Administrative Proceeding File No. 3-9248 UNITED STATES OF AMERICA Before the SECURITIES AND EXCHANGE COMMISSION February 18, 1997 SECURITIES ACT OF 1933 Release No. 33-7389 SECURITIES EXCHANGE ACT OF 1934 Release No. 34-38298 ACCOUNTING AND AUDITING ENFORCEMENT Release No. 885 ----------------------------------- : : ORDER INSTITUTING CEASE- In the Matter of : AND-DESIST PROCEEDINGS : PURSUANT TO SECTIONS 8A ALAN D. ROSSKAMM, : OF THE SECURITIES ACT OF : 1933 AND 21C OF THE Respondent : SECURITIES EXCHANGE ACT : OF 1934 AND FINDINGS AND : ORDER OF THE COMMISSION : ------------------------------------ I. The Commission deems it appropriate and in the public interest that public administrative proceedings be, and they hereby are, instituted pursuant to Sections 8A of the Securities Act of 1933 ("Securities Act") and 21C of the Securities Exchange Act of 1934 ("Exchange Act") against Alan D. Rosskamm ("Respondent"). II. In anticipation of the institution of these proceedings, Respondent has submitted an Offer of Settlement ("Offer"), which the Commission has determined to accept. Solely for the purpose of these proceedings and any other proceeding brought by or on behalf of the Commission or to which the Commission is a party, Respondent, without admitting or denying the matters set forth herein, consents to the issuance of this Order Instituting Cease- and-Desist Proceedings Pursuant to Sections 8A of the Securities Act of 1933 and 21C of the Securities Exchange Act of 1934 and Findings and Order of the Commission ("Order") and to the entry of the findings set forth below. ==========================================START OF PAGE 2====== III. On the basis of this Order and Respondent's Offer, the Commission finds -[1]- the following: A. Respondent Respondent, age 47, is the Chairman, President and Chief Executive Officer ("CEO") of Fabri-Centers of America, Inc. ("Fabri-Centers"). At all relevant times, Respondent was the CEO of Fabri-Centers; he became Chairman in July 1992. B. The Issuer Fabri-Centers, an Ohio corporation whose principal executive offices are located in Hudson, Ohio, is the nation's largest specialty retailer of fabric and crafts, currently operating approximately 915 stores primarily under the names Jo-Ann Fabrics and Crafts, Cloth World and New York Fabrics and Crafts. Fabri- Centers' common stock and corporate debt are registered with the Commission pursuant to Section 12(b) of the Exchange Act and are listed on the New York Stock Exchange. -[2]- C. Background This matter stems from Fabri-Centers' application of the "gross profit method" of accounting during periods immediately before and after a $74.75 million debt offering in March 1992. Under the gross profit method, Fabri-Centers estimated its store inventory levels, gross profit and earnings by applying pre- ---------FOOTNOTES---------- -[1]- The findings herein are made pursuant to Rosskamm's Offer of Settlement and are not binding on any other person or entity named as a respondent in this or any other proceeding. -[2]- On February 18, 1997, the Commission filed a complaint in the United States District Court for the District of Columbia against Fabri-Centers, its former CFO and former controller alleging violations of Section 17(a) of the Securities Act and Sections 10(b), 13(a), 13(b)(2)(A), 13(b)(2)(B) and 13(b)(5) of the Exchange Act and Rules 10b-5, 12b-20, 13a-1, 13a-13, 13b2-1 and 13b2-2 thereunder. Fabri-Centers consented, without admitting or denying the allegations of the complaint, to the entry of a final judgment of permanent injunction and an order that the company disgorge $3.28 million. See SEC v. Fabri-Centers of America, Inc., et. al., Civ. Act. No. 1:97CV00319 (February 18, 1997). ==========================================START OF PAGE 3====== determined margin estimates, referred to as "pegs," against reported sales. Fabri-Centers' long-standing policy was to take physical inventories at each retail store once per year, on a cycle basis, with an approximate equal number of stores inventoried each fiscal quarter. At the beginning of each month, Fabri-Centers began comparing the previous month's physical inventory counts with amounts predicted by the pegs; this reconciliation resulted in either an inventory "shrink" or "pick- up" for each store. The merchandise cost of this variance was then determined and recorded on the company's books and records as a component of cost of goods sold. In periods between physical inventories, Fabri-Centers reported a store's financial performance based on these margin estimates. Fabri-Centers maintained a gross profit reserve account to offset the difference between the pegged inventory levels carried on its books and records and management's best estimate of actual inventory present in the company's stores. The gross profit reserve was important because it was Fabri-Centers' only method to timely capture the effect of price changes. Without the reserve, the effect of an increase or reduction in selling prices would only be recorded slowly over time as the company cycled through its physical inventory calendar. The gross profit reserve was reviewed by the company's top financial and accounting officers at least quarterly. D. Events Leading to the Debt Offering In the fourth quarter of the fiscal year ended February 1, 1992 ("Fiscal 1992"), Fabri-Centers employed more aggressive pricing strategies than it had during the same period in the prior fiscal year. Fabri-Centers' policy was to meet or beat competitive price points and not to lose market share. In the fourth quarter of Fiscal 1992, during its busy holiday season, Fabri-Centers took only eight physical store inventories, the majority of which were of closed or relocated stores, between October 25 and December 31, 1991. In January 1992, Fabri-Centers resumed taking inventories on a cycle basis, and completed physical inventories at 67 of the company's 664 stores. On February 19, 1992, less than three weeks after its fiscal year end, Fabri-Centers issued an earnings announcement; on February 20, 1992, the company filed with the Commission its Annual Report on Form 10-K. Both the February earnings announcement and Form 10-K reported record sales and earnings for the fiscal year and fourth quarter ended February 1, 1992. Fabri-Centers also reported a significant improvement in gross profit margins, particularly fourth quarter gross profit margins. Simultaneously, Fabri-Centers filed an S-3 registration statement for $65 million in convertible subordinated debentures with an over-allotment option of $9.75 million. ==========================================START OF PAGE 4====== In February 1992, Fabri-Centers' CFO, controller and others began receiving negative results from the January physical inventories. By March 4, 1992, the day before the effective date of the S-3 registration statement, the CFO and controller had seen summaries of all 67 January inventories that identified a gross profit shortfall, or shrink, of approximately $1.1 million. These January inventory results reflected a condition existing as of February 1, 1992. During the period February 1991 through December 1991, the company recorded the results of 632 store physical inventories which showed a total net shortfall of $178,000, and the company's fiscal 1992 year-end gross profit reserve was $3.4 million. Had the company taken into consideration the $1.1 million shortfall shown in the January 1992 store physical inventories and extrapolated those results to all stores, then it would have been clear that the year-end gross profit reserve was inadequate and that the company's fourth quarter operating results and financial statements for the just- ended fiscal year were therefore materially misstated. E. False and Misleading Statements to Auditors In connection with the registration statement for the debt offering, Fabri-Centers issued three representation letters to its independent auditors on March 5, 1992 (the effective date of the registration statement), March 13, 1992 (settlement for the initial $65 million offering) and March 26, 1992 (settlement for the $9.75 million over-allotment). Each of these one-page letters was signed by the Respondent and contained the following certification: Since February 1, 1992, there have been no events or transactions, other than those reflected or fully disclosed in the Registration Statement, that have a material effect on the financial statements included therein or that should be disclosed in order to make those statements not misleading. In light of the January inventory results that were available to the company's financial and accounting officers, these representations were materially misleading in that they failed to disclose the negative results of the January physical inventories. Respondent signed all three letters as presented to him without making any inquiry of his CFO, controller or accounting staff. F. Fabri-Centers' Operating Results Continue to Worsen in First Quarter of Fiscal 1993 In February 1992, Fabri-Centers completed physical inventories at another 65 retail stores. Results of these inventories were reported to the CFO, controller and others in March 1992. By April 1, 1992, reconciliations from the 65 ==========================================START OF PAGE 5====== February inventories revealed $1.289 million of additional gross profit shortfall. Moreover, the average per-store shortfall was increasing. These last 132 physical inventories had identified a $2.4 million disparity between actual inventory levels and the peg estimates carried on the company's books. In March 1992, Fabri-Centers took physical inventories at another 76 stores. Results of these inventories identified another $1.658 million of inventory shrink. By this time, the company had identified a discrepancy between actual inventory levels and the peg estimates carried on the company's books of $4 million for 208 stores. Results of these inventories were summarized and distributed to Fabri-Centers' top officials, including Respondent, on a monthly basis. On or about April 7, 1992, Respondent met with other members of senior management to discuss how to respond to lower-than- expected gross profit margins. In preparation, the company's chief financial officer prepared a financial model projecting a $14 million shrink, or gross profit shortfall, in Fiscal 1993, if store physical inventories continued to show similar shortfalls. Fabri-Centers' first quarter of Fiscal 1993 ended on May 2, 1992. On May 16, 1992, the CFO prepared a hand-written memo to the Respondent and others concluding that: (1) inventory shortfalls were