Release No. 34-39400 / December 4, 1997
ACCOUNTING AND AUDITING ENFORCEMENT
Release No. AAE-994 / December 4, 1997
ADMINISTRATIVE PROCEEDING
File No. 3-9500
ADMINISTRATIVE PROCEEDINGS IN THE MATTER OF KPMG PEAT MARWICK LLP
The Commission announced today that it has instituted public administrative proceedings to determine if KPMG Peat Marwick engaged in improper professional conduct and violated and caused violations of the federal securities laws by issuing an unqualified report on the 1995 year-end financial statements of a client from which it lacked independence.
According to the allegations of the Commissions Division of Enforcement and Office of the Chief Accountant:
In approximately January 1995, KPMG Peat Marwick organized and capitalized KPMG BayMark, a firm owned by Edward R. Olson and three others. KPMG Peat Marwick planned to use KPMG BayMark as a vehicle to engage in new lines of business, including the "corporate turnaround" business. Later in 1995, as part of a turnaround engagement, KPMG BayMark installed its principal Olson as the President and Chief Operating Officer of Porta Systems Corp., a financially troubled audit client of KPMG Peat Marwicks Long Island office.
When KPMG Peat Marwick audited Porta's 1995 year-end financial statements and prepared its audit report, KPMG Peat Marwick's financial and business relationships with its audit client Porta and with KPMG BayMark impaired KPMG Peat Marwick's independence from its audit client, in both fact and appearance. In particular, KPMG Peat Marwick lacked independence because: (1) KPMG Peat Marwick had loaned $100,000 to the President/COO of its audit client Porta; (2) KPMG Peat Marwick had capitalized the separate business owned by the President/COO of its audit client Porta; (3) KPMG Peat Marwick had capitalized the "affiliate" of its audit client Porta; (4) KPMG Peat Marwick was entitled to a percentage of the earnings, disposed inventory and restructured debt of its audit client Porta; and (5) by reason of their contractual ties and interdependence, KPMG Peat Marwick and KPMG BayMark should be considered a single entity for independence purposes.
Despite warnings from the staff of the Commissions Office of the Chief Accountant concerning independence issues arising from KPMG Peat Marwicks relationship with KPMG BayMark, KPMG Peat Marwick completed its audit of Porta's financial statements and issued its "Independent Auditors' Report," which represented that it had "conducted [its] audits in accordance with generally accepted auditing standards" ("GAAS"). This statement was false and misleading in that GAAS requires auditors to be independent of their audit clients both in fact and in appearance.
The Division of Enforcement and the Office of the Chief Accountant further allege that, by conducting an audit of Portas 1995 year-end financial statements and rendering an audit opinion thereon at a time it lacked independence from Porta, KPMG Peat Marwick, among other things: (1) rendered Portas 1995 annual report on Form 10-K materially false and misleading in that the financial statements contained therein were not, as represented and as required by Section 13(a)(2) of the Securities Exchange Act of 1934, audited by independent accountants, thus causing Porta to violate Section 13(a) of the Exchange Act and Rule 13a-1 thereunder; (2) directly violated Rule 2-02 of Commission Regulation S-X, which requires that auditors be independent of their audit clients; and (3) engaged in improper professional conduct under Rule 102(e)(1)(ii) of the Commission's Rules of Practice.
A hearing will be scheduled to determine whether the allegations against KPMG Peat Marwick are true and, if so, what remedial actions, if any, are appropriate.
Administrative Proceeding
File No. 3-9500
UNITED STATES OF AMERICA
Before the
SECURITIES AND EXCHANGE COMMISSION
December 4, 1997
_____________________________
In the Matter of ORDER INSTITUTING PROCEEDING
PURSUANT TO RULE 102(e) OF THE
KPMG PEAT MARWICK L.L.P., COMMISSIONS RULES OF PRACTICE
AND SECTION 21C OF THE SECURITIES
Respondent. EXCHANGE ACT OF 1934
_____________________________
I.
