UNITED STATES OF AMERICA
COMMODITY FUTURES TRADING COMMISSION
___________________________ :CFTC Docket No. 96-10 In the Matter of : : Deloitte & Touche LLP :ORDER INSTITUTING PROCEEDINGS and :PURSUANT TO SECTION 6(c) Thomas D. Lux, : OF THE COMMODITY : EXCHANGE ACT AND PART 14 OF :THE COMMISSION'S REGULATIONS :AND FINDINGS AND ORDER :IMPOSING REMEDIAL SANCTIONS Respondents. : ___________________________:
The Commodity Futures Trading Commission ("Commission") has reason to believe that Thomas D. Lux ("Lux") has violated Commission Regulations 1.16(c)(5), 1.16(d)(1) and 1.16(e)(2), 17 C.F.R.1.16(c)(5), 1.16(d)(1) and 1.16(e)(2), and is subject to sanctions pursuant to Commission Regulations 14.4 and 14.8(c), 17 C.F.R.14.4 and 14.8(c), and that Deloitte & Touche LLP ("Deloitte"), as the firm of which Lux was a partner, is liable for Lux's violations pursuant to Section 2(a)(1)(A)(iii) of the Commodity Exchange Act, as amended ("Act"), 7 U.S.C.4. Therefore, the Commission deems it appropriate and in the public interest that a public administrative proceeding be, and hereby is, instituted to determine whether Lux engaged in the violations as set forth herein, whether Deloitte is liable for Lux's violations of Commission Regulation 1.16, and to determine whether any order should be issued imposing remedial sanctions.
In anticipation of the institution of this administrative proceeding, Deloitte and Lux have submitted Offers of Settlement ("Offers") which the Commission has determined to accept. Without admitting or denying the findings herein, Deloitte and Lux acknowledge service of the Order Instituting Proceedings Pursuant to Section 6(c) of the Commodity Exchange Act and Part 14 of the Commission's Regulations and Findings and Order Imposing Remedial Sanctions ("Order"). Deloitte and Lux consent to the use of the findings herein in this proceeding and in any other proceeding brought by the Commission or to which the Commission is a party.
The Commission finds that:
Respondent Deloitte & Touche LLP is a partnership of certified public accountants and consultants with national offices at 10 Westport Road, Wilton, Connecticut 06897.
Respondent Thomas D. Lux was a partner in the Chicago office of Deloitte until June 1, 1996. Lux has not been the subject of any previous Commission or, as far as the Commission is aware, other regulatory action.
B.Other Relevant Entities
First Commercial Financial Group, Inc. ("FCFG") is, and was at all relevant times, an Illinois corporation with its principal place of business at 30 South Wacker Drive, Suite 2020, Chicago, Illinois 60606. FCFG is, and was at all relevant times, registered with the Commission as a futures commission merchant ("FCM") pursuant to Sections 4d and 4f of the Act, 7 U.S.C.6d and 6f (1994).
1. The Deloitte Audit of FCFG
In October 1993, FCFG retained Deloitte to audit FCFG's financial statements for the year ending December 31, 1993 ("1993 1-FR"). Lux was the engagement partner responsible for the audit. In Deloitte's Independent Auditor's Report ("auditor's report") dated March 28, 1994, Deloitte rendered an unqualified opinion on FCFG's 1993 1-FR. On March 31, 1994, FCFG filed its 1993 1-FR with the Commission, pursuant to Commission Regulation 1.10(b), 17 C.F.R.1.10(b).
In early 1994, FCFG made cash disbursements of approximately $1.6 million to two individuals, John Hermanson ("Hermanson") and Robert Schillaci ("Schillaci"). FCFG made disbursements to Hermanson of $1.3 million on January 3, 1994, and $65,000 on January 13, 1994. FCFG disbursed $250,000 to Schillaci on February 4, 1994. According to FCFG, these disbursements were loans. FCFG considered the resulting loans receivable current assets to be included in computing its net capital. However, neither receivable qualified as a current asset under the Commission's net capital rules because they were not properly secured within the meaning of Commission Regulation 1.17(c)(3), 17 C.F.R.1.17(c)(3).
Because the receivables did not qualify as current assets for regulatory purposes, they could not properly be included in computing net capital. According to its 1993 1-FR, FCFG had excess net capital of $819,300 as of December 31, 1993. Accordingly, exclusion of the $1.3 million Hermanson receivable from net capital resulted in FCFG being undercapitalized by an amount in excess of $480,000 as of at least January 3, 1994.
