United States Court of Appeals
FOR THE DISTRICT OF COLUMBIA CIRCUIT
Argued November 23, 2004 Decided February 8, 2005
No. 04-1047
JAMES THOMAS MCCURDY,
PETITIONER
v.
SECURITIES AND EXCHANGE COMMISSION,
RESPONDENT
On Petition for Review of an Order of the
Securities and Exchange Commission
Charles M. Carberry argued the cause and filed the briefs
for petitioner.
Michael A. Conley, Senior Special Counsel, Securities and
Exchange Commission, argued the cause for respondent. With
him on the brief were Giovanni P. Prezioso, General Counsel,
and Eric Summergrad, Deputy Solicitor. Mark R. Pennington,
Assistant General Counsel, entered an appearance.
Before: EDWAR D S, SENTELLE, and RANDOLPH, Circuit
Judges.
Opinion for the Court filed by Circuit Judge RANDOLPH.
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RANDOLPH, Circuit Judge: The Securities and Exchange
Commission suspended James T. McCurdy for one year after
finding that he recklessly departed from generally accepted
auditing standards (“GAAS”) in his audit of a mutual fund’s
1998 financial statements. The case centered on the treatment
of a single receivable on the balance sheet of JWB Aggressive
Growth Fund, a diversified, open-end management investment
company. McCurdy’s arguments are that the Commission
improperly applied GAAS, that its finding of recklessness was
not supported by substantial evidence, and that it exceeded its
authority in imposing a one year suspension.
I.
John W. Bagwell founded JWB Aggressive Growth Fund
and registered it with the Commission in 1995. Bagwell served
as the fund’s chief executive officer and was a member of its
board of trustees. JWB Investment Advisory & Research, Inc.,
Bagwell’s sole proprietorship, was the investment advisor of the
fund, its only client. (We will refer to JWB Investment, in its
capacity as the fund’s advisor, as Bagwell.) At its height, the
fund had 60 investors and assets of $456,000. The fund is now
defunct.
When the fund began operations in 1996, Bagwell
voluntarily agreed to waive any management fees and to
reimburse the fund for its expenses exceeding 2.35% of the
fund’s assets. In the years that followed, the fund paid the
expenses when incurred and Bagwell reimbursed it at the end of
the year for the amount reported in the fund’s “Due From
Advisor” account. The arrangement was terminable at will, with
advance notice to the board of trustees. Until the year ending
December 31, 1998, Bagwell covered all such expenses. At the
end of 1997, the unpaid balance in the “Due From Advisor”
account was $3,783. During 1998, the fund’s expenses grew to
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approximately $100,000. By year end, the “Due From Advisor”
account had an outstanding balance of about $80,000, after an
approximately $20,000 offset for organizational expenses due to
Bagwell.
On November 20, 1998, Bagwell sent a letter to the board,
outlining a proposed repayment plan, with monthly payments of
at least $5,000 a month, beginning that month and continuing
until the receivable was repaid. At a meeting of the five-
member board on December 3, 1998, Bagwell gave notice of his
intention to withdraw from the reimbursement agreement. By
this time, Bagwell had already missed his proposed first
payment. He informed the board that it would be “extremely
difficult” for him to pay off the receivable by year’s end. The
four other board members reviewed Bagwell’s income statement
and balance sheet, which he had provided at the meeting.
Satisfied of his ability to pay, they agreed to allow him until
June 1999 to repay the $80,000 balance on the payment terms he
had proposed.
At the same meeting, the board followed Bagwell’s
recommendation and retained a new auditor, McCurdy &
Associates CPAs, Inc., an accounting firm specializing in
mutual funds. The firm’s founder, James Thomas McCurdy,
had been a certified public accountant licensed to practice in
Ohio since 1980. In light of the fund’s ongoing cost-cutting
efforts, McCurdy pledged in his engagement letter to keep fees
and expenses to a minimum in his audit of the year ending
December 31, 1998.
McCurdy completed his field work on the audit in January
1999, and submitted a report dated January 25. By that time,
Bagwell had missed his first two payments under the board-
approved schedule and was at least $10,000 in arrears.
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McCurdy’s report accompanied the fund’s filings with the
Commission on March 8, 1999.
