UNITED STATES OF AMERICA
Before the
SECURITIES AND EXCHANGE COMMISSION

SECURITIES EXCHANGE ACT OF 1934
Release No. 41580 / June 30, 1999

ACCOUNTING AND AUDITING ENFORCEMENT
Release No. 1141 / June 30, 1999

ADMINISTRATIVE PROCEEDING
File No. 3-9927

In the Matter of EUGENE F. GAUGHAN, C.P.A. Respondent.

ORDER INSTITUTING PUBLIC ADMINISTRATIVE PROCEEDINGS PURSUANT TO SECTION 21C OF THE SECURITIES EXCHANGE ACT OF 1934, MAKING FINDINGS, AND IMPOSING CEASE-AND-DESIST ORDER

I.

The Securities and Exchange Commission (“Commission”) deems it appropriate to institute public administrative proceedings pursuant to Section 21C of the Securities Exchange Act of 1934 (“Exchange Act”) against Eugene F. Gaughan (“Gaughan” or “Respondent”).

II.

In anticipation of the institution of these administrative proceedings, Respondent has submitted an Offer of Settlement which the Commission has determined to accept. Solely for the purpose of these proceedings and any other proceedings brought by or on behalf of the Commission, or to which the Commission is a party, and without admitting or denying the findings herein, except as to the Commission’s jurisdiction over him and the subject matter of the proceeding, which are admitted, Respondent consents to the entry of this Order Instituting Public Administrative Proceedings Pursuant to Section 21C of the Securities Exchange Act of 1934, Making Findings, and Imposing Cease-And-Desist Order (“Order”).

Accordingly, it is ordered that proceedings pursuant to Section 21C of the Exchange Act be, and hereby are, instituted.

III.

On the basis of this Order and Respondent’s Offer of Settlement (“Offer”), the Commission makes the following findings:¹

1. RESPONDENT

Gaughan was the engagement partner on the audits of the consolidated financial statements of W.R. Grace & Co. (“Grace”) for fiscal years 1991 through 1994. Gaughan began his employment with Price Waterhouse LLP (“PW”) in 1968 and became a partner in 1979. (PW merged with Coopers & Lybrand L.L.P. on July 1, 1998 to form PricewaterhouseCoopers LLP.) Gaughan is a certified public accountant.

2. OTHERS

a) Grace was a New York corporation which had its principal executive offices in Boca Raton, Florida during at least a portion of 1991 through 1995. Grace’s primary businesses during this period were packaging, specialty chemicals and health care services. Grace’s securities are currently registered with the Commission pursuant to Section 12(b) of the Exchange Act and its common stock is listed for trading on the New York Stock Exchange. Grace has a December 31 fiscal year end.

b) During the period 1991 through early 1995 (relating to fiscal years 1991 through 1994) (the “relevant period”), National Medical Care, Inc. (“NMC”) was Grace’s main health care subsidiary, with its headquarters in Waltham, Massachusetts. NMC provided kidney dialysis and home health services and manufactured specialized medical products. NMC comprised the majority of Grace’s Health Care Group, which group was, during the relevant period, one of Grace’s core businesses and was reported as a segment in Grace’s consolidated financial statements. The Health Care Group contributed a material portion of the consolidated pretax earnings of Grace during the majority of the relevant period.

3. OVERVIEW

a) During the relevant period, Grace misstated the earnings of the Health Care Group by maintaining at NMC reserves which were not for any probable and reasonably estimable exposures, and which were, therefore, not recorded in conformity with Generally Accepted Accounting Principles (“GAAP”), specifically, Statement of Financial Accounting Standards No. 5 (“FAS 5”), Accounting for Contingencies. PW audited the consolidated financial statements of Grace during the relevant period. Respondent was the PW partner responsible for those audits. Respondent was aware of the purpose of the reserves and, by failing to take the actions described below, was a cause of Grace’s violations of Sections 13(a) and 13(b)(2) of the Exchange Act and Rules 12b-20, 13a-1, and 13a-13 thereunder.

b) During the relevant period, the PW audit team led by Gaughan (the “Grace audit team”) performed audits of Grace’s consolidated financial statements and issued audit reports containing unqualified opinions thereon. These financial statements were included in the Forms 10-K filed with the Commission by Grace for fiscal years 1991 through 1994. The audit reports stated that PW had conducted audits of Grace’s consolidated financial statements in accordance with generally accepted auditing standards (“GAAS”) and opined that Grace’s consolidated financial statements were fairly presented in conformity with GAAP.

