UNITED STATES OF AMERICA
|In the Matter of:
CHARLES E. FALK, CPA,
|ORDER INSTITUTING PROCEEDINGS
PURSUANT TO SECTION 21C OF
THE SECURITIES EXCHANGE ACT OF
1934, AND RULE 102(e) OF THE
The Securities and Exchange Commission ("Commission") deems it appropriate and in the public interest that public administrative proceedings pursuant to Section 21C of the Securities Exchange Act of 1934 ("Exchange Act"), and Rules 102(e)(1)(ii) and (iii)1 of the Commission's Rules of Practice, be and hereby are instituted against Charles E. Falk ("Falk").
In anticipation of the institution of these proceedings, Falk has submitted an Offer of Settlement ("Offer") to the Commission, 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, Falk, without admitting or denying the facts, findings or conclusions contained herein, except that he admits to the Commission's jurisdiction over him and over the subject matter of these proceedings, consents to the issuance of this Order Instituting Public Proceedings Pursuant to Section 21C of the Exchange Act, and Rule 102(e) of the Commission's Rules of Practice, Making Findings and Imposing Remedial Sanctions ("Order").
Accordingly, it is ordered that proceedings pursuant to Exchange Act Section 21C and Rule 102(e) of the Commission's Rules of Practice be, and hereby are, instituted.
On the basis of this Order and Falk's Offer, the Commission makes the following findings:2
Falk, age 49, is a certified public accountant licensed by the States of Virginia and New Jersey. Falk is a principal of Moore Stephens, P.C., formerly known as Mortenson & Associates, P.C. ("Moore Stephens"), a public accounting firm with offices in New Jersey and New York. Falk has been associated with Moore Stephens since 1983, and has been a principal of that firm since January 1988. Falk is also a licensed attorney who, from a separate office in the same building in which Moore Stephens is located, maintains a private law practice.
This auditor independence case arises from Falk's activities as a lawyer while he was a Moore Stephens principal. Beginning prior to fiscal 1992, through fiscal 1996, Moore Stephens served as independent auditor for International Thoroughbred Breeders, Inc. ("ITB"), a public issuer whose securities are registered with the Commission pursuant to Exchange Act Section 12(b), and were, at all times relevant, traded on the American Stock Exchange. Each year Moore Stephens reported on ITB's financial statements, representing that its audits of those financial statements were made in accordance with generally accepted auditing standards, and describing itself as independent. During that period, in 1992, 1995, and 1996 Falk, acting as an attorney, rendered services variously to ITB and its controlling shareholder, Robert E. Brennan.3 Falk's activities as attorney for those clients impaired Moore Stephens' independence with respect to ITB, and rendered Moore Stephens' audit reports, filed with the Commission as part of ITB's annual reports on Form 10-K, materially inaccurate.
Although he was a CPA and principal of Moore Stephens, from time to time Falk also provided services as an attorney. On several occasions in 1992, 1995, and 1996, Falk was retained by ITB as an attorney specifically to provide advice. Falk advised ITB's management concerning the tax consequences of various proposed corporate transactions on ITB's net operating loss carryforwards. In the course of his representation of ITB, Falk generated advice memoranda to senior ITB officers, and billed ITB for those services by means of invoices issued by Falk's law office. During the Division of Enforcement staff's ("staff") investigation of this matter, Falk declined to testify about the subject matter of the advice he rendered, based on the attorney-client privilege. Also, in response to a subpoena duces tecum issued to him by the staff, Falk declined to produce documents reflecting the advice he rendered to ITB, again based on the attorney-client privilege.
When he was advising ITB as its attorney, Falk knew that ITB was an audit client of Moore Stephens. Falk did not participate as engagement partner or concurring partner in any of Moore Stephens' audits of ITB's financial statements. However, on occasion other professional staff at Moore Stephens consulted with him on tax-related questions concerning ITB.
In addition to the services Falk rendered directly to ITB, in 1992 Falk provided legal representation to Robert E. Brennan who was, at the time, ITB's controlling shareholder. Specifically, at Brennan's request Falk drafted four trust instruments to create trusts for Brennan's sons.4 In the staff's investigation of this matter, Falk likewise declined to answer questions related to his legal representation of Brennan, based on the attorney-client privilege.
On an annual basis, Falk initialed an internal Moore Stephens compliance document titled "Independence Compliance Confirmation," representing that he was familiar with the firm's independence policies; that "[p]rohibited relationships do not exist, and transactions prohibited by Firm policy have not occurred." Falk left blank the portion of the Independence Compliance Confirmation which called for a description of "Exceptions" and which directed the certifying personnel to provide a written explanation. Also, to reflect that he had read it, Falk annually signed an internal memorandum which identified Moore Stephens' publicly traded clients, including ITB.
