-------------------- BEGINNING OF PAGE #1 ------------------- UNITED STATES OF AMERICA Before the SECURITIES AND EXCHANGE COMMISSION SECURITIES EXCHANGE ACT OF 1934 Release No. 36357 / October 11, 1995 ACCOUNTING AND AUDITING ENFORCEMENT Release No. 730 / October 11, 1995 ADMINISTRATIVE PROCEEDING File No. 3-8866 ------------------------------ : In the Matter of : ORDER INSTITUTING PROCEEDINGS : PURSUANT TO SECTION 21C OF GIBSON GREETINGS, INC., : THE SECURITIES EXCHANGE ACT WARD A. CAVANAUGH, and : OF 1934 AND FINDINGS AND ORDER JAMES H. JOHNSEN : ------------------------------: I. The Securities and Exchange Commission ("Commission") deems it appropriate and in the public interest that public administrative proceedings be, and they hereby are, instituted pursuant to Section 21C of the Securities Exchange Act of 1934 ("Exchange Act"). II. In anticipation of the institution of these administrative proceedings, Gibson Greetings, Inc. ("Gibson"), Ward A. Cavanaugh, and James H. Johnsen (collectively, "Respondents") have each submitted an Offer of Settlement, each of 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 set forth herein, the Respondents consent to the entry of the findings and to the issuance of this Order Instituting Proceedings Pursuant To Section 21C of the Securities Exchange Act of 1934 and Findings and Order ("Order"). III. The Commission finds the following:-[1]- A. RESPONDENTS 1. Gibson Greetings, Inc., headquartered in Cincinnati, Ohio, is a manufacturer of greeting cards and gift --------- FOOTNOTES --------- -[1]- The findings herein are made pursuant to the Offers of Settlement submitted by Gibson, Cavanaugh and Johnsen and are not binding on any other person or entity named as a respondent in this or any other proceeding. 1 -------------------- BEGINNING OF PAGE #2 ------------------- wrapping paper. Gibson's stock is registered with the Commission pursuant to Section 12(g) of the Exchange Act and listed on the NASDAQ/NMS. 2. Ward A. Cavanaugh, was Gibson's Vice President, Finance and Chief Financial Officer from May 1982 until his retirement in December 1993. Cavanaugh was responsible, along with Gibson's Treasurer, for the preparation of Gibson's Forms 10-Q for the first three quarters of 1993 and signed each of those filings. 3. James H. Johnsen, was the Vice President, Control and Treasurer of Gibson from 1986 until March 1994. Johnsen was responsible, along with Gibson's Chief Financial Officer, for the preparation of Gibson's Forms 10-Q for the first three quarters of 1993 and signed each of those filings. As Gibson's chief accounting officer, Johnsen reported directly to Cavanaugh and was responsible for maintaining the company's books and records. B. FACTS This matter involves violations of the reporting and books and records provisions of the federal securities laws in connection with the accounting for and disclosure of certain derivatives purchased by Gibson.-[2]- While the transactions were entered into on the advice of BT Securities, this Order involves the obligations of Gibson, as a registrant, and those of its senior officers, to comply with the reporting and books and --------- FOOTNOTES --------- -[2]- The derivative products which are the subject of this Order were sold to Gibson by BT Securities Corporation ("BT Securities"), a broker-dealer registered with the Commission pursuant to Section 15(b) of the Exchange Act. In December 1994, the Commission instituted and settled administrative proceedings against BT Securities arising from the sale of derivatives to Gibson. See In re BT Securities Corporation, Rel. Nos. 33-7124, 34-35136, Administrative File No. 3-8579 (December 22, 1994). Bankers Trust Company ("Bankers Trust") and BT Securities are both wholly owned subsidiaries of Bankers Trust New York Corporation. Bankers Trust was the counterparty to each derivative discussed herein sold to Gibson. In the BT Securities matter the Commission found: During the period from October 1992 to March 1994, BT Securities' representatives misled Gibson about the value of the company's derivatives positions by providing Gibson with values that significantly understated the magnitude of Gibson's losses. As a result, Gibson remained unaware of the actual extent of its losses from derivatives transactions and continued to purchase derivatives from BT Securities. In addition, the valuations provided by BT Securities' representatives caused Gibson to make material understatements of the company's unrealized losses from derivatives transactions in its 1992 and 1993 notes to financial statements filed with the Commission. Id. at 4. 2 -------------------- BEGINNING OF PAGE #3 ------------------- records provisions of the federal securities laws. Those obligations are not excused by the fraud of BT Securities. 