The Commission deems it necessary and appropriate in the public interest that this public administrative proceeding be instituted pursuant to Rule 102(e)(1)(ii) of the Commission's Rules of Practice and Section 21C of the Securities Exchange Act of 1934 ("Exchange Act"), to determine whether KPMG Peat Marwick L.L.P. ("KPMG Peat Marwick") engaged in improper professional conduct, directly violated Rule 2-02 of Regulation S-X and caused violations of Section 13(a) of the Exchange Act and Rule 13a-1 thereunder and, if so, what remedial actions or sanctions are appropriate under the circumstances of this case.
II.
After an investigation, the Division of Enforcement and the Office of the Chief Accountant ("OCA") allege:
1. This matter involves the failure of KPMG Peat Marwick to comply with established standards of auditor independence in connection with its audit of the 1995 year-end financial statements of Porta Systems Corp. ("Porta") and preparation of the related audit report.
.Relevant Entities and Person
2. KPMG Peat Marwick is an international accounting firm, with its executive offices in New York City.
3. KPMG BayMark L.L.C. ("KPMG BayMark") was at all relevant times a Delaware limited liability company with offices in New York City. It was owned equally by four individuals, one of whom was Edward R. Olson. KPMG BayMark was the parent holding company of KPMG BayMark Strategies L.L.C. ("KPMG BayMark Strategies") and KPMG BayMark Capital L.L.C. ("KPMG BayMark Capital").
4. KPMG BayMark Strategies was at all relevant times a Delaware limited liability company with offices in Vienna, Virginia. It was owned 51 percent by KPMG BayMark and 49 percent by two of KPMG BayMark's four owners. KPMG BayMark Strategies provided corporate recovery services to troubled companies.
5. KPMG BayMark Capital was at all relevant times a Delaware limited liability company with offices in New York City. It was owned 51 percent by KPMG BayMark and 49 percent by two of KPMG BayMarks four owners. KPMG BayMark Capital offered financial advisory and capital raising services and was registered with the Commission as a broker-dealer.
6. Edward R. Olson owned 25 percent of KPMG BayMark and 24.5 percent of KPMG BayMark Strategies. As part of a KPMG BayMark Strategies turnaround management engagement, Olson became the president and chief operating officer ("President/COO") of Porta.
7. Porta is a Delaware corporation with its principal place of business in Syosset, New York. Its stock is registered with the Commission pursuant to section 12(b) of the Exchange Act and traded on the American Stock Exchange. Porta develops, manufactures and markets telecommunications equipment and systems.
B.Summary
8. As described in detail below, in approximately January 1995, KPMG Peat Marwick organized and capitalized KPMG BayMark, a purportedly independent firm owned by Edward R. Olson and three others. KPMG Peat Marwick planned to use KPMG BayMark as a vehicle to engage in new lines of business, including the "corporate turnaround" business. Later in 1995, as part of a turnaround engagement, KPMG BayMark installed its principal Olson as the President/COO of Porta, a financially troubled audit client of KPMG Peat Marwicks Long Island office.
9. When KPMG Peat Marwick audited Porta's 1995 year-end financial statements and prepared its audit report, KPMG Peat Marwick's financial and business relationship with its audit client Porta and with KPMG BayMark impaired KPMG Peat Marwick's independence from its audit client, in both fact and appearance. In particular, KPMG Peat Marwick lacked independence because: (1) KPMG Peat Marwick loaned $100,000 to the President/COO of its audit client Porta; (2) KPMG Peat Marwick capitalized the separate business owned by the President/COO of its audit client Porta; (3) KPMG Peat Marwick capitalized the "affiliate" of its audit client Porta; (4) KPMG Peat Marwick was entitled to a percentage of the earnings, disposed inventory and restructured debt of its audit client Porta; and (5) by reason of their contractual ties and interdependence, KPMG Peat Marwick and KPMG BayMark should be considered a single entity for independence purposes.
10. Despite warnings from the Commissions OCA staff concerning independence issues arising from its relationship with KPMG BayMark, KPMG Peat Marwick completed its audit of Porta's 1995 year-end financial statements and issued its "Independent Auditors' Report," dated March 22, 1996, which represented that it had "conducted our audits in accordance with generally accepted auditing standards" ("GAAS"). Porta incorporated KPMG Peat Marwick's report as part of its 1995 annual report on Form 10-K, filed with the Commission on April 2, 1996.