Sections 12(b)(1)(J) and (K) and 13(a)(2) of the Exchange Act, and Article III and Rule 1-02(d) of Regulation S-X, authorize the Commission to require financial statements of public issuers to be certified by public accountants who are independent of the issuer, and give the Commission the authority to define the meaning of independence in that context. Rule 2-02 of Regulation S-X, entitled "Accountants' Reports," governs the contents of auditors' reports on issuers' financial statements and requires, among other things, that auditors state "whether the audit was made in accordance with generally accepted auditing standards ["GAAS"]." Regulation S-X further admonishes that "[t]he Commission will not recognize any certified public accountant . . . as independent who is not in fact independent . . . ." Regulation S-X, Rule 2-01(b). Rule 2-01(c) of Regulation S-X states that in determining whether an accountant is independent of a particular person, the Commission "will give appropriate consideration to all relevant circumstances, including evidence bearing on all relationships between the accountant and that person or any affiliate thereof, and will not confine itself to the relationships existing in connection with the filing of reports with the Commission."
The Commission's Codification of Financial Reporting Policies, which interprets Regulation S-X, prohibits members of accounting firms from acting as counsel to the firm's audit clients. Specifically, Section 602.02.e.i. of the Codification of Financial Reporting Policies states that "[c]ertain concurrent occupations of accountants engaged in the practice of public accounting involve relationships with clients which may jeopardize the accountant's objectivity and, therefore, his independence . . . . Acting as counsel [is one of the] occupations so classified." Section 602.02.e.ii. of the Codification of Financial Reporting Policies explains that a "legal counsel enters into a personal relationship with a client and is primarily concerned with the personal rights and interests of such client. An independent accountant is precluded from such a relationship . . . because the role is inconsistent with the appearance of independence required of accountants in reporting to public investors."
That prohibition is grounded in the fundamental conflict that exists between the roles of independent auditor and attorney. Auditors have an obligation to the investing public to be skeptical about the information reported to them by their clients, which demands total independence from the client at all times. Attorneys, on the other hand, have a duty to serve as the client's confidential advisor and loyal advocate. See Comment to Rule 1.3, ABA Model Rules of Professional Conduct ("A lawyer should act with commitment and dedication to the interests of the client and with zeal in advocacy upon the client's behalf."). As noted by the Supreme Court in United States v. Arthur Young & Co., et al., 465 U.S. 805, 817-818 (1984), the attorney's role is to be the client's confidential adviser and advocate, a loyal representative whose duty it is to present the client's case in the most favorable possible light. An independent certified public accountant performs a different role. By certifying the public reports that collectively depict a corporation's financial status, the independent auditor assumes a public responsibility transcending any employment relationship with the client. The independent public accountant performing this special function owes ultimate allegiance to the corporation's creditors and stockholders, as well as to the investing public. This "public watchdog" function demands that the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust.
By acting as attorney to Brennan and ITB, Falk impaired Moore Stephens' independence from ITB. Indeed, Falk's conduct in this situation well illustrates the risk of this occupational conflict. The audit client, ITB, specifically requested that Falk render his services as an attorney, thereby seeking to protect the information it communicated to him through the attorney-client privilege (which Falk later invoked in testimony and in response to a document subpoena). Thus Falk, in his role as attorney, became privy to information concerning ITB that he was unable to use or communicate in his role as a principal in ITB's audit firm. Invoking the attorney-client privilege gives the appearance that the client communicated to Falk information that might adversely reflect on the integrity of ITB's financial reporting. It is possible that Brennan and ITB made the communication to Falk knowing that Falk would be duty bound not to disclose it to the Moore Stephens audit partners.
Given his role as legal counsel for ITB, Falk improperly signed Moore Stephens' Independence Compliance Confirmation, misrepresenting that prohibited relationships did not exist. By Falk's legal representation of ITB and Brennan, Falk impaired Moore Stephens' independence with respect to its audits of ITB's financial statements, rendering the firm's reports on ITB's financial statements, purportedly as independent auditors, materially inaccurate. Because Moore Stephens' audit reports were included as part of ITB's annual reports on Form 10-K, Falk's conduct also resulted in violations of Exchange Act Section 13(a) and Rule 13a-1 thereunder. Through his conduct, Falk failed to comply with Rule 2-02 of Regulation S-X, and caused and willfully aided and abetted violations of Exchange Act Section 13(a) and Rule 13a-1 thereunder.