4. EXCESS RESERVES AT NMC

a) Gaughan and other members of the Grace audit team became aware during the 1991 audit that Grace and NMC had deferred reporting income at NMC for the purpose of bringing the earnings of the Health Care Group in line with targeted estimates. NMC deferred reporting income by increasing or establishing reserves (the “excess reserves”) which were not for any probable and reasonably estimable exposures, and which were, therefore, not recorded in conformity with GAAP, specifically, FAS 5.

b) During the relevant period, the amount of the excess reserves ranged from over $7 million to over $60 million.

c) In late 1991, Gaughan and others on the Grace audit team met with the Grace chief financial officer (the “Grace CFO”) and a Grace assistant controller and inquired about the excess reserves. The Grace CFO stated that the deferral of income caused by the creation of the excess reserves was intended to keep the growth rate at NMC within a targeted range. Gaughan advised the Grace CFO that the deferral was not in conformity with GAAP, specifically FAS 5. Gaughan further advised that appropriate accounting called for the amounts to be included in income as earned.

d) During the 1991 audit, the Grace audit team, under the direction and with the knowledge of Gaughan, proposed an adjustment to eliminate the excess reserves from Grace’s consolidated financial statements, as well as other adjustments. Grace management declined to record those adjustments. Gaughan concluded that the proposed adjustments, which included those related to the excess reserves, were not material to Grace’s consolidated financial statements taken as a whole, and thus not required to be recorded in Grace’s 1991 consolidated financial statements for those statements to be fairly presented in conformity with GAAP.

e) During fiscal year 1992, the Grace audit team, under the direction and with the knowledge of Gaughan, had conversations with Grace management regarding the level of the excess reserves. In a meeting held in the fourth quarter of 1992, the Grace CFO informed Gaughan and others on the Grace audit team that (a) NMC expected to again defer income in 1992; (b) the income growth at NMC would slow from its current 30% level, and (c) a reduction of the excess reserves in the future would help smooth the anticipated decline in growth. Gaughan and the other members of the Grace audit team told the Grace CFO that PW had posted the 1991 income deferral to PW’s schedule of proposed adjustments and that future increases or decreases in the excess reserves would result in proposed adjustments. The Grace CFO then discussed the possibility that the 1992 deferral could be used to cover other exposures. Gaughan and the Grace audit team agreed to monitor the situation. The income deferral for 1992 was not used to cover any other exposures.

f) In January 1993, prior to the completion of the 1992 audit, Gaughan received a copy of an October 1991 memorandum (the “October 1991 Memorandum”) authored by the NMC chief financial officer and addressed to the Grace CFO. Gaughan received the October 1991 Memorandum from the PW partner overseeing the NMC audit work. The October 1991 Memorandum stated that the excess reserves were to be used for profit planning purposes. The October 1991 Memorandum also stated that the excess reserves would be excluded when calculating payments to NMC employees under NMC’s Long Term Incentive Plans. Gaughan already knew that excess reserves were established for profit planning purposes and knew that others on the Grace audit team also knew this fact. At the time he received it, Gaughan did not disclose or discuss the October 1991 Memorandum with anyone on the Grace Audit team or at Grace.

g) During the 1992 audit, the Grace audit team, under the direction and with the knowledge of Gaughan, again proposed an adjustment to eliminate the excess reserves from Grace’s 1992 consolidated financial statements, as well as other adjustments. Grace management declined to record those adjustments. Gaughan concluded that the proposed adjustments, which included those related to the excess reserves, were not material to Grace’s consolidated financial statements taken as a whole, and thus not required to be recorded in Grace’s 1992 consolidated financial statements for those statements to be fairly presented in conformity with GAAP.

h) At meetings held in January 1993 between members of the Grace audit team and Grace financial and senior management, including the Grace chief executive officer, Gaughan restated PW’s conclusion that the excess reserves were not in conformity with GAAP. Gaughan obtained an agreement from Grace financial and senior management that the excess reserves would not increase in 1993, and that the reserves already established would be returned to income in the near future (which the Grace audit team defined as over the next several years) in a manner that would not distort materially Grace’s consolidated financial statements. This method of correcting the reserve misstatement was not in conformity with GAAP.

i) In June 1993, Grace’s Internal Audit Director (the “Director”) raised the issue of the excess reserves with Grace’s Audit Committee (the “Audit Committee”). Gaughan was not present at the time. The Audit Committee requested that its Secretary (the “Secretary”) investigate the matter.

j) In June 1993, the Secretary asked Gaughan about the excess reserves and later provided Gaughan with a draft of a report that the Secretary was to make to the Audit Committee. Gaughan disclosed that the Grace audit team had proposed adjustments to eliminate the excess reserves and his conclusions as to the materiality of those adjustments, but he did not disclose that he knew that the excess reserves were created for profit planning purposes. Although Gaughan, whose office was in New York, sent the October 1991 Memorandum to the files of the Grace audit team in Florida at this time, he did not discuss the October 1991 Memorandum with, or provide it to, the Secretary.

k) On June 30, 1993, the Secretary presented the report at a special Audit Committee meeting. That report did not discuss the purpose of the excess reserves. The report stated that the Grace audit team had from time to time “questioned whether the reserve was appropriate in nature and amount” and had “advised that the reserve would not be appropriate in the context of separate financial statements with respect to NMC.” The report also stated that the Grace audit team had “evaluated the potential effects of all unrecorded adjustments which came to [its] attention during the course of [its] audit and concluded that they do not significantly affect the fairness of the consolidated financial statements or the financial reporting process.”

