Full opinion text
MEMORANDUM OF DECISION AS TO JACK BURKE DEFENDANTS AND ARTHUR YOUNG & COMPANY DEFENDANTS WITH SUMMARY OF SEPARATELY FILED SPECIFIC FINDINGS AND CONCLUSIONS AS TO SAID DEFENDANTS SWEIGERT, District Judge. After trial of the above case before the Court without a jury, the Court, having previously rendered an oral decision from the bench as to Jack Burke and the Jack Burke-controlled defendant companies which were directly involved in the JB and Geotek programs (hereinafter referred to collectively as “the Jack Burke defendants”); and as to Arthur Young & Company and four individual Arthur Young & Company Certified Public Accountants (hereinafter referred to collectively as “AY”), now files this Memorandum of Decision elaborating on that oral decision and including herein a summary of its separately filed “Specific Findings and Conclusions re 'Jack Burke Defendants and 'Arthur Young & Company Defendants”, with references thereto. The Court has found against the Jack Burke defendants on some issues and in their favor on others. (See p. 728, infra). The Court has found in favor of the Arthur Young & Company defendants on all issues. (See p. 730, infra). BACKGROUND AND STATUS OF THE LITIGATION For a better understanding of the issues considered in this Memorandum of Decision and in the separately filed Specific Findings and Conclusions, we first set forth a brief statement concerning the background of the case. During the 1960’s defendant Jack Burke began to form a number of investment programs for the purpose of exploring and drilling for oil and gas. The first series of such programs were joint ventures, known as the JB-64, JB-65, JB-66, JB-67 and JB-68 Oil Exploration Programs, in which defendant JB Oil Company, a corporation owned and controlled by Jack Burke, served as manager and in turn contracted with defendant The Fundamental Oil Company (hereinafter “Fundamental”), also a corporation owned and controlled by Jack Burke, to serve as operator of the programs. In September, 1969, an exchange offer was made pursuant to which investors in the JB-64, JB-65, JB-66 and JB-67 programs exchanged their interests in those programs for corporate shares in defendant Petroleum 2000 Corporation (hereinafter “P-2000”). In October, 1970, investors in the JB-68 program exchanged their interests in that program for corporate shares in defendant Petroforce Corporation (hereinafter Petroforce). Since these JB programs were intended for only intra-state investment, interests in them were sold under permits obtained from the California Corporation Commissioner, without any registration with the SEC. In 1969, Burke began another series of programs which were limited partnerships and were known as the Geotek 69-1, 70-1, 70-2, 71-1 and 71-2 programs. In these programs Geotek Resources Fund, Inc., (hereinafter “GRF”), a corporation owned and controlled by Jack Burke, was named as the general partner, and it in turn contracted with GTR Management Company, Inc., (hereinafter “GTR”), a corporation also owned and controlled by Jack Burke, to serve as manager of the programs. GTR, in turn, utilized Fundamental for various purposes in furthering oil and gas exploration, property acquisitions and operations on behalf of the Geotek programs. The Geotek limited partnerships were sold both within and without the State of California and were for that reason registered with the SEC. In 1969, defendants Jack Burke and Percy Goodwin sold in the State of Washington interests in two other California limited partnerships — Hydrocarbon Associates, Ltd., (hereinafter “Hydro”) and Petro Development Associates, Ltd., (hereinafter “Petro”). In both of these programs Percy Goodwin appeared as the general partner along with the Citrix Oil Company, a corporation wholly owned and controlled by Jack Burke. In October, 1970, investors in these Hydro and Petro programs exchanged their program interests for corporate shares in defendant Washington Oil Investors, Inc., (hereinafter “Washington Oil”). By 1971, a total of approximately $30 million had been invested by the public in these three series of programs — $12 million by 379 investors in the JB programs; $17 million by 1200 investors in the Geotek programs; $600,000 by 21 investors in the Hydro program; and $400,000 by 16 investors in the Petro program. THE SEC INVESTIGATIONS In January, 1970, the SEC, then having before it the matter of the clearance of certain registration materials for Geotek 69 — 1, made an order of investigation and, in the course of its investigation, concluded that the prospectus for that program did not adequately reflect Jack Burke’s previous oil and gas affiliations. This matter was soon resolved by the SEC’s acceptance of an offer from the Jack Burke defendants to issue voluntarily a modified prospectus for Geotek 69-1 and also to allow any Geotek 69-1 investor, who desired to do so, to rescind his investment. In February, 1971, the SEC, then having before it the matter of the clearance of some proxy material prepared in connection with a proposed merger of the Geotek and other programs into corporate form with the Pacific Oil and Gas Company, made a second order of investigation and received from Jack Burke an affidavit dated January 28, 1972. In this Jack Burke affidavit, which purported to disclose all his prior activities in the oil and gas business, Burke omitted to disclose his previous connection with four companies — Island Oil Corporation, Regent Oil Corporation, Northern Continental Petroleum Corporation and Ramada Drilling Company- — which companies he had secretly set up, and which he owned and controlled through his brother Robert Burke. Thereafter, Jack Burke caused these companies to enter into certain transactions with Fundamental in its capacity as the Jack Burke-controlled operator of the JB programs. Shortly after receiving this Jack Burke affidavit, the SEC happened to come upon information indicating to it for the first time a possible connection between Jack Burke and the Island Oil Corporation. When the SEC asked Burke to explain this connection, Burke, on February 14, 1972, confessed to his business associates and, in effect, to the SEC, his past connection with these so-called secret companies and the fact that his SEC affidavit was false in omitting to so show. Thereafter, at the insistence of his business associates, Burke resigned all officerships and directorships which he had held in the so-called Jack Burke-controlled companies. Subsequently, but prior to the filing of the instant action, Petroforce brought suit in California State Court against Jack Burke, the four so-called secret companies and other Burke-controlled companies, alleging improper dealings by those defendants with the JB programs — a lawsuit that has not been prosecuted. THE PENDING ACTION In May, 1973, the SEC brought this civil action under the federal securities acts (15 U.S.C. §§ 78e and 77t(b)) against Jack Burke and others, alleging violations of several sections of the Securities Acts (15 U.S.C. §§ 77g(a); 78g(b); 78n(a); and 78o (d)) and seeking the injunctive relief authorized by 15 U.S.C. §§ 78e and 77t(b). In this action, the SEC has included as defendants, not only Jack Burke and the so-called Jack Burke-controlled companies, but also the so-called investor-controlled entities. This latter group includes P-2000, Petroforce, and Washington Oil. In addition to the above-named defendants, the SEC also joined