In March 1994, during the course of a subsequent events review for the audit of FCFG's 1993 1-FR, the auditors discovered the disbursements to Hermanson and Schillaci. The audit team questioned Mark Rehn ("Rehn"), FCFG's president, about the disbursements and was told that they were loans. The audit team also questioned Rehn concerning the collateral for the loans and discovered that FCFG lacked proper collateral for regulatory purposes. Whereupon, Lux concluded that the loans were unsecured for regulatory purposes and advised FCFG accordingly.
Lux next inquired if FCFG had prepared any net capital computations subsequent to December 31, 1993. The audit team advised him that the subsequent event review had revealed that no such computations had been prepared. Commission Regulation 1.18(b), 17 C.F.R.1.18(b), requires an FCM to make and keep a record of, in accordance with Regulation 1.31, formal computations of its adjusted net capital and its minimum financial requirements pursuant to Regulation 1.17 or the requirements of the FCM's designated self-regulatory organization ("DSRO") to which it is subject, as of the close of business each month. Therefore, a January 1994 month-end net capital computation should have been available no later than the first week of March 1994.
Discovery of the unsecured loans put Lux in possession of information which indicated that FCFG had effected transactions which resulted in FCFG being significantly undercapitalized. Accordingly, Lux should have conducted an inquiry into the effect of the unsecured loans on FCFG's net capital and what impact the transactions would have on FCFG's ability to continue as a going concern. That inquiry was not made. In addition, no inquiry was made as to the reason a January 1994 month-end net capital computation had not been prepared, and no consideration was given to the impact of the lack of that capital computation on the reports to be filed with the Commission.
Lux concluded that FCFG was required to include a note to its 1993 1-FR which identified the loans as subsequent events and disclosed the amount of the loans and that they were unsecured. However, the note failed to address either the effect of the
loans on FCFG's net capital or the firm's ability to continue as a going concern.
FCFG's financial statements and the auditor's report were reviewed by a concurring reviewer at Deloitte. The concurring reviewer did not conclude that the unsecured loans required any additional disclosures regarding FCFG's net capital or its ability to continue as a going concern. The specialization of the concurring reviewer, who was a deputy professional practice director, included auditing financial institutions, but not Commission registrants.
The Commission notes that its investigation of this matter found no firm-wide or systemic problems with respect to
Deloitte's audit processes and procedures.
2.Subsequent Regulatory Action
Subsequent to the filing of FCFG's 1993 1-FR, the Commission and NFA conducted investigations of the firm's finances. On May 2, 1995, the Commission filed an administrative complaint charging FCFG with, inter alia, filing a false 1993 1-FR with the Commission and with failing to maintain required net capital and operating while undercapitalized at various times. The Commission and NFA inquiries were, to a large extent, prompted by the note Lux had concluded FCFG was required to include in its financial statements. No public customers suffered losses as a result of either FCFG's undercapitalization or the conduct of the audit.
3.Subsequent Action by Deloitte
Beginning in September 1995, as a result of the investigation by the Commission, Deloitte restricted Lux's ability to engage in activities associated with being an audit partner, including serving clients as the audit engagement partner and signing audit reports. Lux ceased being a partner on June 1, 1996, and has since terminated his employment with Deloitte.
D.Violations of Commission Regulations
1.Failure to Conduct the Audit in Accordance With GAAS
Regulation 1.16(d)(1) requires that audits pursuant to
Regulation 1.16 be done in accordance with generally accepted auditing standards ("GAAS"). The audit of FCFG departed from GAAS in two ways. First, Lux failed to make appropriate inquiry after learning that FCFG had effected transactions which had a significant adverse effect on the firm's net capital and raised substantial doubt about FCFG's ability to continue as a going concern for a reasonable period of time. Second, he rendered an opinion on FCFG's financial statements which failed to disclose or reflect either the effect of the transactions on the firm's net capital or any substantial doubt as to FCFG's ability to continue as a going concern for a reasonable period of time.
a.Failure to Make Appropriate Inquiry
Statement on Auditing Standards ("SAS")1 (AU Section 560), sets out the auditor's responsibilities with respect to the subsequent events review. SAS 1 states that:
...the independent auditor should perform other auditing procedures with respect to the period after the balance- sheet date for the purpose of ascertaining the occurrence of subsequent events that may require adjustment or disclosure essential to a fair presentation of the financial statements in conformity with generally accepted accounting principles.