.KPMG Peat Marwicks Violation of the Independence Rules
11. Financial statements filed with the Commission must, under Exchange Act ..12 and 13(a)(2), be certified by "independent" accountants. SEC Regulation S-X, which sets forth rules regarding the form and content of financial statements filed under the federal securities laws, states that "[t]he Commission will not recognize any certified public accountant or public accountant as independent who is not in fact independent" (Rule 2-01(b)).
12. The Commission and GAAS view both the fact and the appearance of auditor independence as essential for investors to have confidence that an audit represents a wholly unbiased review of management's presentation of the corporate financial picture. Regulation S-X provides that, in assessing an auditor's independence, the SEC "will give appropriate consideration to all relevant circumstances, including evidence bearing on all relationships between" the auditor and the audit client (Rule 2-01(c)). Regulation S-X further requires (Rule 2-02) the accountant's report to state whether the audit was conducted in accordance with GAAS, and GAAS requires auditors to avoid situations that may lead others to doubt their independence.
1.KPMG Peat Marwick Lacked Independence Because It Loaned $100,000 to the President/COO of Its Audit Client Porta
13. At the time it audited Porta's 1995 financial statements, KPMG Peat Marwick had a $100,000 loan outstanding to Portas President/COO, Edward Olson. In making this loan, KPMG Peat Marwick contractually bound Olson to invest the funds in KPMG BayMark.
14. Olson was the principal decision-maker at Porta. He signed Porta's annual report on Form 10-K, containing the financial statements certified by KPMG Peat Marwick, on April 1, 1996 as "President" of Porta. Olson had also signed Portas management representation letter to KPMG Peat Marwick in connection with the audit of Porta's 1995 financial statements. In this letter, Olson took responsibility "for the fair presentation in the consolidated financial statements of [Portas] financial position, results of operations, and cash flows in conformity with generally accepted accounting principles."
15. As Porta was then in financial difficulties and attempting a turnaround, Olsons particular mandate from Porta was broad. He was specifically required to put in place a management team that would "report directly" to him, manage the companys operations, develop a business plan for Porta, restructure the company's business, evaluate personnel, develop reward and compensation systems, and "take whatever actions are necessary to enable the Company to survive."
16. Regulation S-X states that, during the period of professional engagement or as of the date of an audit report, an auditor will not be considered independent if he or she had "any direct financial interest or any material indirect financial interest" in the audit client (Rule 2-01(b)(1), emphasis supplied). In this regard, an auditor's independence will be jeopardized by "[d]irect and material indirect business relationships ... with persons associated with the client in a decision-making capacity, such as officers" as this would "cause the accountant to lose the appearance of objectivity and impartiality in the performance of his audit" (SEC Codification of Financial Reporting Policies, .602.02(g) (emphasis supplied)). And in particular, an auditor may not make loans to management personnel of the audit client (AICPA Ethics Ruling 101-1).
17. KPMG Peat Marwick's $100,000 loan to Olson was a direct financial interest in Porta, because Olson was Portas President/COO. As a result of its loan to Olson, KPMG Peat Marwick was not independent of Porta when it conducted its audit and issued its audit report, under Regulation S-X (Rule 2-01(b)(1)).
2.KPMG Peat Marwick Also Lacked Independence Because It Capitalized the Separate Business Owned by the President/COO of Its Audit Client Porta
18. KPMG Peat Marwicks financial ties to Olson, the President/COO of its audit client, were not limited to the $100,000 loan referred to above. In addition, KPMG Peat Marwick provided virtually all of the start-up capital for KPMG BayMark, a separate business which was 25% owned by this officer of an audit client.
19. By far the largest portion of KPMG Peat Marwicks capitalization of Olsons separate business took the form of a five-year revolving line of credit extended to KPMG BayMarks two operating subsidiaries. KPMG Peat Marwicks original credit extension was in the amount of $4.6 million, but over time the balance grew to over $8 million. No principal repayment was required (absent certain specified events) until January 1, 2000. In effect, this amount represented the funding by KPMG Peat Marwick of the start-up losses of Olsons firm.