other defendants who, according to SEC, have allegedly violated the securities acts by participating with and aiding Jack Burke and the Jack Burke-controlled companies to violate those acts. Among these additional defendants are the Arthur Young & Company defendants (“AY”) — the nationally based certified public accounting firm and its four individual accountants — which defendants had been engaged by the Jack Burke defendants to perform certain auditing services for the JB and Geotek programs; also Robert Burke, Jack Burke’s brother and an officer of certain of the above-mentioned so-called secret companies; Arthur Lempert, one of the attorneys for Jack Burke and the Burke-controlled companies, and an officer of GRF and GTR; Jacqueline Aldrich, a bookkeeper-accountant who was an officer of Fundamental, P-2000, Petroforce, GRF and GTR; Percy Goodwin, a securities salesman associated with Jack Burke in the sale of Petro and Hydro interests in the State of Washington and a general partner of those two programs; and Robert Mount, an associate of Jack Burke, who sold interests in the JB programs and was an officer of Fundamental, JB Oil Company, P-2000, Petroforce, Charter Street, GRF and GTR. THE PRELIMINARY INJUNCTION On October 9, 1973, the SEC sought a preliminary injunction in this case upon the ground that it appeared likely that, unless preliminarily enjoined, Jack Burke, although resigned from his officerships and directorships, might still control or attempt to influence or control the Geotek programs. On that same day, October 9, 1973, this Court issued its Memorandum of Decision and Order enjoining any such Burke control, and, because it then also appeared likely that there had been a commingling of assets and liabilities of and between the various programs, the Court also appointed a receiver for Fundamental, GRF, GTR and the individual Geotek programs. All five of the Geotek programs have since been operating through the receiver. Neither the JB programs (now P-2000 and Petroforce) nor the Hydro and Petro programs (now Washington Oil) were placed in the receivership. THE CRIMINAL PROSECUTION In June, 1974, a criminal indictment was returned in this court charging Jack Burke with violations of 15 U.S.C. §§ 77q(a) and 77x (fraud in the sale of securities); 18 U.S.C. § 1341 (mail fraud); and 18 U.S.C. § 1001 (false statements); and also charging Jack Burke, Arthur Lempert and Robert Rose (an attorney and officer of both GRF and GTR) with violation of 18 U.S.C. § 371 (conspiracy). In the course of a jury trial on those charges, defendant Jack Burke changed his plea to a plea of guilty to violation of 18 U.S.C. § 1001 — a charge arising out of the false affidavit above-mentioned. Thereupon, on January 20, 1975, Jack Burke was sentenced to 30 months imprisonment and a fine was imposed in the amount of $5,000. No criminal convictions were ever obtained against Burke on the fraud and conspiracy charges, and defendants Lempert and Rose were acquitted on motions granted by the Court. THE TRIAL OF THIS CIVIL ACTION AND PRESENT STATUS In June, 1975, the pending civil case came on for a long and complex trial before this Court, sitting without a jury, for 34 court days during which 30 witnesses were heard and approximately 760 exhibits were introduced. Upon completion of the SEC case in this trial in October, 1975, motions were made by all defendants under Rule 41(b), Fed.R.Civ.P. to dismiss the action. As to defendant Jack Burke, the case is now ready for judgment upon the trial record — supplemented by an offer of proof of certain further facts filed December 15, 1975. As to the AY defendants, the Court heard their defensive evidence (except for certain evidence relating to their affirmative defenses) and on that record the case is also ready for judgment as to AY. THE APPLICABLE LAW — SCIENTER Before summarizing the Court’s separately filed Specific Findings and Conclusions with respect to the SEC charges against the Jack Burke defendants and AY, we set forth the legal standard by which the conduct of those defendants has been judged. The SEC brings this statutory enforcement action under the federal securities laws, charging that the Jack Burke defendants made material misstatements and/or omissions in the JB and Geotek program “basic documents” and also in certain of the JB and Geotek program receipts and disbursements financial statements. The SEC also charges that AY made material misrepresentations and/or omissions in its audit report certifications of those JB and Geotek program financial statements. Since the JB programs were never registered with the SEC, the SEC’s claims with respect to those programs are based only upon Section 17(a) of the Securities Act of 1933 (15 U.S.C. § 77q(a)) and Section 10(b)/Rule 10b-5 of the Securities Exchange Act of 1934 (15 U.S.C. § 78j(b)/17 CFR 240.10b-5. The Geotek programs, however, were registered with the SEC, and the SEC’s claims with respect to those programs are based, not only on Sections 17(a) and 10(b)/10b-5, but also upon Sections 14(a) and 15(d) of the 1934 Act. (15 U.S.C. §§ 78n(a), 78o(d)). The Supreme Court in Ernst & Ernst v. Hochfelder, 425 U.S. 185, 96 S.Ct. 1375, 47 L.Ed.2d 668 (1976), has held that proof of ordinary negligence is insufficient to establish liability in a private Section 10(b)/Rule 10b-5 damage action. The Court noted in Hochfelder that Section 10(b) expressly makes unlawful the use or employment of “any manipulative or deceptive device or contrivance” in contravention of SEC rules, and, upon a review of the legislative history of that language, the Court held that some type of “scienter” is required to establish 10(b)/10b-5 private action liability. For the purposes of its decision the Court defined “scienter” as “intent to deceive, manipulate or defraud” and declined to decide whether, in some circumstances mere “reckless” behavior would be sufficient to establish liability under 10(b)/10b-5. (425 U.S. at 193, n. 12, 96 S.Ct. 1376). In so ruling, the Court rejected and overruled the Ninth Circuit’s “flexible duty standard”, insofar as that standard permitted the establishment of 10(b)/10b-5 liability for mere negligent conduct which was in breach of a duty of ordinary or even extreme care. (See, e. g. White v. Abrams, 495 F.2d 724 (9th Cir. 1974)). In Hochfelder, however, the Court expressly declined to consider the question herein presented — i. e., whether the same “scienter” now required in a private 10(b)/10b-5 damage action is also required in a 10(b)/10b-5 statutory enforcement action brought by the SEC. (425 U.S. at 193 n. 12, 96 S.Ct. 1376). Prior to the Supreme Court’s decision in Hochfelder, the degree of culpability required to establish liability in a 10(b)/10b-5 SEC enforcement action was established by a majority of cases to be “negligence” or the “lack of due diligence.” SEC v. Management Dynamics, Inc., 515 F.2d 801 (2d Cir. 1975); SEC v. Texas Gulf Sulphur Co., 401 F.2d 833, 854-855 (2d Cir. 1968); SEC v. Spectrum, Ltd., 489 F.2d 535, 541 (2d Cir. 1973); SEC v. Dolnick, 501 F.2d 1279 (7th Cir. 1974); SEC v. Van Horn, 371 F.2d 181 (7th Cir. 1966). Contra, SEC v. Coffey, 493 F.2d 1304 (6th Cir. 1973). Section 17(a), although substantially similar to Section 10(b)/10b-5, does not contain the specific language of Section 10(b) relied upon in Hochfelder to require proof of “scienter” in private 10(b)/10b-5 actions and was not specifically discussed by the Supreme Court