If the auditor ascertains that such subsequent events have occurred he must:
Make such additional inquiries or perform such procedures as he considers necessary and appropriate to dispose of questions that arise in carrying out the foregoing procedures, inquiries, and discussions.
Lux failed to inquire properly into or to investigate properly the effect of the loans on FCFG's net capital. This left critical questions unresolved. Accordingly, he failed to make the appropriate inquiry called for under SAS 1.
In addition, because the loans raised a going concern issue, SAS 59, which concerns the auditor's consideration of an entity's ability to continue as a going concern, imposed an additional inquiry requirement. SAS 59 states that the auditor should consider:
... whether the results of his procedures performed in planning, gathering evidential matter relative to the various audit objectives, and completing the audit, identify conditions and events that, when considered in the aggregate, indicate there could be substantial doubt about the entity's ability to continue as a going concern for a reasonable period of time. It may be necessary to obtain additional information about such conditions and events, as well as the appropriate evidential matter to support information that mitigates the auditor's doubt.
Lux possessed sufficient information that suggested that FCFG was significantly undercapitalized at least as early as January 3, 1994, because of the loans. This in turn "indicate[d] there could be substantial doubt about [FCFG's] ability to continue as a going concern." Accordingly, Lux should have conducted
an inquiry to determine what impact the unsecured loans would have on FCFG's ability to continue as a going concern. That inquiry was not made.
According to Lux, additional inquiry and analysis was foregone because FCFG provided a management representation letter which stated that FCFG was in compliance with all regulatory and capital requirements. Under the circumstances, reliance on a standard representation letter reciting that the company was in compliance with all regulatory and capital requirements was not an adequate substitute for additional audit work.
b.Failure to Render An Auditor's Report Which Disclosed or Reflected the Effect of the Loans on FCFG's Net Capital and That Substantial Doubt Existed as to FCFG's Ability to Continue as a Going Concern
SAS 1 identifies two types of subsequent events which require evaluation by the auditor. The second type is applicable here. The SAS states:
The second type consists of those events that provide evidence with respect to conditions that did not exist at the date of the balance sheet being reported on but arose subsequent to that date. These events should not result in adjustment of the financial statements. Some of these events, however, may be of such a nature that disclosure of them is required to keep the financial statements from being misleading. (Emphasis added.)
SAS 1 further explains that:
Occasionally, a subsequent event of the second type has such a material impact on the entity that the auditor may wish to include in his report an explanatory paragraph directing the reader's attention to the event and its effect. (See section 508.19.) (Emphasis added.)
The impact of having made the unsecured loans on FCFG's net capital position was material, immediately as of the date the loans were made, which was January 3, 1994. Disallowance of the loans receivable resulted in the firm being undercapitalized in excess of $480,000. Accordingly, the effect of the loans on FCFG's net capital immediately subsequent to the audit date should have been disclosed in the financial statements. The auditor's report should have reflected the fact that the notes to the financial statements did not make the disclosure.
In addition, because the loans raised an issue as to FCFG's ability to continue as a going concern which was not appropriately resolved before the audit report signoff date, SAS 59 required that additional disclosures be made. With respect to the effect of the auditor's substantial doubt as to an entity's ability to continue as a going concern, SAS 59 states that:
If the auditor concludes that the entity's disclosures with respect to the entity's ability to continue as a going concern for a reasonable period of time are inadequate, a departure from generally accepted accounting principles exists. This may result in either a qualified (except for) or an adverse opinion.
FCFG's financial statements made no disclosure with respect to the going concern issue. Under SAS 59, if the entity fails to disclose the going concern issue adequately, the auditor may consider either a qualified or adverse opinion. In this instance, the going concern issue arose because FCFG had extended unsecured loans which significantly impaired the firm's regulatory capital. This was an event of such significance that Lux was required, absent further inquiry, to render either a qualified or adverse opinion.
2.Failure to Formulate the Scope of the Audit in a Manner Sufficient to Provide Reasonable Assurance That Any Material Inadequacies Would be Discovered
Regulation 1.16(d)(1) states that the scope of audits and reviews of accounting systems, internal accounting controls, and procedures for safeguarding customer and firm assets must be sufficient to provide reasonable assurance that any material inadequacies existing at the date of the examination will be discovered.
The audit of FCFG failed to provide such assurance. During the subsequent event review, Lux was made aware of information which indicated the existence of material inadequacies in FCFG's internal controls, and he failed to investigate and resolve that information. Information which comes to the attention of the auditor during the course of a subsequent event review, even though it is after the examination date, cannot be ignored. The audit was of insufficient scope because it did not include a full and proper investigation and follow up of this information.
