## Facts

- Michael Marchese served as an outside director of Chancellor Corporation and as a member of its audit committee (Dec. 1996–June 1999).
- Marchese did not review Chancellor’s accounting procedures or internal controls and commonly deferred to Chancellor’s CEO and controlling shareholder, Brian Adley.
- In 1997, Chancellor addressed $1.14 million in unsubstantiated payments to entities controlled by Adley; the amount was written off.
- Chancellor pursued acquisition of MRB, with final closing on January 29, 1999, but treated August 1, 1998 as the acquisition date for accounting purposes and consolidated MRB results from that earlier date.
- Chancellor’s original independent auditors reviewed the acquisition documents and advised that GAAP required a 1999 consolidation date; a memorandum communicating this view was sent to Adley and Marchese.
- Adley directed the CFO to backdate a management agreement to support the 1998 consolidation date; the original auditors refused to accept it.
- With Marchese’s approval, Adley replaced the original auditors with new auditors and provided fabricated documents; the new auditors accepted the 1998 consolidation date.
- Chancellor recorded $3.3 million in “consulting fees” payable to Vestex Capital Corporation, an Adley-owned entity, purportedly for acquisition-related services; Chancellor capitalized the amount as an asset rather than expensing it.
- GAAP permits capitalization of outside consulting costs in business combinations only if the consultant is not affiliated with the companies involved; Vestex was affiliated through Adley.
- Chancellor’s 1998 Form 10‑KSB (filed April 1999) reflected the 1998 consolidation date and the capitalized Vestex fees; Marchese and Adley signed the filing.
- As a result of management’s misconduct, Chancellor’s filings materially overstated assets, revenue, and income; the SEC found Marchese acted recklessly in signing the 1998 Form 10‑KSB despite known warning signs.

## Issues

1. Whether Marchese, as an outside director and audit committee member, caused Chancellor’s violations of Exchange Act reporting, books-and-records, and internal-controls requirements by recklessly failing to act on clear accounting and auditor-related red flags.
2. Whether a cease-and-desist order under Exchange Act § 21C was an appropriate remedy based on Marchese’s conduct.

## Decision

- The SEC instituted a cease-and-desist administrative proceeding under Exchange Act § 21C and accepted Marchese’s offer of settlement (without admitting or denying the findings, except jurisdiction).
- The SEC found Marchese caused, and was a cause of, Chancellor’s violations of Exchange Act reporting, books-and-records, and internal-controls provisions.
- The SEC ordered Marchese to cease and desist from committing or causing violations of the cited provisions.

## Legal Principles

- A person may be found to have caused an issuer’s Exchange Act violations where the person’s reckless conduct substantially contributes to the issuer’s reporting, books-and-records, or internal-controls failures.
- Outside directors, including audit committee members, must make reasonable inquiry when confronted with auditor objections, inconsistent audit conclusions, management-driven auditor replacement, or related-party transactions suggesting unreliable financial reporting.
- Signing an issuer’s periodic report in the face of unresolved GAAP objections and significant related-party accounting irregularities can constitute reckless conduct supporting remedial relief.
- Under Exchange Act § 21C, the SEC may impose cease-and-desist relief to prevent future violations based on findings that a respondent caused violations, even absent proof the respondent directly committed the issuer’s primary violations.

## Conclusion

The SEC concluded that an audit committee director who knew of major accounting disputes and related-party red flags, yet failed to investigate and signed a misleading annual report, could be held responsible for causing the issuer’s Exchange Act reporting and controls violations and be subject to a cease-and-desist order under § 21C.


In re Michael Marchese, Exchange Act Release No. 47732, AAER No. 1764 (Apr. 24, 2003)