UNITED STATES OF AMERICA
Before the
SECURITIES AND EXCHANGE COMMISSION

Securities Exchange Act of 1934
Release No. 50428 / September 23, 2004

ACCOUNTING AND AUDITING ENFORCEMENT
Release No. 2108 / September 23, 2004

Admin. Proc. File No. 3-11678

I.

The Securities and Exchange Commission ("Commission") deems it appropriate that cease-and-desist proceedings be, and hereby are, instituted pursuant to Section 21C of the Securities Exchange Act of 1934 ("Exchange Act"), against John E. Isselmann, Jr. ("Respondent" or "Isselmann").

II.

In anticipation of the institution of these proceedings, Respondent has submitted an Offer of Settlement (the "Offer") 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 these proceedings, which are admitted, Respondent consents to the entry of this Order Instituting Cease-and-Desist Proceedings, Making Findings, and Imposing a Cease-and-Desist Order Pursuant to Section 21C of the Securities Exchange Act of 1934 ("Order"), as set forth below.

III.

On the basis of this Order and Respondent's Offer, the Commission finds¹ that:

A. Summary

Isselmann, the former General Counsel of Electro Scientific Industries, Inc. ("ESI" or "Company"), failed to provide important information to ESI's Audit Committee, Board of Directors, and auditors regarding a significant accounting transaction that enabled ESI to report a profit rather than a loss. Isselmann's failure to fulfill his gatekeeper role was a cause of the Company reporting materially false financial results for ESI's first quarter ended August 31, 2002.

ESI's former Chief Financial Officer and Controller had fraudulently decided to eliminate vested retirement and severance benefits for ESI's Asian employees in order to increase ESI's bottom line by $1 million. Isselmann later received written legal advice that the law prohibited the unilateral elimination of the benefits. Despite having opportunities to provide the advice to ESI's Audit Committee, Board of Directors, and auditors, Isselmann failed to do so. Isselmann's failure allowed the CFO and Controller to hide an ongoing fraud. Moreover, while in possession of the written legal advice stating that the law prohibited the unilateral elimination of the benefits, Isselmann was involved in the review process for ESI's quarterly report filed with the Commission describing the elimination of the benefits and the resulting impact on ESI's income.

B. Respondent

Isselmann, age 35, resides in Portland, Oregon, and is licensed to practice law in the State of Oregon. He served as General Counsel of ESI from May 2000 until his resignation in August 2003. ESI is a high technology manufacturer based in Portland, Oregon.²

C. Isselmann Is a Cause of ESI's Filing of a Materially Inaccurate Form 10-Q for the Quarter Ended August 31, 2002

1. ESI's Senior Management Artificially Inflates Quarterly Income

In order to meet external expectations that ESI would be profitable, the Company's CFO and Controller engaged in a scheme to fraudulently inflate ESI's financial results for its quarter ended August 31, 2002. ESI's CFO and Controller reduced expenses and increased ESI's bottom line by $1 million by secretly and unilaterally deciding to eliminate vested retirement and severance benefits in ESI's Asian offices (which included primarily Japan, but also Taiwan and Korea). This accounting transaction violated generally accepted accounting principles because ESI could not legally eliminate the benefits as it had purported to do. The accounting transaction enabled the CFO and the Controller to avoid a loss and report a profit in line with external expectations. Through this fraudulent accounting transaction, ESI artificially inflated its profits by 28% for the quarter.

Isselmann was not involved, present, or consulted when the CFO and the Controller made the accounting decision described above.

2. Isselmann Becomes Aware of the Elimination of the Retirement and Severance Benefits

Isselmann participated in a September 17, 2002 meeting with ESI's Audit Committee and auditors to review the quarterly financial results, including the financial impact of eliminating the retirement and severance benefits. During the meeting, ESI's CFO told the Audit Committee that the Japanese benefits were not legally required and that the decision to eliminate them had been approved by legal counsel. During the same discussion, Isselmann identified ESI's legal counsel in Japan, causing an Audit Committee member to believe that outside legal counsel had reviewed the decision. Although Isselmann was unaware that the CFO had decided to eliminate the benefits in order to fraudulently inflate ESI's financial results, and did not question the CFO about his statements, Isselmann was aware that at that time he had not reviewed or approved the decision to eliminate benefits nor had he, as General Counsel, sought any outside legal review of the issue. At the conclusion of the meeting, the Audit Committee approved the inclusion of the $1 million transaction relating to the benefits in ESI's financial results for the quarter.

During the same time frame, Isselmann was informed that ESI's auditors had been told that the elimination of the benefits had legal support. In connection with the auditors' review of ESI's quarterly financial results, ESI provided the auditors with a written memorandum stating that the benefits had been eliminated because ESI was under "no legal obligation" to pay them and that the change was approved by ESI's CFO and CEO. Isselmann received a copy of this memorandum and was told that it had been written for the auditors. However, Isselmann did not speak directly with the auditors and did not inform them that he had not reviewed the retirement benefits issue and that he had not retained outside counsel to do so.