l) Gaughan attended the June 30, 1993 special Audit Committee meeting. In that meeting, Gaughan told the Audit Committee that although he was not comfortable with the nature or amount of the excess reserves, the Grace audit team had concluded that the unrecorded proposed adjustments regarding excess reserves, when considered with all other proposed adjustments, did not have a material impact on Grace’s consolidated financial statements taken as a whole. In that meeting, Gaughan did not disclose or discuss his knowledge about the purpose of the excess reserves or the October 1991 Memorandum.

m) Under the direction and with the knowledge of Gaughan, the Grace audit team continued to monitor the level of the excess reserves each quarter through the fourth quarter of 1994. At the conclusion of each of its audits for 1993 and 1994, the Grace audit team, under the direction and with the knowledge of Gaughan, proposed an adjustment to eliminate the excess reserves from Grace’s consolidated financial statements, as well as other adjustments. Grace management declined to record those adjustments. Gaughan concluded that the proposed adjustments, which included those related to the excess reserves, were not material to Grace’s consolidated financial statements taken as a whole, and thus not required to be recorded in Grace’s 1993 and 1994 consolidated financial statements for those statements to be fairly presented in conformity with GAAP.

5. AUDITS OF GRACE’S FINANCIAL STATEMENTS FOR 1991 - 1994

a) Gaughan failed to comply with Statement on Auditing Standards No. 53, The Auditor’s Responsibility to Detect and Report Errors and Irregularities, (since superseded by SAS 82, “Consideration of Fraud in a Financial Statement Audit”) in that the excess reserves should have been identified as an “irregularity” rather than an “error” and, as such, Gaughan should have (a) informed the Audit Committee of his knowledge of the purpose of the excess reserves, and (b) insisted as a prerequisite to issuing an unqualified audit report, that Grace eliminate the excess reserves without regard to other possible audit adjustments to Grace’s financial statements.

b) Gaughan failed to comply with Statement on Auditing Standards No. 21, Segment Information in that the inclusion of the excess reserves in the Health Care Group segment information for the period 1991 through 1994 resulted in a material misstatement of segment information which, in turn, was material to Grace’s consolidated financial statements taken as a whole for one or more periods during the relevant period.

c) The excess reserves resulted in a distortion of the income growth trend of Grace’s Health Care Group. In 1991 and 1992, while the reserves were accumulating, Grace reported an income growth rate within targeted levels for its Health Care Group when, in fact, the Health Care Group’s income growth rate was higher than targeted estimates. In 1993 and 1994, while the reserves were released in some periods, Grace continued to report an income growth rate within targeted levels for its Health Care Group when, in fact, the income growth rate for the Health Care Group was lower in some periods than the targeted estimates.

d) Gaughan also failed to comply with Statement on Auditing Standards No. 8, Other Information in Documents Containing Audited Financial Statements in that he failed to take appropriate action relating to material misstatements of fact contained in the MD&A section of Grace’s 1991 through 1994 Forms 10-K relating to the disclosures regarding earnings and an assessment of the Health Care Group.

e) As a result of the failure to comply with the foregoing auditing standards, the audit reports on Grace’s consolidated financial statements included in Grace’s 1991 through 1994 Forms 10-K, misstated that the audits were conducted in accordance with GAAS.

6. GRACE’S VIOLATIONS

Section 13(a) of the Exchange Act requires issuers such as Grace to file periodic reports with the Commission containing information prescribed by specific Commission rules. Such reports must be complete and accurate. Rules 13a-1 and 13a-13 require, respectively, the filing of Forms 10-K and 10-Q. Rule 12b-20 requires, in addition to information required in periodic reports by Commission rules, such further material information as may be necessary to make the required statements not misleading.

Grace, at all times relevant, was subject to the reporting requirements of Section 13(a) of the Exchange Act and the rules promulgated thereunder. The requirement that reports be filed includes the requirement that they be accurate and that financial statements be presented in conformity with GAAP. Grace violated Section 13(a) of the Exchange Act and Rules 12b-20, 13a-1, and 13a-13 by filing Forms 10-K and 10-Q that contained material misrepresentations and omissions concerning the Health Care Group’s and Grace's income and results of operations.

Section 13(b)(2)(A) of the Exchange Act requires certain issuers such as Grace to "make and keep books, records, and accounts, which, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the issuer." Section 13(b)(2)(B) requires certain issuers such as Grace to devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances that transactions are booked accurately in a manner designed to permit the preparation of financial statements in conformity with GAAP. As described above, Grace failed to maintain accurate books and records and failed to maintain an adequate system of internal accounting controls, in violation of Sections 13(b)(2)(A) and 13(b)(2)(B).

IV.

Based on the foregoing, the Commission finds that Gaughan was a cause of Grace’s violations of Sections 13(a) and 13(b)(2) of the Exchange Act and Rules 12b-20, 13a-1, and 13a-13 thereunder.

V.

Accordingly, the Commission hereby accepts Respondent’s Offer of Settlement and orders that Respondent cease and desist from causing any violation and any future violation of Sections 13(a) and 13(b) of the Exchange Act and Rules 12b-20, 13a-1, and 13a-13 thereunder.

By the Commission.

Jonathan G. Katz

Secretary

FOOTNOTES

http://www.sec.gov/litigation/admin/34-41580.htm