On Petition for Review of an Order of the Securities and Exchange Commission
Before: Henderson, Rogers and Garland, Circuit Judges.
The opinion of the court was delivered by: Rogers, Circuit Judge
This appeal challenges an opinion and order of the Securities and Exchange Commission denying two certified public accountants the privilege of practicing before the Commission. It revisits the question of whether the Commission has articulated a clear standard for a finding of "improper professional conduct" under Rule 102(e) of its Rules of Practice, 17 C.F.R. § 201.102(e). We conclude that the lack of clarity identified in the two Checkosky v. SEC opinions of the court, 23 F.3d 452 (D.C. Cir. 1994) (" Checkosky I "), and 139 F.3d 221 (D.C. Cir. 1998) (" Checkosky II "), was not rectified until Rule 102(e) was amended in 1998. As amended, Rule 102(e) establishes that one of the mental states required for a finding of "improper professional conduct," is recklessness, defined as an extreme departure from the standard of ordinary care for auditors. Although the rule is clear now, because it was unclear at the time of the sanctioned conduct in 1994 and the Commission's application of the amended Rule is impermissibly retroactive, we grant the petition for review.
Michael Marrie and Brian Berry, as employees of the accounting firm, Coopers & Lybrand LLP ("Coopers"), acted as engagement partner and manager, respectively, for Coopers' 1994 audit of California Micro Devices, Inc. ("Cal Micro"), which designs, manufactures, and distributes electric circuits and semiconductors. As engagement partner and engagement manager, Marrie and Berry were responsible for ensuring that the 1994 fiscal year audit of Cal Micro was conducted in accordance with generally accepted auditing standards ("GAAS"), and that the financial statements filed with the Securities and Exchange Commission were in conformity with generally accepted accounting principles ("GAAP"). They prepared an audit plan and began field work in July 1994, and on September 29, 1994, filed with the Commission the company's Form 10-K annual financial report for the fiscal year ending June 30, 1994.
Marrie and Berry conducted the audit against a backdrop of massive financial reporting fraud by Cal Micro, unknown to the accountants. The Commission found that in fiscal year 1994, the company fraudulently recognized revenue and receivables for the sale of unshipped or non-existent products, even though its stated policy was to recognize revenue for products only upon shipment to customers; falsified sales records, invoices, and shipping documents, such as shipping merchandise to fictitious customers; and improperly overstated net assets and income, while understating net loss. Cal Micro had attempted to make reported revenues as high as possible in order to maintain the impression of growth after it had lost one of its major customers, Apple Computer Inc., which had accounted for 32% of the company's total product sales the prior year. To avoid detection for improper revenue recognition, Cal Micro's management attempted to "clean" the company's books before the end of the fiscal year, informing Marrie and Berry that it had decided to issue approximately $12 million in credit to "write off" certain accounts receivable. On August 4, 1994, however, Cal Micro issued a press release announcing its net income and earnings for the fourth quarter of 1994, and stated that it was writing off $8.3 million, not $12 million of accounts receivable, $1.3 million of which was written off as bad debt expense. Because amounts written off for returned products would be deducted directly from reported revenues, while amounts written off as bad debt would be treated as expenses and would not decrease reported revenues, Cal Micro attempted to maximize the portion of the write-off allocated to bad debt expense. Following the August 4, 1994 press release, however, Cal Micro's stock price dropped and shareholders brought a lawsuit alleging accounting improprieties.
Regardless, on August 25, 1994, Marrie and Berry, on behalf of Coopers, presented their independent accountants' report addressed to Cal Micro's shareholders and directors, stating that Cal Micro's financial statements complied with GAAP and that the audit had been conducted in accordance with GAAS. Following an independent investigation, Cal Micro filed a revised financial report with the Commission on February 6, 1995, showing a net loss of $15.2 million instead of earnings of $5 million, total revenue of $30.1 million rather than the previously reported $45.3 million, accounts receivable of $6.3 million instead of $16.9 million, $5.1 million in inventories instead of $13.9 million, and net property and equipment of $7.4 million instead of the previously reported $10.4 million.