3. Isselmann Receives Contradictory Written Legal Advice

On October 3, 2002, Isselmann sought legal advice from ESI's counsel in Japan on whether ESI could eliminate the benefits. On October 7, 2002, the outside counsel informed Isselmann in writing that ESI could not unilaterally eliminate its retirement and severance benefits in Japan and that if ESI wanted to terminate the benefits it was required to first consult with and obtain the consent of ESI's Japanese employees. As Isselmann was aware, ESI had neither consulted the Japanese employees nor obtained their consent to the elimination of their retirement benefits. Despite the contradiction with information Isselmann had been told had been written for ESI's auditors, Isselmann did not speak directly with the auditors. Nor did Isselmann provide the information to the Audit Committee, despite the fact that they had questioned the legal review of the matter.

4. Isselmann's Involvement in the Filing of ESI's Form 10-Q

ESI's Disclosure Committee met on October 7, 2002 in order to review and ensure the accuracy of ESI's quarterly report to the Commission on Form 10-Q. Isselmann, other ESI officers and employees, ESI's external auditors, and its Portland-based outside corporate counsel attended the meeting, which had been arranged by Isselmann. During the meeting, Isselmann tried to raise the issue of the termination of the Asian retirement benefits. However, the CFO objected and, as a result, Isselmann provided no further detail and did not provide the written legal advice to the participants in the meeting. After the meeting, Isselmann spoke with the CFO and provided him with a copy of the written legal advice. The CFO subsequently signed the Form 10-Q, which included the $1 million increase to the bottom line resulting from the elimination of the benefits.

On October 15, 2002, ESI filed its Form 10-Q, reporting net income of $158,000 and earnings per share of $0.01 for the quarter. Before the Form 10-Q was filed with the Commission, an Audit Committee member questioned Isselmann about the language describing the elimination of the benefits and the $1 million accounting entry. Isselmann failed to convey the legal advice to the Audit Committee member in response. As a result, the Form 10-Q was not changed.

On March 31, 2003, Isselmann learned that the CFO (who had been promoted to CEO in December 2002) had eliminated the accrued liability for the benefits late at night after learning of an accounting error that negatively impacted earnings. On the night of March 31, 2003, Isselmann reported to ESI's outside counsel his suspicions that the CFO had engaged in misconduct. The next day, Isselmann informed the Audit Committee.

On April 1, 2003, after receiving the written legal advice, the Audit Committee commenced an internal investigation. In August 2003, following the completion of an internal investigation by its Audit Committee, ESI restated its financial results for the quarter ended August 31, 2002. The previously recorded accounting transaction was reversed and the accrued liability of $1 million for the payment of Asian retirement and severance benefits was restored. The restatement revealed that, as a result of the improper reversal of the accrued liability, ESI's originally reported net income was overstated by 28%.

D. Legal Discussion

Section 13(a) of the Exchange Act requires issuers such as ESI to file quarterly reports with the Commission containing such information as the Commission prescribes by rule. Exchange Act Rule 13a-13 requires issuers to file quarterly reports. Under Exchange Act Rule 12b-20, the reports must contain, in addition to disclosures expressly required by statute and rules, such other information as is necessary to ensure that the statements made are not, under the circumstances, materially misleading. The obligation to file reports includes the requirement that the reports be true and correct. The reporting provisions are violated if false and misleading reports are filed. Scienter is not an element of the violations alleged herein.

As described in Parts III(A) through (C) above, Isselmann's failure to convey written legal advice concerning the elimination of the Japanese retirement and severance benefits was a cause of ESI filing a materially false and misleading Form 10-Q for the period ended August 31, 2002.

ESI violated Section 13(a) and Rules 13a-13 and 12b-20 by filing with the Commission a Form 10-Q containing inaccurate financial statements for the quarter ended August 31, 2002. As a result of the conduct described above, Isselmann was a cause of ESI's violation of Section 13(a) and Rules 12b-20 and 13a-13.

IV.

In view of the foregoing, the Commission deems it appropriate to impose the sanctions agreed to in Respondent's Offer.

Accordingly, it is hereby ORDERED that:

A. Respondent cease and desist from causing any violations and any future violations of Section 13(a) of the Exchange Act and Rules 12b-20 and 13a-13 thereunder.

By the Commission.

Endnotes

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¹ The findings herein are made pursuant to Respondent's Offer of Settlement and are not binding on any other person or entity in this or any other proceeding.

² At all relevant times, ESI was an Oregon corporation with its principal place of business in Portland. ESI's common stock was registered with the Commission pursuant to Section 12(g) of the Exchange Act and traded on the Nasdaq National Market.

http://www.sec.gov/litigation/admin/34-50428.htm