1. Background During the first three quarters of calendar year 1993, Gibson engaged in a series of transactions in derivatives which, for accounting purposes, amounted to trading or speculation. During that time, the company entered into, restructured, or terminated derivatives contracts, including on certain occasions cashing out derivatives, or portions of derivatives, which had unrealized gains,-[3]- while rolling over or restructuring those derivatives with unrealized losses. Those transactions were unrelated to Gibson's underlying debt obligations. Gibson initially purchased derivatives with the expectation of reducing the effective interest rate of certain debt obligations. In May 1991, Gibson sold $50 million of 9.33% fixed-rate senior notes ("the senior notes") in a private placement. Interest rates declined subsequent to the private placement, and because the senior notes could not be prepaid for a number of years, in November 1991 Gibson used interest rate swaps to convert $30 million of the senior notes into variable-rate debt. The first two transactions related to the senior notes were conventional fixed-for-floating interest rate swaps, often referred to as "plain vanilla" swaps. However, these two swaps were terminated in July 1992 at a gain and then subsequently succeeded during October 1992 by two less conventional interest rate swaps known as the Ratio Swap-[4]- and the Basis Swap. Both the Ratio Swap and Basis Swap had notional amounts of $30 million and were outstanding at December 31, 1992. Gibson accounted for these derivatives using settlement (or deferral) accounting and deferred all gains and losses for financial statement purposes. 2. Gibson's Derivatives Activities During 1993 In early January 1993 and continuing throughout the first three quarters of 1993, Gibson engaged in a series of derivative transactions. While Gibson's fixed rate debt remained constant, during the first three quarters of 1993, with the knowledge and approval of Cavanaugh and Johnsen, Gibson entered into eighteen derivative transactions, including the purchase of six new derivative products and the termination of both the Ratio Swap and the Basis Swap. Only one of the six new derivatives entered into during 1993 resembled a conventional interest rate swap. Three of the new derivatives were highly-leveraged, meaning that the derivatives were structured to amplify changes in market interest rates. This degree of leverage exposed Gibson to material losses from relatively small adverse movements in interest rates. --------- FOOTNOTES --------- -[3]- For accounting purposes, these payments were treated as deferred gains. -[4]- The terms of certain of the derivatives entered into by Gibson are described in the Appendix. 3 -------------------- BEGINNING OF PAGE #4 ------------------- As a consequence of the significant number of derivative transactions entered into in the first three quarters of 1993, the size of Gibson's derivatives portfolio purportedly linked to the senior notes increased substantially. In the third quarter of 1993, the total notional amount of the outstanding derivatives grew to $167.5 million, more than three times the amount of the senior notes. In 1993, Gibson's strategy relating to derivatives involved an effort to use restructurings to reduce unrealized losses from existing derivatives positions. Some of the restructurings involved cashing out unrealized gains in existing derivatives. However, at no time did Gibson pay cash to terminate a derivative with an unrealized loss. Instead, rather than incur a realized loss by terminating a derivative position, Gibson consistently attempted to trade out of losses by agreeing to new or amended derivatives. The derivative transactions entered into by Gibson resulted in losses primarily because interest rate movements were not correctly anticipated. In addition, each time Gibson shifted unrealized losses into new or restructured derivative positions, the overall mark-to-market value of its derivatives portfolio worsened because pre-restructuring losses were carried forward into the restructured position, along with a new loss representing dealer profits and hedging costs related to the restructuring itself. Gibson was not informed of and did not know the full extent of the losses that accompanied the restructuring of these transactions. Gibson's new derivatives and restructurings worsened the overall mark-to-market value of its derivatives and exposed Gibson to ever-increasing risk of losses. The new derivatives and restructurings were not disclosed in the company's Forms 10-Q filed with the Commission. Gibson's 1993 Forms 10-Q also