in Hochfelder. Nor did the Supreme Court indicate in Hochfelder whether “scienter” is a required element of proof in an SEC enforcement action brought for violations of Sections 14(a) and 15(d) of the 1934 Act. For the purposes of this action, however, we have decided to apply the strict standard of negligence (i. e., ordinary care or due diligence) as to all SEC claims against defendants. APPLICABLE LAW — APPROPRIATENESS OF INJUNCTIVE RELIEF In addition to determining whether the SEC has established the requisite degree of culpability in an SEC enforcement action, it is clearly established that, in such an action, the Court must also further determine whether, as a matter of equity, the issuance of a statutory injunction is appropriate. This equitable determination is one which must be made individually in each ease. The standard upon which the Court must base its decision is whether there is a “reasonable likelihood” or “expectation” that the defendant will commit further violations of the securities laws in the future. SEC v. Texas Gulf Sulphur Co., 258 F.Supp. 262 (SDNY 1966), remanded 401 F.2d 833 (2d Cir. 1968), dec. on remand 312 F.Supp. 77 (SDNY 1970); SEC v. Manor Nursing Centers Inc., 458 F.2d 1082 (2d Cir. 1972); SEC v. Harwyn Industries Corp., 326 F.Supp. 943 (SDNY 1971). See also, Hecht Co. v. Bowles, 321 U.S. 321, 64 S.Ct. 587, 88 L.Ed. 754 (1944); SEC v. W. T. Grant, 345 U.S. 629, 73 S.Ct. 894, 97 L.Ed. 1303 (1952). GENERAL FINDINGS AS TO THE JACK BURKE DEFENDANTS It should first be noted that the oil and gas exploration programs initiated by Jack Burke were not empty shells. All of the JB and Geotek programs have been and now are operating entities with substantial oil and gas properties in various states of actual or potential production; all have substantial income and, of course, debts, but none has ever been judicially found to be insolvent. Some problems have arisen, however, concerning the allocation by the Jack Burke-controlled corporate managers and operators of certain properties, credits and liabilities among the various programs. It should also be noted that financial losses to investors attributable to Jack Burke’s so-called secret dealings, if there were any such losses, were not anywhere near the $30 million which was in effect entrusted to him and his companies under the terms of the basic program documents. As far as the Jack Burke defendants are concerned, we may generally state that, although we have found that in some matters there was deliberate failure to disclose certain material facts (e. g., Jack Burke’s failure to disclose in financial statements that he had been dealing personally, or through Fundamental, with certain of his own secret companies), most of his alleged misstatements and omissions did not involve secret dealings. Many of the charges against the Jack Burke defendants are to the effect that the JB and Geotek financial statements failed to disclose that these defendants were operating the programs in a manner unauthorized by or in contravention of the terms of the basic JB and Geotek documents. Those basic JB and Geotek program documents, however, were so drawn as to vest wide, discretionary operating powers in known Jack Burke-controlled companies (e. g., JB Oil Company, Fundamental, GRF and GTR), and the SEC’s charges concerning such allegedly unauthorized transactions call for a determination as to whether certain operations were (or were not) authorized within the meaning of the basic documents. Whatever may be said about the wisdom of granting such broad operating authorizations and powers as were granted in the JB and Geotek basic documents, it must be borne in mind that those powers and authorizations had been, nevertheless, disclosed to investors in the basic documents prior to investing in the programs and, further, that in the case of the Geotek programs, the prospectuses containing such broad powers and authorizations had all been cleared by the SEC, itself. On the subject of the authority of GTR (the Jack Burke-owned and controlled Geotek manager) to deal with and through Fundamental (another Jack Burke-owned and controlled company) it must be borne in mind that Jack Burke had been widely publicized as the parent, promoter and founder of both the JB and the Geotek programs. The importance of Jack Burke’s overall role in these programs was stressed not only in the basic program documents, but also, according to the evidence in this case, in the actual sales talks made to potential investors. Most of the misrepresentations and/or omissions charged against the Jack Burke defendants were alleged misrepresentations in or omissions from either the written JB and Geotek basic documents upon which interests in the programs were sold, or the programs’ subsequently issued written receipts and disbursements financial statements. As to the AY defendants, any misrepresentations and/or omissions charged against them relate to AY’s audit report certifications of those same written financial statements. It should also be noted that, as far as the program financial statements and the AY certifications thereof are concerned, these were' issued long after the initial public investments had been made in the various programs. Further, there is no evidence in the record showing that any of the Geotek financial statements, or the AY certifications thereof, were ever sent, either by management or by AY, to Geotek investors. The evidence shows only that they were used by the programs for attachment to the annual Form 10k reports filed with the SEC for each Geotek program. The SEC introduced some testimony of JB and Geotek investors for the purpose of showing that, in addition to such misrepresentations and omissions in the basic documents and financial statements, Jack Burke (along with defendants Percy Goodwin and Robert Mount) also made various oral misrepresentations in meetings with potential investors. This testimony, however, fell far short of supporting SEC charges concerning Jack Burke misrepresentations or nondisclosures concerning existing or past material facts. Most of this testimony had to do with conclusory or “puffing” statements upon which investors could hardly have relied and upon which most of the investor witnesses obviously did not rely. These sales talks, as well as the written JB and Geotek program offerings, were directed for the most part to wealthy investors who could afford the risks of oil exploration programs and who might be at least as interested in income tax advantages as in prospective profits. The JB-65 through JB-68 program offering circulars expressly warned that “oil and gas ventures are speculative and that there was no assurance that oil or gas would be discovered in commercial quantities by the programs.” (E. g., Ex. 10D, p. 3). Similarly, the cover page of the Geotek prospectuses contained a caption in large letters that “THESE SECURITIES INVOLVE A HIGH DEGREE OF RISK,” and also contained a disclosure that investment in the Geotek programs was recommended “only for persons who have income that is subject to the higher federal income tax rates and who may benefit from the tax treatment presently allowed such investments under the Federal Tax Laws.” Additionally, the Geotek prospectuses contained a specific section titled “Risk factors”, wherein reference was made to the speculative nature of oil and gas operations and exploration; Jack Burke’s ownership and control of GRF, GTR and