noted above, executive loans, on more than one occasion, were forgiven, giving rise as well to executive compensation.
32 Scalzo was obligated under GAAS to "consider all the relevant circumstances" surrounding the relocation loans, including "the factual context" in which the readers of Tyco's financial statements would "view the financial statement item." Staff Accounting Bulletin No. 99, SEC Release No. SAB - 99 (August 12, 1999). The Commission and the courts have consistently rejected a formulaic and mechanical assessment of materiality relying solely on quantitative measures, such as that apparently conducted by Scalzo in this instance. See Arthur Andersen LLP, Exchange Act Release No. 44444 (June 19, 2001); see also Ganino v. Citizens Utilities Co., 228 F.3d 154, 162 (2d Cir. 2000). Finally, the staff's guidance on materiality states that quantitative benchmarks for assessing materiality (e.g., a five percent threshold) do not apply in circumstances involving self-dealing and misappropriation of corporate assets by senior management. See Staff Accounting Bulletin No. 99, SEC Release No. SAB - 99 ("One rule of thumb in particular suggests that the misstatement or omission of an item that falls under a 5% threshold is not material in the absence of particularly egregious circumstances, such as self-dealing or misappropriation by senior management.") (emphasis added).
33 In fact, although he knew and advised management that GAAP did not allow general unallocated reserves, Scalzo viewed the Tyco corporate general reserve as a convenient mechanism to assist in the closing process.
34 In setting forth this cautionary statement, Statements on Auditing Standards clearly contemplated a situation such as the one that ultimately unfolded at Tyco. Scalzo did not.

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