Falk engaged in improper professional conduct under both negligence standards of Rule 102(e)(1)(ii) of the Commission's Rules of Practice, as defined in Rule 102(e)(1)(iv)(B)(1) and (2). These provisions state that, "[w]ith respect to persons licensed to practice as accountants, 'improper professional conduct' under §201.102(e)(1)(ii) means: . . . .
(B) Either of the following two types of negligent conduct:
(1) A single instance of highly unreasonable conduct that results in a violation of applicable professional standards in circumstances in which an accountant knows, or should know, that heightened scrutiny is warranted.
(2) Repeated instances of unreasonable conduct, each resulting in a violation of applicable professional standards, that indicate a lack of competence to practice before the Commission." a. Falk's Conduct was Highly Unreasonable In Circumstances Where Heightened Scrutiny is Warranted
As previously described, the rules regarding the separation of auditing from the practice of law are clear and well-established. Violation of these rules is, therefore, highly unreasonable conduct, compounded in this case by Falk's improper response to Moore Stephens' own internal questionnaires. Had Falk provided legal advice to ITB even on one occasion alone, that action would reflect highly unreasonable conduct that resulted "in a violation of applicable professional standards in circumstances in which an accountant knows, or should know, that heightened scrutiny is warranted." As the Commission stated in the adopting release for Rule 102(e)(1)(iv) of the Commission's Rules of Practice, "[b]ecause of the importance of an accountant's independence to the integrity of the financial reporting system, the Commission has concluded that circumstances that raise questions about an accountant's independence always merit heightened scrutiny." See §III.C.1. of Amendment to Rule 102(e) of the Commission's Rules of Practice, Release No. 33-7593 (October 19, 1998).
b. Falk Engaged in Repeated Instances of Unreasonable Conduct, Each Resulting in a Violation of Applicable Professional Standards
Falk provided legal advice to ITB's management on multiple occasions, over a period of years, while he was aware that ITB was a Moore Stephens audit client, in contravention of Regulation S-X and the express prohibition set forth in the Commission's Codification of Financial Reporting Policies. While the nature of the violation did not change from year to year, Falk's conduct impaired Moore Stephens' independence for several different ITB audits. Falk thus engaged in "[r]epeated instances of unreasonable conduct, each resulting in a violation of applicable professional standards." This conduct indicates a lack of competence to practice before the Commission that is being addressed in this remedial proceeding.
On the basis of this Order and the Offer submitted by Falk, the Commission finds that Falk failed to comply with Rule 2-02 of Regulation S-X, caused and willfully aided and abetted violations of Section 13(a) of the Exchange Act and Rule 13a-1 thereunder, and engaged in improper professional conduct within the meaning of Rule 102(e)(1)(ii) of the Commission's Rules of Practice.
In view of the foregoing, the Commission has determined that it is in the public interest to accept Falk's Offer. Accordingly, IT IS HEREBY ORDERED, effective immediately, that
1. Falk, pursuant to Section 21C of the Exchange Act, cease and desist from committing or causing any violation and any future violation of Rule 2-02 of Regulation S-X, Section 13(a) of the Exchange Act, and Rule 13a-1 thereunder;
2. Falk is hereby censured pursuant to Rules 102(e)(1)(ii) and (iii) of the Commission's Rules of Practice for the conduct described herein and:
a. Falk, or any firm with which he is or becomes associated in any capacity, shall remain a member of the SEC Practice Section of the American Institute of Certified Public Accountants Division for CPA Firms ("SEC Practice Section") as long as he appears or practices before the Commission as an independent accountant.
b. Falk shall comply with all applicable SEC Practice Section requirements, including all requirements for periodic peer reviews, concurring partner reviews, and continuing professional education, as long as he appears or practices before the Commission as an independent accountant.
c. Within twelve months of the date of this Order, Falk shall enroll in and attend at least forty hours of Continuing Professional Education relating to auditing, accounting, independence and ethics, fifteen hours of which concern the subject of auditor independence and ethics.
By the Commission.
_________________ Jonathan G. Katz Secretary
-- Rule 102(e)(1) of the Commission's Rules of Practice provides, in pertinent part:
The Commission may censure a person or deny, temporarily or permanently, the privilege of appearing or practicing before it in any way to any person who is found by the Commission after notice and opportunity for hearing in the matter . . . (ii) to be lacking in character or integrity or to have engaged in unethical or improper professional conduct; or (iii) to have willfully violated, or willfully aided and abetted the violation of any provision of the Federal securities laws or the rules and regulations thereunder.
-- The findings herein are made pursuant to Falk's Offer and are not binding on any other person or entity in these or any other proceedings.
-- Brennan was, until November 1995, ITB's board chairman and chief executive officer.
-- The trusts, the Christopher Trust, the REB Trust, the KAB Trust, and the Family Investment Trust were established