Charter Street; the possibility of financing the programs by borrowing; and the authorization to the programs to acquire properties from “affiliates, which could result in possible conflicts of interest.” (E. g., Ex. 14, pp. 3-4). SPECIFIC FINDINGS AND CONCLUSIONS SUMMARIZED — CHARGES AGAINST JACK BURKE DEFENDANTS On the SEC charges concerning certain so-called unauthorized transactions, we have found against the Jack Burke defendants on some of these charges and in their favor as to the remainder. (See, Specific Findings and Conclusions — “I. Unauthorized Transactions”). Certain other SEC charges against the Jack Burke defendants are to the effect that, although these defendants did disclose certain affiliated property transfer and drilling contract transactions in the program financial statements, the disclosures were inadequate. We have found against the Jack Burke defendants on some of these charges and in their favor as to the remainder. (See Specific Findings and Conclusions — “II. Affiliated Property Transfers and Drilling Contracts”). Another SEC charge is to the effect that certain JB financial statements were in such form as to conceal from federal tax authorities the fact that the programs had enabled their individual investors to claim more advantageous tax deductions than those to which the investors were properly entitled. On these charges we have found in favor of the Jack Burke defendants. (See, Specific Findings and Conclusions— “HI. Late Clearing Checks”). Another SEC charge is to the effect that in one of the JB financial statements costs relating to a certain oil property (“Tracy Mountain”) were misleadingly described as costs relating to a “production property”. On this charge we have found in favor of the Jack Burke defendants. (See, Specific Findings and Conclusions — “IV. Tracy Mountain”). Certain other SEC charges are to the effect that the Geotek basic documents and financial statements misstated and/or omitted certain material facts relating to the allocation, classification and estimation of overhead expenses. On these charges we have found in favor of the Jack Burke defendants. (See, Specific Findings and Conclusions — “V. Overhead Expenses”). Certain other SEC charges are to the effect that certain JB and Geotek financial statements did not adequately disclose all the material facts concerning certain bank loans obtained by Fundamental. On these charges we have found in favor of the Jack Burke defendants. (See, Specific Findings and Conclusions — “IV. Bank Loans”). Another SEC charge is to the effect that certain Geotek basic documents and financial statements did not disclose that a certain transaction, which was otherwise authorized and fair, was made for the purpose of repaying a cash shortage owing to certain programs. On this charge we have found' against the Jack Burke defendants. (See, Specific Findings and Conclusions— “VII. The Lost Creek-Million Dollar Shortage Transaction”). Another SEC charge is to the effect that the Jack Burke defendants failed to disclose in certain Geotek prospectuses that Jack Burke would receive more remuneration than was specified in the prospectuses. On this charge we have found in favor of the Jack Burke defendants. (See, Specific Findings and Conclusions — “VIII. Remuneration to Jack Burke”). Another SEC charge is to the effect that the Jack Burke defendants failed to comply with certain provisions in the JB basic documents concerning issuance of regular financial reports. On this charge we have found in favor of the Jack Burke defendants. (See, Specific Findings and Conclusions— “IX. Failure to Issue Regular Financial Statements”). With respect to the several charges as to which the Court has found against the Jack Burke defendants, the Court has further found that the misrepresentations and/or omissions were made by those defendants, not merely negligently due to their failure to use ordinary care, but deliberately and with intent to deceive — i. e., “scienter” within the meaning of Ernst & Ernst v. Hochfelder, supra. GENERAL FINDINGS AS TO AY DEFENDANTS In 1966, AY was employed by the JB programs to issue audit report certifications of certain of the programs’ receipts and disbursements financial statements. This audit work was undertaken by AY and continued for about five years. It involved, not only the original JB-64 and JB-65 partnerships which were in existence in 1966, but also the three subsequent JB programs (i. e., JB-66, JB-67 and JB-68) and three of the five subsequent Geotek programs (i. e., Geotek 69-1, 70-1 and 70-2). Prior to certifying these JB and Geotek financial statements, which statements involved a total of nearly $30 million in transactions between the programs and their respective general partners, managers and operators, AY engaged in an extensive accounting examination involving an enormous amount of record vouching, as shown in AY’s voluminous work papers. These AY audit report certifications were in the usual form and certified that AY had examined the statement of the program’s receipts and disbursements for the stated period; that its examination was made in accordance with generally accepted auditing standards, and, accordingly, included such tests of the accounting records and such other auditing procedures as AY considered necessary in the circumstances; and that, in AY’s opinion, the statement presented fairly the receipts and disbursements of the particular program in conformity with generally accepted accounting principles. It should also be noted that AY, in addition to strongly denying any deviation from accepted auditing standards, has from its very first appearance urged certain separate, so-called equitable affirmative defenses, asserting in effect, that the SEC included AY as a defendant herein, not in good faith on the merits, but for other ulterior purposes. For reasons hereinafter set forth, it is unnecessary to pass upon these or any other AY affirmative defenses. If the legal standard applicable in SEC statutory enforcement cases were not still an open question, and if “scienter” (i. e., intent to deceive, manipulate or defraud) was clearly established as an essential element in an SEC Section 10(b)/10b-5 enforcement action, then AY would be entitled to an immediate dismissal from this case. There is not a scintilla of evidence that anything was misstated or omitted by AY in its audit report certifications consciously, intentionally or with fraudulent purpose to decdive either investors, the SEC or anyone else. The evidence is clearly to the effect that, if anything was misstated or omitted by AY in its audit certifications, it was done so in the good faith belief and judgment that AY was following generally accepted auditing standards; that AY utilized such tests of program-related accounting records as it considered necessary under the circumstances and that, in AY’s professional opinion, the audit report certifications did fairly present the status and condition of the receipts and disbursements of the particular programs. However, since, as already noted in this Memorandum, there is still some question whether mere negligent violation of accepted auditing standards is sufficient to constitute federal security law violation in an-SEC statutory enforcement case, we have applied to AY the strict test of due diligence or negligence. SPECIFIC FINDINGS SUMMARIZED— CHARGES AGAINST AY DEFENDANTS The SEC, in substance and effect, charges that the