FCFG's extension of unsecured loans in excess of its available excess net capital indicated the existence of a material inadequacy. Such large unsecured disbursements of required net capital, if appropriate corrective action was not taken, could reasonably be expected to inhibit FCFG's prompt completion of transactions and discharge of its responsibilities to customers and other creditors and to result in material financial loss. Deloitte's audit team conducted tests of FCFG's loans receivable during the course of the audit. Nevertheless, discovery of the unsecured loans and their probable effect on FCFG's net capital and ability to continue as a going concern
called for additional investigation into FCFG's lending practices. No additional investigation took place.
FCFG's failure to prepare a month-end net capital computation for January 1994 also indicated the existence of a material inadequacy. The failure to prepare timely net capital computations could, if appropriate corrective action was not taken, reasonably be expected to result in a material misstatement of FCFG's financial statements and schedules and violations of the Commission's recordkeeping and financial reporting requirements. Moreover, the circumstances surrounding Lux's discovery of this information, including the fact that he asked about the computation precisely because the audit team had found the loans, made it all the more necessary to resolve the information. Nevertheless, Lux again failed to investigate.
The unsecured loans and FCFG's failure to prepare a January 1994 capital computation, when viewed in the aggregate of the surrounding circumstances, absent additional investigation, required Lux to conclude that the audit had disclosed material inadequacies at FCFG. However, Lux concluded that there were no material inadequacies in internal controls, even though the audit team had not gathered audit evidence appropriate to support such a conclusion. Lux thereby violated Regulation 1.16(d)(1).
3.Failure to Report on Material Inadequacies
Under Regulation 1.16(e)(2), independent auditors are required to call material inadequacies to the attention of the registrant. The registrant then has the responsibility to give notice of the material inadequacies to the Commission and its DSRO. The registrant must furnish the independent auditor a copy of its notice to the Commission and its DSRO within three business days. If the independent auditor fails to receive such notice or disagrees with the statements contained in the notice, the independent auditor must inform the Commission and the DSRO by reporting the material inadequacy within three business days.
The audit evidence actually gathered indicated that material inadequacies existed in FCFG's internal controls. Lux either had to gather additional evidence that supported a different conclusion or report the material inadequacies. Since he did not gather any such additional evidence, he needed to report the material inadequacies under Regulation 1.16(e)(2). He did not bring the material inadequacies to FCFG's attention nor did he or FCFG report the material inadequacies to the Commission or FCFG's DSRO.
4.Violations of Regulation 1.16(c)(5)
Regulation 1.16(c)(5) states that an FCM shall file concurrently with the annual report a supplemental report by the accountant describing any material inadequacies found to exist or found to have existed since the date of the previous audit. The supplemental report on material inadequacies filed with FCFG's annual report stated that the audit did not disclose any material inadequacies. Again, Lux had gathered evidence which, absent additional evidence, required a conclusion that material inadequacies existed in FCFG's internal controls. Those material inadequacies needed to be resolved or reported. Since the material inadequacies were not resolved, they should have been reported in the supplemental report.
5."Improper Unprofessional Conduct"
Part 14 of the Commission's Regulations, 17 C.F.R.14.1 et seq. (Rules Relating to Suspension or Disbarment From Appearance and Practice), describe the circumstances under which persons may be denied, either temporarily or permanently, the privilege of appearing or practicing before the Commission as an attorney or accountant.
Regulation 14.2(b) defines practice before the Commission under Part 14 to include (emphasis added):
(1) The preparation of any statement,
opinion or other paper by any attorney
or accountant filed with or submitted
to the Commission on behalf of another
person in or in connection with any
application, notification, report or other
(2) Transacting any other formal business
with the Commission, on behalf of another
person, in the capacity of an attorney
or accountant. (Emphasis added.)
This language encompasses the types of reports by auditors mandated by Regulation 1.16.
Pursuant to Regulation 14.8(c), the Commission may sanction any person who is found by the Commission to have engaged in "improper unprofessional conduct" either in the course of an adjudicatory, investigative, rulemaking or other proceeding before the Commission or otherwise. By virtue of the failures
described above, Lux engaged in improper unprofessional conduct during the course of the audit.