20. Olsons firms ability to repay the credit extended by KPMG Peat Marwick depended, in part, on the receipt of funds from Porta. To secure repayment of this debt, KPMG Peat Marwick took a security interest in the accounts receivable, contracts and all of the other assets of Olsons firm. This included the firms receivables from and its contract with Porta.
21. Additionally, KPMG Peat Marwick further capitalized Olsons separate business by extending $100,000 loans to each of Olsons three partners. These loans were similar to the $100,000 loan that KPMG Peat Marwick made directly to Olson. As with Olson, the other recipients of these individual loans were contractually obligated to use the borrowed funds to capitalize Olsons firm.
22. Thus, KPMG Peat Marwick provided virtually all of Olsons firms initial start-up capital, provided the equity contributions of its principals, and funded its operations and losses. As with the direct loan to Olson, KPMG Peat Marwicks $8 million capitalization of Olsons firm constituted a direct, or material indirect, business relationship with an officer of an audit client. For this additional reason, KPMG Peat Marwick was not independent of Porta when it conducted its audit of Porta and issued its audit report.
3.KPMG Peat Marwick Also Lacked Independence Because It Fully Capitalized the "Affiliate" of Its Audit Client Porta
23. KPMG Peat Marwicks $8 million capitalization of KPMG BayMarks two operating subsidiaries, and particularly its capitalization of KPMG BayMark Strategies, meant that KPMG Peat Marwick lacked independence for an additional reason. Regulation S-X (Rule 2-01(b)(1)) prohibits an audit firm from any direct financial interest or any material indirect financial interest in an "affiliate" of its audit client. Regulation S-X (Rule 1-02(b)) defines "affiliate" to include an entity that "controls" another entity.
24. Here, KPMG BayMark Strategies was an "affiliate" of Porta because it "controlled" Porta during the audit period. Under the October 2, 1995 "turnaround" agreement, KPMG BayMark Strategies was, among other things, to "take whatever emergency actions" were needed for Portas survival; "restructure the business around a plan we develop, and manage the Company accordingly"; "put in place a management team"; and "establish control of the Companys cash flow." KPMG BayMark Strategies representative Olson was installed as Portas President/COO, and Portas managers were to "report directly" to him. Under Regulation S-X, this control made KPMG BayMark Strategies an "affiliate" of Porta.
25. Just as KPMG Peat Marwick could not capitalize its audit client Porta, so also it could not capitalize KPMG BayMark Strategies, an affiliate of its audit client. As a result of its capitalization of Portas affiliate, KPMG Peat Marwick was not independent of Porta when it conducted its audit and issued its audit report, under Regulation S-X (Rule 2-01(b)(1)).
4.KPMG Peat Marwick Also Lacked Independence Because It Was Entitled to a Percentage of the Earnings, Disposed Inventory and Restructured Debt of its Audit Client Porta
26. Under its October 2, 1995 "turnaround" agreement, Porta was required to pay KPMG BayMark Strategies a management fee of $250,000. In addition, the agreement required Porta to pay a contingent "success fee" consisting of: (i) five percent of Porta's quarterly earnings before interest and taxes during the turnaround engagement and for 3 years after the end of the engagement; (ii) one percent of total excess Porta inventory bartered, liquidated or otherwise disposed of; and (iii) one-half percent of total Porta debt restructured or modified, excluding debentures.
27. KPMG BayMark in turn was required, under a January 1, 1995 agreement, to pay five percent of its quarterly consolidated fee income -- including KPMG BayMark Strategies income from Porta -- to KPMG Peat Marwick. This arrangement gave KPMG Peat Marwick a contingent interest in the earnings, disposed inventory and restructured debt of its audit client Porta.
28. As Portas financial performance would improve, greater fees would flow to KPMG BayMark and KPMG Peat Marwick. And the turnaround agreement gave KPMG Peat Marwick the ability to perpetuate itself as the auditor of the financial statements reflecting Portas financial performance. Specifically, the agreement allowed Porta to continue "existing relationships" with its accountants -- KPMG Peat Marwick -- but required KPMG BayMark Strategies consent to retain new accountants.