AY defendants knew or should have known of certain of the Jack Burke defendants’ above-mentioned improper practices, misstatements and/or omissions and, therefore, that the AY defendants violated the federal securities laws (either as primary defendants or as aiders and abettors of the Jack Burke defendants) by misstating in their audit report certifications that the JB and Geotek financial statements and AY’s examination thereof were in accordance with generally accepted accounting principles and generally accepted auditing standards. On all of these charges against the AY defendants we have found in their favor. (See, Specific Findings and Conclusions — I—VI, VIII and X). A separate further SEC charge against AY is to the effect that, in preparing its audit report certifications of the program receipts and disbursements financial statements, AY inadequately audited the books and records of Fundamental. On this charge against the AY defendants we have found' in their favor.' (See, Specific Findings and Conclusions — “X. Failure to Further Audit Fundamental”). FINDINGS RE PROPRIETY OF INJUNC-TIVE RELIEF With respect to the appropriateness of injunctive relief in this action, the Court finds and concludes that, as to the Jack Burke defendants, the federal securities laws violations as herein found against said defendants are such that there is a reasonable likelihood and expectation that, unless now enjoined as provided in 15 USC §§ 78e and 77t(b), said defendants will commit further violations of the securities laws in the future. As to AY, the Court finds and concludes that, even if a violation of the securities laws, as contended by the SEC herein, were found, the evidence is insufficient to show a reasonable likelihood or expectation that AY would commit further violations in the future. FINDINGS RE ENTRY OF JUDGMENT AS TO AY Since multiple parties are involved in this action, the Court hereby determines that there is no just reason for delay and directs the entry of a final judgment in favor of the AY defendants pursuant to Rule 54(b), Fed.R.Civ.P. This Memorandum of Decision, containing the General Findings and Conclusions of the Court, together with the Court’s separately filed Specific Findings and Conclusions, which are hereby referred to and incorporated as a part hereof, constitute the findings and conclusions of the Court as required by Rule 52(a), Fed.R.Civ.P. COURT’S SPECIFIC FINDINGS AND CONCLUSIONS RE JACK BURKE DEFENDANTS AND ARTHUR YOUNG & COMPANY DEFENDANTS 1. UNAUTHORIZED TRANSACTIONS The SEC first contends that the Jack Burke defendants engaged in certain practices and transactions in the JB and Geotek programs which were not authorized, or were expressly prohibited, by the JB and Geotek basic documents and, therefore, that the basic documents and the audited financial statements for those programs contained material misstatements and/or omissions with respect to these “unauthorized” practices or transactions. The SEC’s contentions concerning these allegedly unauthorized transactions fall into four separate subcategories which will be discussed below: (A) Role of Fundamental; (B) Improper Disbursements; (C) Separate Bank Accounts; (D) Competitive Bidding. A. Role of Fundamental The Fundamental Oil Corporation (hereinafter “Fundamental”), a corporation wholly owned and controlled by Jack Burke, engaged in a variety of activities on behalf of the JB and Geotek programs, as well as engaging in activities on its own behalf. The SEC’s primary objection to the role of Fundamental, however, relates to the Geotek programs and is to the effect that, acting in contravention of the basic documents, both Geotek Resources Fund, Inc. (hereinafter, “GRF”), as general partner of the programs, and GTR Management Company (hereinafter, “GTR”), as manager of the programs, caused Fundamental to engage in a number of allegedly unauthorized Geotek program activities. As to the JB programs, the SEC concedes that the JB Oil Company was expressly authorized in the JB programs’ basic documents to deal with Fundamental, and contends only that the description of Fundamental set forth in a portion of one of the program’s basic documents was misleading. 1. Geotek Programs With respect to the Geotek programs, in contradistinction to the JB programs, Fundamental was not expressly named in the basic documents as a company which would perform program-related functions; the only specific reference to Fundamental in the Geotek basic documents was in a biographical section of the prospectuses, wherein it was disclosed that Jack Burke, Chairman and President of GRF and GTR, was also the President and sole stockholder of Fundamental and that certain other officers of GRF and GTR also were, or had been, officers of Fundamental. (Exhibits 12 and 13, pp. 15-16; Exhibits 14 and 15, p. 11; Exhibits 16 and 17, pp. 12-13). Although during the trial the SEC broadly contended that management of the Geotek programs had no authority at all to deal with Fundamental, that contention was supported only by equally broad testimony of one of the SEC’s expert witnesses (Ten Eycke of the SEC staff). In its post-trial arguments, the SEC narrowed that contention to more specifically contend that the Jack Burke defendants misstated or failed to disclose that Fundamental was engaging in the following unauthorized Geotek program activities: (i) that Fundamental was acting as an “operator” for the Geotek programs; (ii) that Fundamental was holding legal title to the Geotek program properties; (iii) that Fundamental was receiving and holding “advance” disbursements which had been advanced by the programs to GTR and in turn by GTR to Fundamental; (iv) that Fundamental was pledging program properties as collateral for bank loans. As to AY, the SEC contends that AY knew or should have known of these allegedly unauthorized activities of Fundamental and of the Jack Burke defendants’ failure to disclose them and that AY, therefore, improperly certified the audited Geotek financial statements. (a) The Basic Documents With respect to each of these challenged aspects of Fundamental’s activities in the Geotek programs, the Geotek basic documents provided in pertinent part as follows: (i) Fundamental as “Operator” The Geotek prospectuses provided that it was contemplated that GTR, as manager of the Geotek programs, would enter into transactions on behalf of the programs with “various oil and gas operators, suppliers and contractors for the furnishing of equipment, supplies and services, including drilling services”; that neither GRF, as General Partner of the Geotek programs, nor GTR, nor any officer or director of either (all defined to be “affiliates”) would have any interest directly or indirectly in any such operators, suppliers or contractors or derive any profit from such transactions; that, nevertheless, “affiliates” could acquire properties, participate in drilling operations and engage in other activities in the oil and gas business for their own account, but that “[n]o oil and gas lease or interest therein or other real or personal property of any kind [would] be acquired for the benefit of the Limited Partnerships from such affiliates except for a price not greater than the actual cost of such property to the affiliated seller” (emphasis added); that properties could be acquired from an affiliate for a price greater than cost, but not greater than the then market value of the property, if, and only if, Geotek