The fund’s audited financial statements showed $340,484
in assets, of which $83,399 represented the “Due From Advisor”
receivable. In light of the fact that twenty-five percent of the
fund’s assets depended on the collectibility of this related-party
account, McCurdy recognized that the receivable was material
and would require special scrutiny. In analyzing the probability
of collecting the receivable, he relied on the board’s decision to
allow Bagwell time to repay his obligation. He read the minutes
of the meeting. He also spoke to the fund’s attorney, who was
present at the meeting. But he did not speak with any board
member or with Bagwell (except to confirm that the receivable
existed), and he neither examined nor tested the financial data
Bagwell presented to the board. McCurdy also relied on the
February 1999 renewal of the fund’s bond by Gulf Insurance
Company, although he took no steps to ascertain the basis for
the company’s decision. And he considered Bagwell’s history
of making timely payments in previous years, as well as the fact
that the receivable could no longer continue to grow because the
reimbursement arrangement had terminated. On the basis of this
information, McCurdy concluded that the receivable was
probably collectible and that it properly could be treated as an
asset under generally accepted accounting principles.
The Commission charged McCurdy with improper
professional conduct in violation of Rule 102(e) of the
Commission’s Rules of Practice, citing his failure to obtain
sufficient competent evidence to support his conclusion
regarding the receivable, his failure to render an accurate report,
and his lack of professional skepticism and due professional
care. After an evidentiary hearing, an administrative law judge
concluded that while McCurdy’s audit of the receivable did not
comport with GAAS, his conduct did not constitute reckless or
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highly unreasonable behavior. The Commission disagreed,
finding McCurdy’s audit both reckless and highly unreasonable.
It therefore suspended McCurdy from practicing before the
Commission for one year.
II.
Information is the lifeblood of the market. For the market
to operate efficiently -- indeed, for it to operate at all --
information must have some measure of reliability. Investor
confidence is bolstered by the knowledge that public financial
statements have been subjected to the rigors of independent and
objective investigation and analysis. See, e.g., AMERICAN
I NSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS (“AICPA”),
CODE OF PROFESSIONAL CONDUCT § 53, available at
http://www.aicpa.org; VINCE N T M. O’R EILLY ET AL.,
MONTGOMERY’S AUDITING 13-14 (11th ed. 1990). Independent
auditors therefore must exercise reasonable diligence in
reviewing financial statements. See AICPA, CODIFICATION OF
STATEMENTS ON AUDITING STANDARDS (“AU”) § 230.01
(1998). Because it is not possible to give each transaction the
fullest scrutiny, professional auditing standards have come to
recognize, through decades of experience, particular factors that
arouse suspicion and call for focused investigation. These
factors are the so-called “red flags” for which all auditors are
trained to remain alert. See Howard v. SEC, 376 F.3d 1136,
1149 (D.C. Cir. 2004) (citing Graham v. SEC, 222 F.3d 994,
1006 (D.C. Cir. 2000), and Wonsover v. SEC, 205 F.3d 408, 411
(D.C. Cir. 2000)).
Among transactions calling for close inspection are related-
party transactions, including transactions between a company
and its officers or directors. Such dealings are viewed with
extreme skepticism in all areas of finance. See, e.g., 17 C.F.R.
§ 210.4-08(k)(1) (one of many disclosures of related-party
6
transactions required by the Commission in the securities
context); Gordon v. Comm’r, 85 T.C. 309, 326-27 (1985)
(explaining “heightened” skepticism of the form related-party
transactions). The reason for this is apparent: Although in an
ordinary arms-length transaction, one may assume that parties
will act in their own economic self-interest, this assumption
breaks down when the parties are related. A company that
would perform a thorough credit-risk assessment before
extending a loan might not do so if the loan were to one of its
officers or directors. Accordingly, GAAS explicitly recognize
the need for particular care in the auditor’s examination of
material related-party transactions. AICPA, AU § 334.
In response to the inherently suspicious nature of such
transactions, the AICPA has identified particular sources of
information to which an auditor should turn for assurance
regarding material outstanding balances associated with related-
party transactions: “audited financial statements, unaudited
financial statements, income tax returns, and reports issued by
regulatory agencies, taxing authorities, financial publications, or
credit agencies.” AICPA, AU § 334.10(e). McCurdy took no
steps to obtain or consult any of these sources with regard to this
receivable. The question then is whether, in view of the
information upon which he did rely, the Commission was
warranted in finding that he lacked sufficient information to
form a reasoned judgment about the receivable’s collectibility.
A.