29. KPMG Peat Marwicks contingent right to receive revenues based on Portas success put KPMG Peat Marwick in a direct, or material indirect, business relationship with an audit client. For this additional reason, KPMG Peat Marwick was not independent of Porta when it conducted its audit and issued its audit report.
5.KPMG Peat Marwick Also Lacked Independence Because KPMG Peat Marwick and KPMG BayMark Should Be Considered a Single Entity for Independence Purposes
30. As described below, KPMG Peat Marwick and KPMG BayMark, while legally organized as separate entities, were structured to operate as a single entity and should be considered as such in assessing KPMG Peat Marwicks independence. For this reason as well, KPMG Peat Marwick violated the independence rules by auditing Porta (i) while KPMG BayMarks Olson ran Porta as its President/COO, and (ii) while KPMG BayMark had direct and material indirect financial and business relationships with Porta.
31. In early 1994, KPMG Peat Marwick's Corporate Transaction Services Department evaluated the firms ability to compete in the potentially lucrative investment banking and corporate recovery markets. KPMG Peat Marwick concluded that it could not compete directly in these markets due to independence rules preventing auditors from accepting contingent fees from audit clients, participating in the management of audit clients, or providing broker-dealer services to audit clients. Nevertheless, KPMG Peat Marwick decided that it could participate in these areas through a "strategic alliance" with an entity -- ultimately named KPMG BayMark -- that KPMG Peat Marwick would establish and capitalize, but in which it would hold no equity interest.
32. A promotional video produced for KPMG Peat Marwick partners underscored how closely it expected to operate with KPMG BayMark. KPMG Peat Marwick estimated that KPMG BayMark would, within four or five years, bring KPMG Peat Marwick $250 million in royalties and contract service fees annually. The video stated that, although not legally obligated to use KPMG Peat Marwick staff in providing client services, KPMG BayMark would have "powerful business reasons" to do so. The video stated specifically that, if KPMG BayMark should utilize professionals from some other source, KPMG Peat Marwick could eliminate KPMG BayMark's primary source of business by declining to make further client referrals. Additionally, the video asserted that the "recognition and trust" inspired by the KPMG name would bring "value to the table."
33. KPMG Peat Marwick and KPMG BayMark formally established their professional inter-relationship and economic dependence in a five-year agreement, dated January 1, 1995. This agreement structured their relationship in such a way that they operated functionally as a single entity:
.KPMG BayMark was required to use the designation "KPMG" as part of its own corporate name (Agreement .1.2(a)). It was also required to use the KPMG logo "in close proximity" to the KPMG BayMark name (.1.2(c)), and to use the phrase "A Strategic Alliance of KPMG Peat Marwick" (.1.2(d)).
.KPMG Peat Marwick had the right to approve or reject KPMG BayMark's policy and procedures manual, and specifically had the right to approve or reject KPMG BayMark's engagement procedures and client acceptance procedures (.2.4).
.KPMG Peat Marwick had the right to approve or reject KPMG BayMark's advertising materials (.1.2(c)). KPMG BayMark was not allowed to "publicly or privately disseminate" any promotional materials or advertising without KPMG Peat Marwick's prior approval (.4.5). KPMG Peat Marwick was to assist KPMG BayMark in developing promotional materials and advertising (.4.5) and in establishing a marketing and communications program acceptable to KPMG Peat Marwick (.2.6).
.KPMG BayMark was required to obtain KPMG Peat Marwick's "express written consent" before entering into any "joint venture, partnership or similar arrangement with any person or entity" (.5.2).
.KPMG Peat Marwick agreed to make available to KPMG BayMark "credit facilities in an aggregate amount of up to $4,600,000" (.2.7). (Ultimately KPMG Peat Marwick increased this amount to over $8 million.)
.KPMG Peat Marwick also agreed to loan $100,000 to each of the four KPMG BayMark principals for them to make their equity contributions to KPMG BayMark. The loans were to be "on a non-recourse basis" and secured only by the principals' equity in KPMG BayMark (.2.7).