Resources Fund approved the acquisition by a vote of its directors and if the acquisition price was confirmed as not greater than the market value by a written evaluation report signed by an independent petroleum engineer. (E. g., Exhibits 12 and 13, pp. 17 — 18). The Geotek limited partnership agreements provided, without limitation as to affiliates, that the General Partner (GRF) had complete authority in the management and control of the business of the programs and that the General Partner’s powers included, but were not limited to, the power “to enter into operating agreements with others with respect to properties acquired by the Limited Partnership, naming a third party as operator . . . and containing such terms, provisions and conditions as the General Partner shall approve.” (E. g., Exhibits 12 and 13, p. A-2, § 6.1). It was under this authorization in the limited partnership agreements that the General Partner entered into a management agreement with GTR for each of the Geotek programs. The Geotek management agreements provided, without limitations as to affiliates, that the Manager (GTR) could “authorize an industry associate who owns a share of the working interest in a property or another qualified person to act as operator” and that, in the event this was done by the Manager, the Manager would act as agent for the programs in dealing with such “third party operator” and would “execute an operating agreement not inconsistent with the terms of the management agreement.” (E. g., Exhibits 12 and 13, p. B-3, § 3.4). The evidence is to the effect that no formal written operating (or “management service”) agreement similar to that executed between the JB Oil Company and Fundamental was ever executed between GTR and Fundamental. (ii) Fundamental as Holder of Legal Title to Program Properties The Geotek management agreements provided that “[ujnless otherwise directed by the Partnership, the Manager shall hold legal title to the Partnership’s properties .”. (E. g., Exhibits 12 and 13, p. B-3, § 3.5). (iii) Fundamental as Recipient of Advance Disbursements Although the basic documents contain no express provisions concerning the Manager’s authority to retransfer funds advanced to it to a third party, the management agreements did generally provide that the Manager had the authority, not only to manage the programs by itself, but also “to employ others from time to time in order to provide the experienced, qualified and competent personnel in the conduct of the Partnership’s business.” (E. g., Exhibits 12 and 13, p. B — 1, § 1.1). (iv) Fundamental as Pledger of Program Properties as Collateral for Bank Loans The Geotek limited partnership agreements provided that the General Partner (GRF) was authorized to “[b]orrow money from banks and other lending institutions for any Limited Partnership purpose and in connection therewith to hypothecate the assets of the Limited Partnership including, without limitation, the production and proceeds of production therefrom to secure repayment of the borrowed sums.” (E. g., Ex. 13, p. A-3). (b) The Evidence The evidence with respect to each of the above-mentioned four aspects of Fundamental’s role in the Geotek programs is to the effect that: (i) Fundamental, although not actually acting as the “on-site operator” for program drilling rigs, was responsible for engaging and supervising third parties to .operate such rigs and for providing supplies and services for program drilling operations; (ii) that Fundamental did hold legal title to the program properties; (iii) that Fundamental did receive advance disbursements from GTR which had initially been advanced to GTR from the programs; and (iv) that Fundamental did pledge program properties as collateral for bank loans. (c) Findings and Conclusions We find and conclude with respect to these four challenged aspects of Fundamental’s role in the Geotek programs that the relevant provisions in the basic Geotek documents are so broad as to make it unclear whether or not any of the activities of Fundamental, which are challenged by the SEC, were actually unauthorized or otherwise improper. It is not clear, for example: (i) what is meant by the term “operator”, as it was used in the three different Geotek basic documents, and whether the term “operator”, at least as used in the limited partnership and management agreements, was required to be a non-affiliate; (ii) whether the general partner (or the manager) “otherwise directed” that Fundamental would hold legal title to the program properties, as authorized by the management agreements; (iii) whether any provision of the basic Geotek documents expressly or in substance prohibited GTR from transferring to Fundamental funds disbursed to GTR by the programs; (iv) whether, assuming Fundamental properly held legal title to the program properties, Fundamental was prohibited by the basic documents from pledging said properties upon instructions from the general partner to do so. We therefore conclude from the foregoing that the evidence is insufficient to support a finding that the representations in the basic documents concerning the role of Fundamental were fraudulent, intentional or, under the circumstances of this case, even negligent misstatements, as to which some further disclosure was required. We further find and conclude, however, that, even if the role of Fundamental was improperly represented or inadequately disclosed, the question remains whether, under the circumstances of this case, any of the misrepresentations or omissions were material. In other words, we must still determine whether, even if the challenged activities of Fundamental were not authorized by the basic documents, such unauthorized activities constituted material deviations from the terms of the basic documents. In connection with this issue of materiality, the evidence is to the effect that Fundamental, GRF and GTR were widely known to be, in effect, one and the same and, therefore, that nothing done by Fundamental on behalf of the programs in fact increased the degree of risk to the Geotek investors. For over four years prior to the Geotek programs, Fundamental had been the expressly named and widely known “operator” for all the JB programs. With the exception of the Geotek 69-1 prospectus, the Geotek prospectuses disclosed that Jack Burke had been “an officer and a shareholder of companies which have acted as operator for and supplied services and property to the JB programs and others” (E. g., Ex. 14, p. 17). As above indicated, the Geotek prospectuses also disclosed the existence of Fundamental, the fact that Jack Burke was the President and sole shareholder of Fundamental, and the fact that several officers and officials of GTR and Geotek resources Fund were also officers or officials of Fundamental. The Geotek prospectuses also emphasized the importance of Jack Burke’s personal role in the management of the Geotek programs, and disclosed that Jack Burke was the organizer, founder and owner of more than 80% of the outstanding stock of GTR (Manager of the Geotek programs); that GTR, in turn, owned all of the outstanding stock of GRF (General Partner of the Geotek programs) and Charter Street (underwriter of the Geotek programs); and that GTR could be deemed the “promoter” or “parent” of the corporations involved in the Geotek offerings. (E. g., Exhibit 12, p. 3). We further note that the evidence shows that Fundamental was merely a “wash” corporation