A basic guideline of field work requires auditors to form
their opinions on the basis of “[s]ufficient competent evidential
matter,” “obtained through inspection, observation, inquiries,
and confirmations.” AICPA, AU § 326.01. In considering the
evidence upon which McCurdy relied, the Commission properly
disregarded what was not competent. The Commission found,
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for instance, that Gulf Insurance Company’s renewal of the
fund’s bond in February 1999 could not support a reasonable
judgment that the receivable was collectible. The bond covered
“Uncollectible Items,” with a limit of liability of $25,000. The
record does not establish whether, at the time, Gulf was aware
of the status of the receivable. The Commission believed that
Gulf had only the fund’s 1997 financial statements, apparently
because the 1998 financial statements listing the receivable were
not filed with the Commission until March. In re McCurdy,
Exchange Act Release No. 34-49182, 2004 WL 210606
(“Comm’n Op.”), at *4, *6 (Feb. 4, 2004). In any case,
McCurdy could not have known whether Gulf investigated the
receivable in deciding to renew the bond. He did not contact
Gulf or otherwise attempt to ascertain the reason for Gulf’s
decision; his inference of support for the collectibility of the
receivable amounted to pure speculation.
The Commission also properly rejected McCurdy’s reliance
on the size of the receivable. McCurdy viewed $83,399 as not
“inherently large.” Id. at *7. As compared to what? Bagwell
must have thought it a large sum; at the board meeting, he told
the trustees that it would be “extremely difficult” for him to
come up with that amount of money by the end of 1998. What
matters under GAAS is that the receivable comprised a quarter
of the fund’s assets, which made it important for an independent
auditor to examine carefully whether Bagwell could and would
repay the balance on time. For similar reasons, the Commission
refused to give any credit to McCurdy’s assertion that the
receivable was probably collectible because it would not get any
larger in 1999. Id. Like the Commission, we cannot see how
this makes it more likely that the fund would collect the balance
remaining at the end of 1998.
After discounting this evidence, two sources of support for
McCurdy’s conclusion remain: Bagwell’s history of payment
8
in prior years, and the decision of the board of trustees to extend
Bagwell’s repayment period. Bagwell’s previous payments are
only minimally instructive, in light of the fact that the 1998
receivable dwarfed the prior balances. In addition, as the
Commission stated, “[w]hile a history of default would have
been a source of concern, the lack of such a history does not
establish probable collectibility on these facts.” Id. That leaves
the decision of the board, to which McCurdy gave “substantial”
weight in forming his opinion. Id. at *5. The most glaring
problem with McCurdy’s reliance on this fact is that he
considered only the vague and narrow snapshot offered by the
official minutes of the December 3 meeting, which consisted of
the following two sentences:
The Board then questioned Mr. Bagwell at length
concerning the financial condition of the Adviser, the
Adviser’s ability to pay off the account in a reasonable
time period, and the sources of income available to the
Adviser to pay off such sums. The Adviser presented a
balance sheet and income statement to the Board and
demonstrated, to the satisfaction of the Board, that the
Adviser would be able to pay off the account not later
than June of 1999.
Neither the reliability of Bagwell’s balance sheet nor his
financial condition at the time can be gleaned from these
statements. Collection of the debt depended on both. Yet
McCurdy took no steps to investigate. The Commission
determined, with ample support in the record, that the evidence
McCurdy had before him at the conclusion of his audit was
insufficient to support his conclusion that the receivable was
probably collectible. 15 U.S.C. § 78y(a)(4); Steadman v. SEC,
450 U.S. 91, 97 n.12 (1981).
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B.
McCurdy maintains that his actions fell within the bounds
of auditor judgment as contemplated by GAAS. He points to
AU § 326.22, which states that the “amount and kinds of
evidential matter required to support an informed opinion are
matters for the auditor to determine in the exercise of his or her
professional judgment after a careful study of the circumstances
in the particular case.” Speaking of judicial discretion, Chief
Justice Marshall observed that such choices are not left to a
court’s “inclination, but to its judgment; and its judgment is to
be guided by sound legal principles.” United States v. Burr, 25
F. Cas. 30, 35 (C.C. Va. 1807). To paraphrase, an auditor must
exercise, not his “inclination,” but his “professional judgment”
and that judgment must be “guided by sound” auditing
principles, among which are a “thorough . . . search for
evidential matter,” AU § 326.23, and an “attitude that includes
a questioning mind and a critical assessment of audit evidence,”
AU § 230.07. The Commission’s conclusion that McCurdy was
derelict in performing these and other auditing functions is
amply supported.
McCurdy’s departures from GAAS fell into two basic
categories. He formed an opinion on the basis of insufficient
evidence, and he failed to obtain additional evidence that might
properly have supported an opinion. In reaching its finding of
recklessness, the Commission focused on errors of the latter
type. Under SEC Rule 102(e), recklessness is “not merely a
heightened form of ordinary care,” but rather an “extreme
departure from the standards of ordinary care, . . . which
presents a danger of misleading buyers or sellers that is either
known to the [actor] or is so obvious that the actor must have
been aware of it.” 63 Fed. Reg. 57,164, 57,167 (Oct. 26, 1988)
(quoting SEC v. Steadman, 967 F.2d 636, 641 (D.C. Cir. 1992)).