.The parties contemplated that for an hourly fee (.2.3), KPMG Peat Marwick would provide financial analysis and other support services to KPMG BayMark (.2.2) relating to KPMG BayMark's business, which was defined as including "investment banking, merchant banking, corporate recovery, crisis management, asset management and related financial services" (.2.1).
.Additionally, KPMG BayMark agreed to pay KPMG Peat Marwick "5% of [KPMG BayMark's] quarterly consolidated fee income ... less any fees payable to affiliates or subsidiaries of KPMG, any referral, and brokerage fees payable to any party" (.3.1). KPMG BayMark was required to pay this percentage of its income to KPMG Peat Marwick for three years, with negotiated readjustments every two years following (.3.2).
.KPMG Peat Marwick was required to "assist in developing" KPMG BayMark's business from "sources" at KPMG Peat Marwick (.4.7). And KPMG BayMark was required "to assist in developing" KPMG Peat Marwick's "financial analysis and support services business" through "sources" at KPMG BayMark (.2.8).
.KPMG Peat Marwick had the right to periodically inspect the books and records and the properties and assets of KPMG BayMark and its subsidiaries (.2.5).
.The audited financial statements of KPMG BayMark were to be addressed by its auditors to both KPMG Peat Marwick and KPMG BayMark (.3.4). And KPMG Peat Marwick had the specific right to do its own audit of KPMG BayMark's books and records to determine that fees owed to KPMG Peat Marwick had been accurately determined and paid (.3.3).
34. This relationship of intertwined business dealings and economic interdependence was approved at the highest levels in both firms. The agreement was signed on behalf of KPMG Peat Marwick by the Chairman of the firm, and on behalf of KPMG BayMark by two of its four principals.
35. KPMG Peat Marwick and KPMG BayMark engaged in a common business enterprise. Indeed, BayMark was expressly conceived as a surrogate for KPMG Peat Marwick to use to staff and profit from engagements it realized it could not undertake. They should be viewed as a single entity for purposes of evaluating KPMG Peat Marwick's independence during the audit and at the time it issued a report on Porta's 1995 consolidated financial statements.
36. As a single entity with KPMG BayMark for independence purposes, KPMG Peat Marwick violated the independence rules by auditing Porta while KPMG BayMarks Olson ran Porta as its President/COO. Regulation S-X (Rule 2-01(b)(2)) prohibits an audit firm "member" from being an officer of an audit client either as of the date of the auditor's report or during the period covered by the financial statements. "Member" is defined to include "any professional employee [of the audit firm] involved in providing any professional service" to the audit client. As a principal of KPMG BayMark, Olson was a "member" of KPMG Peat Marwick under Rule 2-01(b)(2), given that KPMG Peat Marwick and KPMG BayMark should be viewed as a single entity for purposes of evaluating KPMG Peat Marwick's independence. Because Olson was the President/COO of Porta, KPMG Peat Marwick was not independent under Rule 2-01(b)(2).
37. Also as a single entity with KPMG BayMark for independence purposes, KPMG Peat Marwick separately violated the independence rules by auditing Porta while KPMG BayMark had a direct and material indirect financial and business relationship with Porta. Regulation S-X (Rule 2-01(b)(1)) prohibits an audit firm member from having a direct or material indirect financial or other business interest in the audit client during the period of the auditors professional engagement. As described above, KPMG BayMark had a substantial interest in Porta arising from the October 2, 1995 turnaround agreement. Because KPMG BayMark had this interest in Porta, KPMG Peat Marwick was not independent under Rule 2-01(b)(1).
38. By conducting an audit of Portas 1995 year-end financial statements and rendering an audit opinion thereon at a time it lacked independence from Porta, KPMG Peat Marwick, inter alia: (1) rendered Portas 1995 annual report on Form 10-K materially false and misleading in that the financial statements contained therein were not, as represented and as required by Section 13(a)(2) of the Exchange Act, audited by independent accountants, thus causing Porta to violate Section 13(a) of the Exchange Act and Rule 13a-1 thereunder; (2) directly violated Rule 2-02 of Commission Regulation S-X, which requires that auditors be independent of their audit clients; and (3) engaged in improper professional conduct under Rule 102(e)(1)(ii) of the Commission's Rules of Practice.