did not disclose the current market values of the company's derivatives or the substantial changes in the company's derivatives positions which had taken place since year-end 1992. Throughout the first three quarters of 1993, Gibson deferred gains and losses from its derivatives transactions. Furthermore, Gibson did not provide any disclosure in the MD&A section of its 1993 Forms 10-Q concerning the nature or risks of its new derivative positions. (a). First Quarter 1993 During the first quarter of 1993, Gibson entered into two new derivatives, a Spread Lock and a Treasury-Linked Swap, and significantly shortened the maturity of the Ratio Swap. As of the end of the first quarter of 1993, Gibson had four outstanding derivative positions with a total notional amount of $120 million. (b). Second Quarter 1993 During the second quarter of 1993, Gibson terminated the remaining term of the Ratio Swap and added a second Spread Lock. Then, following a rise in interest rates, Gibson reduced the notional amount of the Treasury-Linked Swap to $17.5 million in exchange for amending both Spread Locks to less favorable levels. In addition, Gibson replaced the profit 4 -------------------- BEGINNING OF PAGE #5 ------------------- potential in the Treasury-Linked Swap with a $25 million Knock-Out Call Option. As of the end of the second quarter of 1993, Gibson had five outstanding derivative positions with Bankers Trust with a total notional amount of $132.5 million. (c). Third Quarter 1993 During the third quarter of 1993, interest rates began to decline, which threatened to cause the Knock-Out Call Option to terminate with no value. To preserve unrealized gains related to the Knock-Out Call Option, Gibson agreed to enter into a Time Trade in order to amend the Knock-Out Call Option by lowering the knock-out barrier. On the same date Gibson also agreed to terminate the Basis Swap for cash. Gibson amended the Time Trade twice during August 1993 to pay for changing the terms of the Knock-Out Call Option to prevent its expiration. The day after the second amendment, Gibson terminated the Knock-Out Call Option in exchange for $475,000 in cash. As noted above, in the second quarter both Spread Locks had been raised to unfavorable levels to pay for reducing the notional amount of the Treasury-Linked Swap. Late in the third quarter, Gibson agreed to reduce the unrealized losses associated with the two Spread Locks by entering into a $60 million Wedding Band. Near the end of the third quarter, the Treasury-Linked Swap expired without loss to Gibson. As of the end of the third quarter of 1993, Gibson held four derivative positions with Bankers Trust with a total notional value of $150 million. 3. Gibson's Books, Records, and Internal Controls Gibson's books and records did not contain quarterly mark-to-market values for the derivatives and did not identify or separate transactions that for accounting purposes amounted to trading or speculation. Gibson also lacked adequate internal controls for ascertaining whether derivatives transactions were consistent with corporate derivatives objectives established by Gibson's Board of Directors. The Board had approved a resolution on April 15, 1992 authorizing the Vice President, Finance or his designee "to take such actions as he may deem appropriate from time to time to effectuate interest rate swap transactions relating to the Corporation's obligations upon such terms as he may approve." This resolution did not authorize transactions beyond interest rate swap transactions relating to the corporations's debt. No specific procedures were put in place to implement that resolution, such as procedures to place limits on the amounts, types or nature of derivatives transactions, or to assess the risks of derivatives transactions. Gibson also lacked adequate controls designed to ensure that its derivatives positions were accounted for in accordance with Generally Accepted Accounting Principles ("GAAP"). IV. ANALYSIS 5 -------------------- BEGINNING OF PAGE #6 ------------------- A. APPLICABLE LAW 1. Accounting Standards Derivative positions must be marked to market and unrealized gains or losses from those positions must be recognized in income unless they meet the criteria for deferral accounting. The determination of whether deferral accounting is appropriate must be based on an evaluation of the accounting literature, industry practice, and the particular facts and circumstances of each situation and it is the registrant's obligation to make that determination. For accounting purposes, Gibson's course of conduct involving these derivative transactions amounted to trading or speculation, and therefore the derivative transactions did not qualify for deferral accounting.