The SEC brought its first enforcement action of 2012 against an auditor last Monday. It is not a terribly subtle case. All of the so-far unproven facts that follow come from the SEC’s complaint, filed in the Southern District of Florida. Briefly, Daniel Imperato is alleged to have orchestrated a scheme to use Imperiali, a business development company that Imperato owned and controlled, to defraud investors by making it appear that Imperiali was a thriving multinational corporation with several wholly-owned businesses. That happened not to be true. While Imperiali purported to have assets ranging between $3.5 million and $269 million, with projected annual sales of up to $500 million, the company actually had no assets at all, according to the complaint. It did allegedly have $2.5 million it raised from investors based on these misrepresentations.
Unfortunately for Lawrence O’Donnell, a former CPA from Aurora, Colorado, he decided to get involved with this enterprise and served as Imperiali’s auditor from 2006 through 2008. The first audit, in 2006, passed without incident. The audited financial statements accurately reflected that Imperiali was merely a shell, with no significant operations or revenue, and that its only asset was cash raised in a stock offering.
In November 2007, though, Imperiali allegedly filed a Form 10-KSB for the fiscal year ended August 31, 2007. The Statement of Investments in that filing overstated the company’s assets by $70 million, according to the SEC’s complaint. Because the total value did not match the corresponding assets reported on its balance sheet, the company’s financial statements allegedly did not comply with GAAP. O’Donnell’s accompanying audit report allegedly falsely stated that Imperiali’s financial statements were presented in conformity with GAAP and also allegedly falsely stated that his audit was conducted in accordance with PCAOB standards. He allegedly knew or was reckless in not knowing that they weren’t, and it allegedly wasn’t. The pattern repeated itself in March 2008 when Imperiali again filed audited financial statements with an 8-K. Allegedly.
According to the complaint, O’Donnell also knew or was reckless in not knowing that (1) the company’s March 2007 Forms 10 included false audit reports on financial statements he did not audit himself; (2) Imperiali’s financial statements contained glaring inconsistencies; and (3) serious questions existed regarding the valuation of portfolio companies. In September 2007, O’Donnell addressed a letter to Imperiali’s board saying that he had discovered evidence of possible illegal acts as defined in Section 10A of the Exchange Act, including using his audit report on financial statements he did not audit. Still, O’Donnell allegedly conducted another audit of Imperiali’s financial statements and reviewed several 10-Qs that included unaudited financial statements for the company. The financial statements audited by O’Donnell contained information and valuations that he allegedly knew or was severely reckless in not knowing were false and misleading.
O’Donnell was charged with violating Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. O’Donnell was previously registered with the PCAOB, which in October 2010 revoked his sole proprietorship’s registration, permanently barred him from associating with a registered public accounting firm, and ordered him to pay a civil penalty of $75,000. The Colorado Division of Registrations allegedly revoked his CPA license at roughly the same time.
The lessons here should be obvious, but auditors should remember that their conversations with management can make them aware of – and create liability for – false audit reports on financial statements that they did not actually audit. While Imperiali’s CFO settled his case, the other defendants, including O’Donnell, continue in litigation.