D.KPMG Proceeded With Its Audit of Porta (i) Without Disclosing Olsons Role as President/COO of Porta in Ongoing Discussions With OCA, and (ii) Without Satisfying OCAs Conditions for Approval of the Relationship With KPMG BayMark
39. In late 1995, representatives of KPMG Peat Marwick engaged in discussions with the Commissions OCA staff regarding KPMG Peat Marwicks independence, in view of its actual and projected relationship with KPMG BayMark. For the reasons stated above, the fact that Olson on October 2, 1995 had become the President/COO of Porta, a KPMG Peat Marwick audit client, was obviously a crucial fact in assessing whether KPMG Peat Marwick was independent of the audit client. Yet as KPMG Peat Marwick was performing its Porta audit in early 1996, KPMG Peat Marwick still had not disclosed Olsons position to the Commissions OCA staff in ongoing discussions concerning KPMG Peat Marwicks independence.
40. Senior members of KPMG Peat Marwicks management contemporaneously recognized Olsons role at Porta as potentially an "extreme embarrassment" for KPMG Peat Marwick. A December 5, 1995 internal KPMG Peat Marwick email circulated among senior officials of the firm states:
"We have been asked by a KPMG office whether BayMark Strategies (Ed Olsen [sic]) may act as interim president, for 15 months ($10,000 a month), for a public audit client. The purpose is to turn around the companies [sic] financial condition and develop a new strategy. KPMG will continue to be the auditors during the turn around period and the original Chairman/CEO and a new CFO from industry will continue their roles.
"[Two partners in KPMG Peat Marwicks Department of Professional Practice] believe this situation is not appropriate. They believe if there is ever an audit failure in this type of situation, where we are indirectly getting representations from KPMG BayMark, we will be extremely embarrassed as a firm. In THEORY, they believe the situation should be able to work if Strategies is truly independent and not controlled by KPMG, but the form is such that it does not work.
"... A no answer has obvious impacts to the financial success of the strategic alliance with BayMark Strategies and spill over effects to BayMark Capital transactions with public audit clients." (emphasis supplied)
41. However even without disclosure of the critical fact that Olson had become Portas President/COO, the Commissions OCA staff had already questioned KPMG Peat Marwicks independence in auditing companies that were clients of KPMG BayMark. A December 29, 1995 internal email circulated among several KPMG Peat Marwick senior partners admitted that the Commissions Chief Accountant -- still unaware of Olsons position with Porta -- had established four separate conditions that KPMG Peat Marwick would have to satisfy to avoid an independence problem: (i) remove the KPMG initials from KPMG BayMark's name and the names of its subsidiaries; (ii) eliminate any form of royalty fee paid to KPMG Peat Marwick by KPMG BayMark; (iii) obtain repayment of loans made by KPMG Peat Marwick to KPMG BayMark officers; (iv) obtain the determination of the Commission's Division of Market Regulation that KPMG Peat Marwick need not register as a broker-dealer or be listed as controlling a broker-dealer in filings with the Commission. The email acknowledged that the Chief Accountant could not come to "a final conclusion" on this matter before discussions with others at the Commission.
42. The December 29, 1995 KPMG Peat Marwick email also confirmed advice from the Commissions Chief Accountant concerning ongoing engagements. The email states that the matter would have to be "resolved quickly" on the basis discussed in order for KPMG BayMark to "be able to complete the engagements in process without jeopardizing our [KPMG Peat Marwicks] independence with respect to our SEC audit clients."
43. In a January 31, 1996 letter, the Commissions Chief Accountant confirmed to KPMG Peat Marwick the four conditions stated in the December 29, 1995 email and explicitly stated that until these conditions were met "the independence issues ... are, and will remain, open." A senior KPMG Peat Marwick official replied by letter that "[o]ur respective recollections [as to OCAs prior independence advice] are generally consistent."
44. Yet in completing its Porta audit and certifying Porta's financial statements on March 22, 1996, KPMG Peat Marwick met absolutely none of the conditions specified by the Commission's Chief Accountant in late 1995 and memorialized in KPMG Peat Marwicks December 29, 1995 email. Nor were these conditions met at the time Porta filed its Form 10-K containing the financial statements with the Commission on April 2, 1996.