On August 10, 1999, just shy of five years after Marrie and Berry presented the audit report to Cal Micro's shareholders, the Commission, through the Division of Enforcement and Office of the Chief Accountant, instituted disciplinary proceedings against Marrie and Berry pursuant to Rules 102(e)(1)(ii) and 102(e)(1)(iv)(A). The Commission alleged that Marrie and Berry had engaged in improper professional conduct in that they each "violated GAAS by failing to exercise appropriate professional skepticism, obtain sufficient competent evidential matter, or adequately supervise field work" in connection with three aspects of the 1994 audit: (1) the write-off of $12 million of accounts receivable; (2) the confirmation of the accounts receivable; and (3) the accounting of the sales returns and allowances for sales returns. The Commission also claimed that Marrie's and Berry's failures to examine the write-off, to investigate discrepancies in the confirmation responses, and to analyze Cal Micro's sales returns and the adequacy of its allowance for returns, were "an extreme departure from professional standards." Further, according to the Commission, Marrie and Berry were reckless in ignoring "unmistakable red flags" that indicated potential accounting irregularities in the areas of revenue recognition, accounts receivable confirmations, sales returns, sales cutoff, and cash collections. As a result, the Commission alleged that Cal Micro's financial statements for the fiscal year 1994 were materially false and misleading and were not prepared in conformity with GAAP.
On September 21, 2001, an administrative law judge ("ALJ") dismissed the charges, finding that Marrie and Berry had not engaged in improper professional conduct within the meaning of Rule 102(e). The ALJ ruled that reckless conduct under Rule 102(e)(1)(iv)(A) "must approximate an actual intent to aid in the fraud being perpetrated by the audited company," and that the Commission had failed to prove that Marrie's and Berry's conduct had been reckless. In re Marrie, Initial Decision of the ALJ, Release No. 101, File. No. 3-9966, at 35, 81 (Sept. 21, 2001)(" In re Marrie I" ). On July 29, 2003, the Commission reversed the dismissal of the charges and imposed remedial sanctions barring Marrie and Berry from practicing before the Commission, subject to Rule 102(e)(5)'s provision for reinstatement. See 17 C.F.R. § 201.102(e)(5). In sanctioning Marrie and Berry, the Commission stated that "[t]he 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. Recklessness, then, can be established by a showing of an extreme departure from the standard of ordinary care for auditors." In re Marrie, Exchange Act Release No. 48246, 2003 WL 21741785 at *11-*12 (July 29, 2003) (" In re Marrie II "). According to the Commission, proof of an actual intent to defraud or assist in a fraud was not required. Id. at *12. Nor was it necessary to show that the auditor had filed a "materially" misleading document: "An auditor who fails to audit properly under GAAS should not be shielded because the audited financial statements fortuitously are not materially misleading." Id. at *13. Finally, the Commission did not consider a good faith defense. The Commission found that Marrie and Berry recklessly violated fundamental principles of audit work, failed to exercise due care and appropriate professional skepticism, and failed to collect sufficient competent evidential matter to provide a basis for the audit opinion with respect to Cal Micro's write-off, accounts receivable, and sales returns. Id. at *30.
Rule 102(e), 17 C.F.R. § 201.102(e), provides the Commission with a means to ensure that the professionals on whom it relies "perform their tasks diligently and with a reasonable degree of competence." Touche Ross & Co. v. SEC, 609 F.2d 570, 582 (2d Cir. 1979). It is directed at protecting the integrity of the Commission's own processes, as well as the confidence of the investing public in the integrity of the financial reporting process. Recognizing the particularly important role played by accountants in preparing and certifying the accuracy of financial statements of public companies that are so heavily relied upon by the public in making investment decisions, the Commission, following the court's Checkosky opinions, adopted amendments to Rule 102(e) to specify under what circumstances accountants could be held liable under the Rule. Prior to the 1998 amendments, Rule 102(e) provided that:
(1) Generally. The Commission may censure a person or deny, temporarily or permanently, the privilege of appearing or practicing before it in any way to any person who is found by the Commission after notice and opportunity for hearing in the matter: (i) Not to possess the requisite qualifications to represent others; or (ii) To be lacking in character or integrity or to have engaged in unethical or improper professional conduct; or (iii) To have wilfully violated, or willfully aided and abetted the violation of any provision of the Federal securities laws or the rules and regulations thereunder.
17 C.F.R. § 201.102(e)(emphasis added). On June 12, 1998, in response to the court's holding in Checkosky II, 139 F.3d at 223, that the Commission had failed to articulate a clear standard for "improper professional conduct," the Commission proposed amendments to Rule 102(e) to set forth categories of conduct that would constitute "improper professional conduct." The amendments provided, among other things, that a finding of "improper professional conduct" could be made based on reckless conduct, as defined in the securities fraud context, see SEC v. Steadman, 967 F.2d 636, 641-42 (D.C. Cir. 1992); Sundstrand Corp. v. Sun Chem. Corp., 553 F.2d 1033, 1045 (7th Cir. 1977), cert. denied, 434 U.S. 875 ...