McCurdy contends that the Commission ignored this scienter
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requirement. The record is otherwise. The Commission
properly applied the standard, noting at the outset of its
recklessness analysis that McCurdy “knew that the Receivable
was ‘very material’ to the Fund; he also recognized that it
represented a related party transaction.” Comm’n Op. at *8.
The Commission so stated in order to highlight the danger
signals apparent to McCurdy. He knew that the receivable
presented a significant risk of misleading the public if it were
reported as an asset and yet not probably collectible. His actions
in response fell short of GAAS requirements, but did they
constitute an extreme departure?
The Commission’s finding of recklessness rested on a
combination of the suspicious nature of the receivable, and the
stunning lack of skepticism and investigatory initiative
McCurdy displayed. Upon entering into his engagement with
the fund, McCurdy was confronted by a surfeit of red flags
surrounding the receivable. The receivable was nearly ten times
the amount of the GAAS-dictated materiality threshold, which
McCurdy calculated at the outset of the engagement. The
related-party interest underlying the transaction was not minor:
Bagwell was the founder and CEO of the fund, a trustee, and its
investment advisor. As if this were not enough, the arrangement
that gave rise to the receivable also was described by the board’s
counsel as, “under normal circumstances, . . . illegal.” Comm’n
Op. at *2. Not only a professional auditor charged with a duty
of skepticism, but any rational observer, should have been
highly suspicious in the face of these facts. See AICPA, AU
§ 230.07.
In short, investigating and classifying this receivable was
McCurdy’s single most important task in performing his audit.
Yet his actions in response to this duty were perfunctory at best.
As this court recently held, “an extreme departure occurs, for
instance, when an auditor ‘skips procedures designed to test a
11
company’s reports or looks the other way despite suspicions.’”
Marrie v. SEC, 374 F.3d 1196, 1206 (D.C. Cir. 2004) (quoting
In re Marrie, 2003 WL 21741785, at *11-*12 (July 29, 2003)).
In defense of his complete failure to seek firsthand corroboration
of Bagwell’s financial situation, McCurdy asserts that GAAS in
fact prefer independent evidence to records in the control of the
audited company. We do not understand the point. The fund --
not Bagwell -- was McCurdy’s client, and the subject of the
audit. The records in question related to Bagwell in his capacity
as the fund’s advisor, and those records were under Bagwell’s
control, not the fund’s. McCurdy’s rationale also does not
explain his failure to contact the other trustees, whom McCurdy
repeatedly describes as “independent” in justifying the weight
he gave their decision. See Brief for Petitioner at 34-38. As the
Commission noted, GAAS required these inquiries. Had
McCurdy made them, it would have added little additional cost
to the audit, but would have offered the possibility of significant
additional insight -- such as, for example, the fact that, by the
time McCurdy completed his audit report, Bagwell had not
made any of his agreed-upon payments. McCurdy’s failure to
take these simple steps amply supports the Commission’s
finding of recklessness. We therefore need not reach the
Commission’s alternate finding of highly unreasonable conduct.
C.
The Commission may impose sanctions for a remedial
purpose, but not for punishment. See SEC Rule 102(e)(1)(iv);
Johnson v. SEC, 87 F.3d 484, 490 (D.C. Cir. 1996). McCurdy
contends that because the Commission based its suspension
solely on his past conduct, the order was ultra vires and should
be set aside. It is difficult to imagine how any suspension,
remedial or not, could be based on anything but past actions. At
all events, the Commission here began its order by stating that
“it is in the public interest for [McCurdy] to be denied the
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privilege of appearing or practicing before the Commission,”
Comm’n Op. at *1, and later specifically noted that “McCurdy
has significant experience in audit work,” which “makes his
failure to conduct the audit in accordance with applicable
professional standards particularly troublesome,” id. at *9. It is
troublesome, the Commission continued, because the
Commission “anticipate[d] that he will continue to conduct
audits of public companies.” Id. The purpose of the sanction
thus was not to punish McCurdy, but rather to protect the public
from his demonstrated capacity for recklessness in the present,
and presumably to encourage his more rigorous compliance with
GAAS in the future. The Commission acted within the bounds
of its authority in issuing this order.
Accordingly, the petition for review is denied.
So ordered.