which made no profits; that Fundamental had no employees of its own, but “shared" the services of a single group of employees with GTR, which latter company actually paid the employees; and further, that it was generally known at all times since 1964 that Jack Burke, JB Oil Co., GTR and Fundamental all occupied the same offices and utilized the same record keeping facilities. Finally, the evidence shows that, as early as 1970, the SEC, itself, had information before it, indicating the nature of Fundamental’s role in the Geotek programs, and that the SEC took no action nor made any comment concerning any impropriety or invalidity of Fundamental’s role under the basic Geotek documents. We find, for example, that, in January, 1970, as a result of an SEC investigation into the various Jack Burke entities, Jack Burke, himself, informed the SEC of the nature of Fundamental’s role in the operations of the Geotek programs; that Fundamental was described as an “operator” for the Geotek programs in an October, 1970 press release; that a bulletin sent to investors in October, 1970, indicated Fundamental was conducting merger negotiations on behalf of Geotek; that a Memo of Agreement sent to the SEC in early 1971 stated that Fundamental was an “operator” for the Geotek programs; and that AY’s own financial report of April, 1971, disclosed that Fundamental was a company owned by Jack Burke and that Fundamental had borrowed $2.5 million from a bank for the purpose of continuing development of oil and gas properties under management by GTR, including properties managed on behalf of the Geotek 69-1 program. From this evidence, we find and conclude that the authorization of power to the Jack Burke-controlled Geotek management companies was so broad and so clearly disclosed that failure to further disclose the role of Fundamental (merely another Jack Burke-controlled company) did not constitute a material deviation from the terms of the basic documents. The SEC finally contends, however, that even though both GTR and Fundamental were controlled by Jack Burke (i. e., as the chief executive officer of both companies), GTR and Fundamental were different in the following material respects: (a) GTR had “outside” directors, whereas Fundamental did not; (b) GTR was, in at least small part, owned by outsiders, whereas Fundamental was wholly owned by Jack Burke; (c) GTR managed only the assets of Geotek programs, whereas Fundamental managed assets of non-Geotek programs and entities (e. g., P-2000, Petroforce and Washington Oil); (d) GTR managed the Geotek programs pursuant to a written management agreement with GRF, whereas Fundamental had no written agreement with either GTR of GRF. The evidence is to the effect, however, that Jack Burke, as president of both GRF and GTR, had access to the funds of the Geotek programs without operating through Fundamental. Further, there is no evidence with respect to the Geotek programs that Burke’s dominant position in the Geotek programs was not subject to such controls as were exercised or exercisable by the eventually appointed independent directors of GRF and GTR, and there is no evidence that these companies did not actually perform their respective functions with respect to Geotek dealings with Fundamental. As to these allegations insofar as they are brought against the Jack Burke defendants, we find and conclude that the evidence is insufficient to show said defendants fraudulently, intentionally or, under the circumstances of this case, even negligently made any material misstatements or omissions. As to AY, we find and conclude that the evidence is insufficient to show that AY fraudulently, intentionally or, under the circumstances of this case, even negligently made any material misstatements or omissions in certifying the financial statements in question. 2. JB Programs As to the JB programs, with the exception of the JB-68 program, the program-related activities which Fundamental was authorized to perform were fully described in both the offering circulars and the program agreements. The JB-64 through JB-67 program offering circulars provided that, after production had been obtained in a test well block, the JB Oil Company and the program participants would execute a “joint operating agreement”; that the operator would ordinarily be Fundamental, which was described as “a management company which has provided administrative and oil field operating services to Company and affiliated companies for several years.” (Exhibits 10A, 10B and IOC, p. 4, ¶ 4; Exhibit 10D, p. 5, ¶ 4). In the JB — 65, JB-66 and JB-67 offering circulars, it was further disclosed that the management of the JB Oil Company was “identical” or “substantially identical” to the management of Fundamental and that the services of Fundamental would be furnished at cost (Exhibits 10B and IOC, p. 4, ¶ 4; Exhibit 10D, p. 5, ¶ 4). In the JB-65 and JB-66 offering circulars it was disclosed that Jack Burke was the Chief Executive Officer of both the JB Oil Company and Fundamental (Exhibit 10B, p. 6; Exhibit IOC, p. 8). The JB-64 through JB-66 program agreements provided that Fundamental would furnish the JB Oil Company with management and administrative services at cost and that, although the JB Oil Company would be designated as “Operator” for each producing well, the JB Oil Company was authorized to delegate contractually some or all of the duties of operator to Fundamental, or to some other company (Exhibits 11A, 11B and 11C, § 7.1). It was pursuant to this authorization in the JB program agreements that the JB Oil Company, on behalf of JB-64, and Fundamental as “operator”, entered into an operating or “management service” agreement, dated June 30, 1964 (Exhibit 696), which agreement was thereafter made applicable to all other JB programs. (Exhibits 696(a)-700). In the JB-67 program agreement, however, the above-mentioned authorization clause was slightly modified to provide that the JB Oil Company could delegate the duties of operator to “an independent contractor, such as the Fundamental Oil Corporation” (emphasis added). (Exhibit 10D, § 7.7). The SEC contends that this phrase, describing Fundamental as an “independent” contractor constitutes a material misstatement by the Jack Burke defendants and further, that the Jack Burke defendants should have affirmatively corrected the misstatement in the subsequently issued financial statements for the JB-67 program. As to AY, the SEC contends that it knew or should have known that this description of Fundamental was false and misleading and that the Jack Burke defendants had failed to disclose Fundamental’s affiliated status and that AY, therefore, should not have certified the JB — 67 financial statement. Both the Jack Burke defendants and AY contend that the description of Fundamental as an independent contractor was not intended to mislead investors with respect to Jack Burke’s ownership and control of the corporation but was intended merely to describe the type of contractual relationships into which the JB Oil Company was authorized to enter. As to this SEC allegation insofar as it is brought against the Jack Burke defendants, we find and conclude that, even if the deseription of Fundamental as an independent contractor could technically be considered to be a misstatement, the evidence is insufficient to show that the description, when read in the context of the remainder of the JB-67 program agreement and in the context of the