indeed averaging $20,000 per store, and (2) the company had sufficient information to see the shortfall at Fiscal 1992 year-end. At the meeting of the Board of Directors on May 21, 1992, which Respondent presided over, senior management informed the Board that earlier projections for Fiscal 1993 gross profit were unlikely to be obtained, citing "unusually severe price competition" during the past six to nine months. Management also informed the Board that sales in recent weeks had been below expectations. G. Fabri-Centers Materially False and Misleading First Quarter Form 10-Q On June 16, 1992, Fabri-Centers filed with the Commission its Form 10-Q for the first quarter of Fiscal 1993. The Form 10- Q stated that gross profit margins were equal to the prior year's gross profit margins, without disclosing that gross profit margins had markedly declined as demonstrated consistently by January, February and March physical store inventories. The Form 10-Q also failed to disclose the existence of the "unusually severe price competition" that had been reported to the Board on May 21, 1992. Respondent signed the Form 10-Q. ==========================================START OF PAGE 6====== IV. OPINION A. Applicable Law Section 17(a)(2) of the Securities Act prohibits an issuer from obtaining money by means of an untrue statement or material omission in connection with the offer or sale of securities. Section 17(a)(3) prohibits any transaction, practice or course of business which would operate as a fraud upon actual or potential purchasers. Violations of Sections 17(a)(2) and (3) do not require proof of scienter. Aaron v. SEC, 446 U.S. 680, 694 (1980). Section 13(a) of the Exchange Act requires that issuers with securities registered pursuant to Section 12 of the Exchange Act file periodic and other reports with the Commission containing such information as the Commission prescribes by rule. Rule 13a- 13 requires issuers to file quarterly reports. Implicit within the reporting requirements of Section 13(a) and Rule 13a-13 is an obligation that the information reported be true and correct. See, e.g., SEC v. Savoy Industries, Inc., 587 F.2d 1149, 1165 (D.C. Cir. 1978), cert. denied, 440 U.S. 913 (1979). Additionally, Rule 12b-20 requires issuers to include such further material information necessary to make these periodic reports not misleading under the circumstances they were made. Section 13(a) further requires that financial statements contained in an issuers' annual and quarterly reports comply with Regulation S-X, which in turn requires the addition of such further material information as is necessary to make the financial statements not misleading. 17 C.F.R.  210.4-01(a). Section 13(a) also requires that the non-financial statement portion of annual and quarterly reports comply with certain parts of Regulation S-K. Item 303 of Regulation S-K requires a registrant to disclose, in the MD&A section, known trends or uncertainties that have had or are reasonably expected to have a material impact on net sales or revenues or income from continuing operations. 17 C.F.R.  229.303(a)(3)(ii). Specifically, issuers must disclose changes in their competitive situation to comply with Regulation S-K. FR-36 (1989). Rule 13b2-2 under the Exchange Act prohibits officers and directors from making false or misleading statements, or omitting to state material facts necessary in order to make the statements made not misleading, to an accountant in connection with the preparation or filing of any document required to be filed with the Commission. ==========================================START OF PAGE 7====== B. Violations by Respondent Respondent violated Sections 17(a)(2) and (3) of the Securities Act and Rule 13b2-2 of the Exchange Act by failing to make adequate inquiry before signing the materially misleading representation letters to the company's auditors in connection with the registration statement for the March 1992 debt offering. Respondent caused the company to violate Section 13(a) of the Exchange Act and Rules 13a-13 and 12b-20 thereunder by signing and approving the Company's false and misleading Form 10-Q for the first quarter of Fiscal 1993. V. FINDINGS The Commission finds that Respondent violated or caused Fabri-Centers to violate Sections 17(a)(2) and (3) of the Securities Act and Section 13(a) of the Exchange Act and Rules 12b-20, 13a-13 and 13b2-2 thereunder. VI. OFFER OF SETTLEMENT Respondent has submitted an Offer in this proceeding which the Commission has determined to accept. Respondent, in his Offer, consents to this Order making findings, as set forth above, and ordering Respondent to cease and desist from committing or causing any violation of, and committing or causing any future violation of, Sections 17(a)(2) and (3) of the Securities Act, Section 13(a) of the Exchange Act and Rules 12b- 20, 13a-13 and 13b2-2 thereunder. VII. ORDER Accordingly, IT IS HEREBY ORDERED, pursuant to Section 8A of the Securities Act and Section 21C of the Exchange Act, that Respondent cease and desist from committing or causing any violation of, and committing or causing any future violation of, Sections 17(a)(2) and (3) of the Securities Act, Section 13(a) of the Exchange Act and Rules 12b-20, 13a-13 and 13b2-2 thereunder. By the Commission. Jonathan G. Katz Secretary