I concluded that there were numerous opportunities between 1997, when the alleged fraud began, and 2001, when the financial statements were first questioned, that the fraudulent practices could or should have been brought to the attention of the audit committee, and the audit committee could have stepped in to help resolve what became the genesis for the SEC taking enforcement action against Xerox and its outside auditor.

Shortly after the initial SEC complaint, Joseph Boyle, the KPMG relationship partner for the Xerox engagement in 1999 and 2000, moved to dismiss the complaint for failure to state a claim against him. As the relationship partner, Boyle served as liaison between KPMG and the Xerox board of directors, including its audit committee.

In denying this motion, the court detailed the nature of Boyle's alleged participation in and knowledge of Xerox's fraudulent accounting practices.

First, prior to becoming the relationship partner for Xerox, Boyle allegedly learned about flaws in Xerox's return-on-equity-based accounting model. The return on equity (ROE) "technique" was designed to accelerate the recognition of finance income over the term of the lease as current income without requiring Xerox to formulate and apply a valid method of estimating its finance income. The audit committee had advised Boyle that this artificial device had been applied retroactively to close the gap between actual and planned results. With Boyle's knowledge, he permitted the audit partner to sign off on the 2000 financial statements knowing that there were no audit procedures to determine whether the ROE model correctly reported revenues.

Second, Boyle knew that Xerox was using a second device known as "margin normalization" to increase the amount of lease revenue recognized at the beginning of the equipment lease, without KPMG performing an audit procedure to verify this technique.  Boyle nevertheless accepted Xerox's representation that it did not know the fair value of its equipment and therefore could not allocate revenue appropriately among equipment, finance and service at the inception of the lease.
 
Third, in the third quarter of 1999 one of the audit partners advised Boyle of his concerns about Xerox's financial reporting and that he should report these concerns to the audit committee. Not only did Boyle not report this to the audit committee, but he permitted the audit partner to sign off on the 1999 financial statements. Earlier in 1999, Boyle and the same audit partner took a position that these "adjustments" were immaterial for 1998 and 1999, but advised Xerox to discontinue these accounting methods in future years. However, the complaint alleges that Xerox continued the very same improper accounting methods in 2000 and 2001.

The complaint also alleged that Boyle had actual knowledge of the other Xerox accounting irregularities, including the setting up of an improper reserve and the increase of the use of so-called "PAS" transactions to improperly recognize $398 million in revenue in 1999. It also alleged that Xerox's financial department frequently raised significant accounting issues late in the audit, making audit review very difficult. In 2000 when another audit partner took over the Xerox account, Boyle allegedly did nothing to resolve the issues that he knew had been a serious concern of that audit partner's predecessor.
 
Boyle's principal point was that the SEC had not properly alleged scienter -- intent to defraud -- under the provisions of The Private Securities Litigation Reform Act of 1995. The PSLRA requires proof that the defendant acted with the particular state of mind, and with respect to each alleged violation the complaint must state with particularity facts giving rise to a strong inference that the defendant acted with a required state of mind.

The court stated that this requirement is satisfied if the defendant's conduct was "highly unreasonable, representing an extreme departure from the standards of ordinary care to the extent that the danger was either known to the defendant or so obvious that the defendant must have been aware of it." Even though a violation of GAAP, standing alone, is insufficient, allegations of recklessness are sufficient when they demonstrate that the defendant[s] "failed to review or check information that they had a duty to monitor, or ignored obvious signs of fraud."

The court determined that the allegations summarized above sufficiently detailed the various ways in which Boyle learned of the alleged fraudulent accounting practices, that these practices resulted in material misstatements in Xerox's published financials, that he knew of or participated in KPMG's audit of those financials, and that he failed to speak and act when he had a duty to do so. In short, the SEC's allegations of conscious misbehavior or recklessness were sufficient under the PSLRA.
 
Boyle's second principal argument was that he was not a signatory on any of the KPMG audits of Xerox. The court summarily dismissed this argument by pointing out that although private litigants can not sue someone for aiding and abetting, the PSLRA specifically authorizes the SEC to file such a claim under section 10(b) of the Exchange Act. The court then held that the SEC's complaint sufficiently alleged that Boyle knowingly provided substantial assistance to KPMG and Xerox.

Again, I ask the same question, where was the audit committee when all of these fraudulent practices occurred? True, Boyle allegedly concealed certain fraudulent practices from them. However, an audit committee can not be passive. Sarbanes-Oxley specifically empowers the audit committee, including the use of its own independent counsel and financial expert, to be proactive in all phases of the audit procedure.

This litigation indicates what could happen when the audit committee is asleep at the switch.

• The Liability of Financial Professionals
• Audit Committee and Management Disclosure Requirements of the Sarbanes-Oxley Act
• Sarbanes-Oxley and the "Reliance on Others Defense"
• Defining "Non-Audit" Services: The Audit Committee's Role

CHARLES HECHT has been a principal of his own law firm specializing in securities law since 1971. He was previously on the staff of the Division of Corporate Finance of the Securities and Exchange Commission at its headquarters in Washington, DC. Mr. Hecht would appreciate any input on subject matters within the SEC accounting area which you believe would be appropriate for a future article.