6.Deloitte's Liability for Lux's Regulatory Violations Pursuant to Section 2(a)(1)(A)(iii) of the Act
Section 2(a)(1)(A)(iii) of the Act provides that:
the act, omission, or failure of any official, agent, or other person acting for any individual, association, partnership, corporation, or trust within the scope of his employment or office shall be deemed the act, omission or failure of such individual, association, partnership, corporation, or trust, as well as of such official, agent or other person.
Lux, as the engagement partner on the 1993 audit of FCFG, acted on behalf of Deloitte and within the scope of his office. Consequently, under Section 2(a)(1)(A)(iii), Deloitte is liable for Lux's violations of Regulations 1.16(c)(5), 1.16(d)(1) and 1.16(e)(2).
FINDINGS OF VIOLATIONS
Solely on the basis of the consent evidenced by the Offer, and without any adjudication on the merits, the Commission finds that Lux violated Commission Regulations 1.16(c)(5), 1.16(d)(1) and 1.16(e)(2). The Commission further finds that Lux engaged in improper unprofessional conduct within the meaning of Commission Regulation 14.8(c). The Commission finds that, by virtue of his violations of the Commission's Regulations and his improper unprofessional conduct, Lux is subject to sanctions under Commission Regulations 14.4 and 14.8(c). Solely on the basis of the consent evidenced by the Offer, and without any adjudication on the merits, the Commission finds that, pursuant to Section 2(a)(1)(A)(iii) of the Act, Deloitte is liable for Lux's violations of Regulations 1.16(c)(5), 1.16(d)(1) and 1.16(e)(2).
LUX'S OFFER OF SETTLEMENT
Lux has submitted an Offer of Settlement in which, without admitting or denying the findings in this Order, he admits the jurisdiction of the Commission with respect to the matters set forth in this Order; waives: 1) service of complaint and notice of hearing, 2) a hearing, 3) all post-hearing procedures, 4) judicial review by any court, 5) any objection to the staff's participation in the Commission's consideration of the Offer, and 6) any claim that the settlement of this proceeding, including the imposition of any remedy herein, is a punitive penalty; stipulates that the record basis on which this Order is entered consists solely of this Order and the findings to which he has consented in the Offer, which are incorporated in this Order; and consents to the Commission's issuance of this Order, which makes findings as set forth above, and orders Lux to cease and desist from further violations of Commission Regulations 1.16(c)(5), 1.16(d)(1) and 1.16(e)(2) and censures him for violations of the Commission's Regulations, pursuant to Commission Regulation 14.4, and for improper unprofessional conduct, pursuant to Commission Regulation 14.8(c).
DELOITTE'S OFFER OF SETTLEMENT
Deloitte has submitted an Offer of Settlement in which, without admitting or denying the findings in this Order, it admits the jurisdiction of the Commission with respect to the matters set forth in this Order; waives: 1) service of complaint and notice of hearing, 2) a hearing, 3) all post- hearing procedures, 4) judicial review by any court, 5) any objection to the staff's participation in the Commission's consideration of the Offer, and 6) any claim that the settlement of this proceeding, including the imposition of any remedy herein, is a punitive penalty; stipulates that the record basis on which this order is entered consists solely of this Order and the findings to which it has consented in the Order; and consents to the Commission's issuance of the Order, which makes findings as set forth above, and orders Deloitte to comply with its undertakings set out below in Part VII of this Order and imposes a civil monetary penalty of $100,000 upon Deloitte.
Accordingly, IT IS HEREBY ORDERED THAT:
1.Lux shall cease and desist from further violations of Commission Regulations 1.16(c)(5), 1.16(d)(1) and 1.16(e)(2),
17 C.F.R.1.16 (c)(5), 1.16(d)(1) and 1.16(e)(2);
2.Pursuant to Commission Regulations 14.4 and 14.8(c), 17 C.F.R.14.4 and 14.8(c), the Commission hereby censures Lux for violations of the Commission's Regulations and for improper unprofessional conduct;
3. Deloitte shall comply with the following undertakings for a period of four years from the date of the entry of the Order:
a. that the concurring reviewer on each and every audit of a Commission registrant shall have at least five (5) years experience auditing Commission registrants or broker-dealers; and
b. that each year any Deloitte partner who acts as a concurring reviewer on audits of futures commission merchants take at least 8 hours of continuing professional education courses dealing with futures commission merchant or broker-dealer issues.
4.Deloitte shall pay a civil monetary penalty in the amount of $100,000. Such penalty shall be paid, in total, by Deloitte within five (5) days of the date of this Order.
By the Commission.
Jean A. Webb
Secretary to the Commission
Commodity Futures Trading Commission
Dated: September 25, 1996