-[5]- 2. Reporting Requirements (a). Section 13(a) and Related Rules Section 13(a) of the Exchange Act requires issuers of securities registered pursuant to Section 12 of the Exchange Act to file periodic and other reports with the Commission containing such information as the Commission by rule prescribes. Rule 13a-13 promulgated under Section 13(a) requires issuers to file quarterly reports on Form 10-Q with the Commission. Rule 12b-20 under the Exchange Act requires that periodic reports filed with the Commission contain all information necessary to ensure that the statements made are not materially misleading. The reporting requirements necessarily include the requirement that the information supplied be accurate. See SEC v. Savoy Industries, Inc., 587 F.2d 1149, 1165 (D.C. Cir. 1978), cert. denied, 440 U.S. 913 (1979). (b). MD&A Requirements Forms 10-K and 10-Q require an issuer to supply in the MD&A section of those filings the information set forth in Item 303 of Regulation S-K. Item 303(a)(3)(iii) requires issuers to discuss in one component of the MD&A, the discussion of results of operations, "any known trends or uncertainties that have had or that the registrant reasonably expects will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations." Instruction 3 to Item 303(a) states: "The discussion and analysis shall focus specifically on material events and uncertainties known to management that would cause reported financial information not to be necessarily indicative of future operating results." It is also management's responsibility in the MD&A: --------- FOOTNOTES --------- -[5]- Despite the lack of definitive authoritative guidance on the use of deferral accounting for derivatives, there is a consensus in practice, and support in the accounting literature, for the proposition that financial instruments used to speculate on interest rates, prices, or foreign currencies cannot be afforded favorable deferral accounting treatment. 6 -------------------- BEGINNING OF PAGE #7 ------------------- to identify and address those key variables and other qualitative and quantitative factors which are peculiar to and necessary for an understanding and evaluation of the company. Interpretive Release: Management's Discussion and Analysis of Financial Condition and Results of Operations; Certain Investment Company Disclosures, Release Nos. 33-6835, 34-26831, IC-16961, FR-36 (May 18, 1989) III.A (quoting Securities Act Release No. 6349 (September 28, 1981)(hereafter "Interpretive Release")). See also In re Caterpillar, Inc., Rel. Nos. 34-30532, AAER 363 (March 31, 1992). For interim reports, such as a quarterly report on Form 10-Q, Item 303(b) requires a discussion and analysis of the results of operations "to enable the reader to assess material changes in financial condition and results of operations" that have occurred since the end of the preceding fiscal year. Discussions of material changes in results of operations must identify any significant elements of the registrant's income or loss from continuing operations which do not arise from or are not necessarily representative of the registrant's business. See Instruction 4 to Item 303(b); Section III.E, Interim Period Reporting, in Interpretive Release. Where MD&A disclosure is required, it must be "quantified to the extent reasonably practicable." Id.; In re Caterpillar, Inc., supra, at 11 and 14. 3. Books, Records and Internal Controls Requirements Section 13(b)(2)(A) of the Exchange Act requires issuers 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." A company's "books and records" include not only general ledgers and accounting entries, but also memoranda and internal corporate reports. Under Section 13(b)(2)(A), a company's books and records should reflect transactions in conformity with accepted methods of reporting economic events, and the transactions should be reflected in such a manner as to facilitate the preparation of financial statements in conformity with GAAP. Section 13(b)(2)(B) requires issuers to "devise and maintain a system of internal accounting controls" sufficient to provide reasonable assurances that, among other things, transactions are executed in accordance with management's general or specific authorization and are recorded as necessary to permit preparation of financial statements in conformity with GAAP. B. GIBSON 1. Books and Records and Internal Controls Violations Gibson violated Section 13(b)(2)(A) and Section 13(b)(2)(B) of the Exchange Act with respect to its derivatives activities. Gibson failed to record the value of the derivative positions that are the subject of this order on a mark-to-market basis during the first three quarters of 1993, and in fact did 7 -------------------- BEGINNING OF PAGE #8 ------------------- not obtain mark-to-market values for derivatives as of quarter end during that period. Gibson also failed to establish internal controls sufficient to identify such derivative positions and require that they be marked to market, and to ensure that derivative transactions were executed in accordance with the April 15, 1992 Board resolution. Gibson thus failed to "devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances" that the company's financial statements would be prepared in accordance with GAAP and that transactions would be executed in accordance with management's authorization. 