JB-67 offering circular, constitutes a fraudulent, intentional, or, under the circumstances of this case, even a negligent material misstatement or omission. As to AY, we find and conclude that the evidence is insufficient to show that AY fraudulently, intentionally or, under the circumstances of this case, even negligently made any material misstatements or omissions in certifying the JB-67 program financial statement. B. Improper Disbursements The second category of allegedly unauthorized transactions challenged by the SEC involves certain disbursements of funds in the JB and Geotek programs. The evidence shows that capital for each of the JB and Geotek programs was acquired by seeking and obtaining cash investments or “subscriptions” from individual investors. Each program was held open to receive such subscriptions for a limited period of time and each program had a dollar maximum for the total of aggregate subscription funds which it would receive. The evidence further shows that, for the purposes of the day-to-day operation of the programs, the subscription funds were periodically disbursed by the programs to their operator and/or manager. The SEC contends that the Jack Burke defendants failed to disclose that certain aspects of the disbursement of such funds were not authorized by the basic documents. The JB-64 through JB-66 program agreements provided that “[s]uch moneys shall be disbursed to Company from time to time upon presentation of, and only for the purpose of paying invoices, bills and statements for expenses (or obligations) incurred in the program.” (Exhibits 11-A, 11-B and 11-C, §§ 4.6 and 4.7). The JB-67 and JB-68 program agreements were changed somewhat: the JB-67 program agreement provided that the subscription fund “shall be disbursed by [JB Oil] Company from time to time upon presentation of invoices, bills or statements for obligations incurred or to be incurred” (Exhibit 11-D; § 4.6); the JB-68 program agreement provided that the subscription fund “shall be disbursed by [JB Oil] Company from time to time upon presentation by the payee of invoices, bills, statements or a guarantee concerning agreements made or to be made.” (Exhibit 11-E; § 4.4). As to the Geotek programs, the prospectuses provided that “after a minimum of $200,000 in subscriptions for investment in a particular Limited Partnership has been received, such monies may be used by the [general partner] for the purchase of properties and other interests for, and the payment of expenses incurred on behalf of, the Limited Partnership being formed” (Exhibits 12-15, p. 7; Exhibits 16 and 17, p. 8); that “any Limited Partnership’s capital may be used for the acquisition of interests in properties or projects owned by any of the other Limited Partnerships” (Exhibits 12 — 15, p. 8; Exhibits 17 and 18, pp. 9 — 10); that, “[i]f not immediately needed for Limited Partnership purposes, [Limited Partnership] funds may be temporarily invested in certificates of deposit or other interest bearing securities, with the interest thereon being credited to such Limited Partnership” (Ibid.); and further, that “[s]ueh funds may also be temporarily used for the purchase of properties for investor, and transfer . to Limited Partnerships formed at a later date” (Exhibits 12-15, pp. 7 and 9; Exhibits 16 and 17, pp. 8 and 10-11). The Geotek prospectuses also provided that, unless otherwise delegated, the GTR Management Company would “manage the capital and operations of each Limited Partnership” and would do so under the terms of a “Management Agreement” (Exhibits 12-15, pp. 10 and 20; Exhibits 16 and 17, pp. 11 and 27). The Geotek limited partnership agreements provided that the General Partner “shall have full, exclusive and complete authority in the management and control of the business of the Limited Partnership;” that “the powers of the General Partner include, but are not limited to, the power to [i]f not immediately needed for Limited Partnership purposes, temporarily invest Limited Partnership funds in certificates of deposit,” etc., as above set forth in the Geotek prospectuses (Exhibits 12-17, § 6.1(m) pp. A — 2 and A-4). The Geotek management agreements provided that “[t]he Partnership hereby employs the Manager to act for it” in the business of the Partnership; that “[t]he Partnership shall transmit the Partnership capital to the Manager in such amounts and at such times as the Manager shall request;” and that “[i]f not immediately needed for Partnership purposes, the Manager may temporarily invest Partnership funds in certificates of deposit,” etc., as above-set forth in the prospectuses. (Exhibits 12-17; §§ 1.1, 2.1 and 3.6, pp. B-l, B-2 and B-3). 1. Advance Disbursements The SEC first contends that, contrary to the express terms of the JB and Geotek basic documents, the programs made certain “advance” disbursements to the operator and/or manager (i. e., disbursements in excess of the actual expenditures which had at that time been incurred by the operator and/or manager), and that the Jack Burke defendants omitted to state in the basic program documents or the program financial statements that such “advance” disbursements would be, were being or had been made. The SEC also contends that AY either knew or should have known of these “advance” disbursements and of the Jack Burke defendants’ failure adequately to disclose them and, therefore, that AY improperly certified the JB and Geotek financial statements. As to this allegation, we first find and conclude that the JB-67, JB-68 and the Geotek basic documents did authorize advance disbursements and, therefore, that the basic documents for those programs contained no material misstatements or omissions. As hereinabove set forth, the JB-67 and JB-68 program agreements expressly authorized disbursements for obligations “made or to be made” and “incurred or to be incurred ”, and the Geotek management agreements expressly authorized disbursements to the manager “as the Manager may request”, without limitation as to the purposes for which such funds may be requested. With respect to the earlier JB-64, JB-65 and JB-66 programs, however, we find and conclude that advance disbursements were not expressly authorized by the basic documents. The JB-64, JB-65 and JB-66 program agreements provided that program funds “shall be disbursed . . . only for the purpose of paying invoices, bills and statements for expenses (or obligations) incurred in the program.” However, as to all the JB and Geotek programs (including JB-64, JB-65 and JB-66), we further find and conclude that, even if the “advance disbursements” were not expressly authorized by the basic documents, the fact that they had been made was adequately disclosed in the JB and Geotek program financial statements. In each of the JB — 64, JB-65 and JB-66 programs’ financial statements there appeared a line-item entry labeled “Advance to operator”, which was accompanied by a footnote which stated as follows: “At [date of the close of the statement period] the program had transferred funds to Fundamental in excess of the billings rendered by Fundamental to that date . . . [t]his amount, [dollar amount] is shown in the accompanying financial statement as an advance to the operator.” (Exhibits 18a, 18b and 18, note 2).1 **** The identical line-item entry also appeared in the JB-67 and JB-68 financial statements, and it was also accompanied by a footnote which stated as follows: “From inception of the Pro