45. Upon learning for the first time after the filing of the Porta Form 10-K (i) that KPMG BayMarks principal Olson was also Portas President/COO, and (ii) that KPMG Peat Marwick had proceeded with the Porta audit without making the specific structural changes specified by the Chief Accountant in 1995, the OCA staff advised KPMG Peat Marwick on May 20, 1996 that it did not view KPMG Peat Marwick as independent with respect to the Porta audit. The Commissions Chief Accountant formally advised Portas chairman of this fact by letter dated June 21, 1996:
"It has come to the attention of the staff that during the most recent fiscal year, Porta System's President and Chief Operating Officer, Edward R. Olson, was a joint owner of KPMG Baymark and its subsidiaries. In the opinion of the staff, the existence of financial, operating and other relationships among Mr. Olson, KPMG Baymark and KPMG Peat Marwick, adversely impacts KPMG Peat Marwick's independence with respect to Porta Systems. For this reason, you are advised that the financial statements of Porta Systems for the year ended December 31, 1995 that are filed in the Form 10-K are considered to be unaudited and not in compliance with the requirements of the federal securities laws and Rule 2-01 of Regulation S-X."
46. This determination by OCA made it necessary for Porta to have its financial statements re-audited by another firm.
47. For the reasons stated above, KPMG Peat Marwick failed to comply with Rule 2-01 of Regulation S-X, and hence its independence was impaired, with respect to its audit of Porta's 1995 consolidated financial statements and its audit report thereon. As a result of KPMG Peat Marwick's lack of independence, Porta's 1995 Form 10-K did not comply with Section 13(a) of the Exchange Act and Rule 13a-1 thereunder, which require that all annual reports on Form 10-K contain financial statements certified by independent accountants.
48. By the conduct described above, KPMG Peat Marwick engaged in improper professional conduct under Rule 102(e), directly violated Rule 2-02 of Regulation S-X, and caused violations of Section 13(a) of the Exchange Act and Rule 13a-1 thereunder.
III.
In view of the allegations made by the Division of Enforcement and the Office of the Chief Accountant, the Commission deems it necessary and appropriate in the public interest that public administrative proceedings be instituted pursuant to Rule 102(e)(1)(ii) of the Commission's Rules of Practice and Section 21C of the Exchange Act to determine:
A.Whether the allegations set forth in Section II above are true and to afford the Respondent an opportunity to establish any defense to such allegations; and
B.What remedial actions or sanctions, if any, against the Respondent are appropriate in the public interest pursuant to Rule 102(e) of the Commission's Rules of Practice and Section 21C of the Exchange Act.
IV.
IT IS HEREBY ORDERED that a public hearing for the purpose of taking evidence on the questions set forth in Section III hereof shall be convened not earlier than 30 days and not later than 60 days from service of this Order, at a date, time and place to be fixed, and before an Administrative Law Judge to be designated by further order as provided by Rule 200 of the Commission's Rules of Practice, 17 C.F.R. .201.200.
IT IS FURTHER ORDERED that Respondent shall file an Answer to the allegations contained in this Order within 20 days after service upon it of said Order as provided by Rule 220 of the Commission's Rules of Practice. 17 C.F.R. .220. If Respondent fails to file an Answer within the time provided or fails to appear at a hearing after being duly notified, Respondent will be deemed in default and the proceedings may be determined against such party upon consideration of this Order, the allegations of which may be deemed to be true as provided by Rules 220 and 310 of the Commission's Rules of Practice. 17 C.F.R. .201.220 and 201.310.
This Order shall be served upon the named Respondent personally or by certified mail forthwith.
In the absence of an appropriate waiver, no officer or employee of the Commission engaged in the performance of investigative or prosecutorial functions in this or any factually related proceedings will be permitted to participate or advise in the decision upon this matter, except as a witness or counsel in proceedings held pursuant to notice. Because this proceeding is not "rule making" within the meaning of Section 4(c) of the Administrative Procedure Act, it is not deemed subject to the provisions of that section delaying the effective date of any final Commission action.
By the Commission.Jonathan G. Katz
Secretary