2. Reporting Violations (a). Gibson's Financial Statements Contained in its 1993 Forms 10-Q Gibson's accounting treatment for its derivatives activities during 1993 failed to comply with GAAP. By the first quarter of 1993, Gibson's derivatives activities described in this order had, for accounting purposes, become speculative, and remained so throughout the first three quarters of 1993. Such activities require mark-to-market accounting, with market value changes recognized through the income statement. Gibson, however, deferred gains and losses from derivatives transactions during the first three quarters of 1993. That practice caused material misstatements in the financial statements filed with the Commission by Gibson for the first three quarters of 1993. Gibson thus violated Section 13(a) of the Exchange Act and Rules 13a-13 and 12b-20. (b). MD&A Disclosure The MD&A sections in Gibson's Forms 10-Q for 1993 failed to comply with the requirements of Item 303 of Regulation S-K. Despite the significant quarter-to-quarter changes in the nature, terms, risks and fair values associated with Gibson's derivatives, the 1993 Forms 10-Q were silent on the subject of interest expense and derivatives activities. Gibson failed to provide MD&A disclosure of known uncertainties caused by numerous changes in its derivatives positions, including the significant risks assumed by the company. Gibson thus violated Section 13(a) of the Exchange Act and Rules 13a-13 and 12b-20. C. CAVANAUGH AND JOHNSEN Cavanaugh and Johnsen, as the Chief Financial Officer and Treasurer, respectively, were responsible for Gibson's accounting for and disclosure of its derivative positions in 1993. Cavanaugh and Johnsen were also responsible for maintaining the company's books and records and implementing internal controls. Both were involved in the decisions to enter into the derivatives and were familiar with their terms. Cavanaugh and Johnsen's failure to ensure that these derivatives transactions were marked to market and their failure to provide in Gibson's 1993 10-Qs a disclosure of the company's changing derivatives positions, caused violations by Gibson of Section 13(a) and Rules 13a-13 and 12b-20. Similarly, their failure to maintain, or require that others maintain, adequate books and records and internal controls caused violations by Gibson of Sections 13(b)(2)(A) and 13(b)(2)(B). 8 -------------------- BEGINNING OF PAGE #9 ------------------- V. FINDINGS Based on the foregoing, the Commission finds that Gibson violated Sections 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act and Rules 13a-13, and 12b-20, and that Cavanaugh and Johnsen caused violations of Sections 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act, and Rules 13a-13 and 12b-20 thereunder. VI. OFFER OF SETTLEMENT The Respondents have each submitted an Offer of Settlement in which, without admitting or denying the findings herein, each consents to the Commission's issuance of this Order, which makes findings, as set forth above, and orders: (i) Gibson to permanently cease and desist from committing or causing any violation or future violation of Sections 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act and Rules 13a-13 and 12b-20; and (ii) Cavanaugh and Johnsen to permanently cease and desist from causing any violations and any future violation of Sections 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act and Rules 13a-13 and 12b-20. In accepting Gibson's offer of settlement, the Commission notes that Gibson has restated its financial statements for the first three quarters of 1993. VII. ORDER Accordingly, IT IS HEREBY ORDERED THAT A. Gibson shall cease and desist from committing or causing any violation or future violation of Sections 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act and Rules 13a-13 and 12b-20. B. Cavanaugh and Johnsen shall cease and desist from causing any violation or future violation of Sections 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act and Rules 13a-13 and 12b-20. By the Commission. ___________________ Jonathan G. Katz Secretary 9 -------------------- BEGINNING OF PAGE #10 ------------------- APPENDIX-[6]- Ratio Swap Under the Ratio Swap, based on a $30 million notional amount (the amount used to determine the periodic payments between the counterparties), for a period of five years Bankers Trust would swap an interest payment determined at a fixed rate of 5.50% in exchange for Gibson's variable rate interest payment determined by the square of the six-month London Interbank Offered Rate ("LIBOR") rate divided by 6%, i.e., (LIBOR X LIBOR)/6%. Basis Swap Under the Basis Swap, for a period of four-and-a-half years, based on a notional amount of $30 million, Bankers Trust and Gibson would swap variable rate interest payments structured such that Gibson would receive a net semiannual payment of as much as fourteen basis points, i.e., $42,000, as long as six-month LIBOR was not more than 0.29% lower than six-month LIBOR at the beginning of the immediately preceding semiannual period. If six-month LIBOR fell more than 0.29%, Gibson would have to pay $1,500 to Bankers Trust for each additional basis point, or 0.01%, decline in six-month LIBOR. Spread Lock #1 As initially negotiated, Gibson locked in a spread related to a seven-year swap of 38 basis points commencing November 15, 1994. Gibson and Bankers Trust agreed to cash settle the transaction on November 15, 1994. The spread lock was amended five times during the first nine months of 1993, including changing the underlying dealer spread to be based upon ten-year swaps commencing August 15, 1995. Treasury-Linked Swap The Treasury-Linked Swap had a term of eight months. Under this transaction, Gibson was required to pay LIBOR and would receive LIBOR plus 200 basis points, on a $30 million notional amount. At maturity, Gibson was required to pay Bankers Trust $30 million, and Bankers Trust would pay the lesser of $30.6 million or an amount determined by the following formula: Amendments to the Treasury-Linked Swap, among other things, substituted the three-year Treasury yield for the two-year Treasury yield and altered the maturity. Spread Lock #2 At the time the second Spread Lock was entered into, the first Spread Lock had already been amended so that it was based upon ten-year spreads and commenced on August 15, 1995. The structure of the second Spread Lock was substantially the same as the original structure of the first Spread Lock. That --------- FOOTNOTES --------- -[6]- This Appendix does not describe all of Gibson's derivative transactions or each of the amendments to the derivatives discussed. 10 -------------------- BEGINNING OF PAGE #11 ------------------- is, it was based upon seven-year spreads commencing November 15, 1994 but with a lower spread of 31.5 basis points. However, within two weeks, the second Spread Lock was amended such that both Spread Locks were based upon ten-year swap spreads locking in a spread of 36 basis points. Knock-Out Call Option The Knock-Out Call Option required Bankers Trust to pay Gibson on settlement date an amount calculated as follows: (6.876% - Yield at Maturity of 30-year Treasury security) x 12.5 x $25,000,000. If at any time during the life of the Knock-Out Call Option, the yield on the 30-year U.S. Treasury security dropped below 6.48%, the option expired, or was "knocked out," and became worthless. The option was not exercisable until maturity on September 28, 1993. The yield on the 30-year Treasury security at which the Knock-out Call Option expired was amended three times in August 1993. Time Trade Gibson would receive $150,000 for each six-month period while paying Bankers Trust $7,500 for each day during the six-month period that LIBOR was set outside of the specified range. The calculation periods and specified ranges for the purpose of determining the payments between Gibson and Bankers Trust were as follows: August 6, 1993 - February 6, 1994--3.1875% - 4.3125% February 6, 1994 - August 6, 1994--3.2500% - 4.5000% August 6, 1994 - February 6, 1995--3.3750% - 5.1250% February 6, 1995 - August 6, 1995--3.5000% - 5.2500% The Time Trade was amended three times during the third quarter, including increasing Gibson's per diem payment for LIBOR setting outside of the specified range to $9,750 and then to $13,800. Wedding Band The Wedding Band was a one-year option linked to both Spread Locks and thus had a notional amount of $60 million. The Wedding Band amended the Spread Locks such that the spread would be increased or decreased by an amount determined by the formula .85 x [six-month LIBOR at maturity - 3.75%] if six-month LIBOR set at or outside of the range of 3.00% to 5.00% during the twelve months subsequent to entering into the transaction. 11