UNITED STATES OF AMERICA SECURITIES AND EXCHANGE COMMISSION SECURITIES EXCHANGE ACT OF 1934 Release No. 41425 / May 19, 1999 ACCOUNTING AND AUDITING ENFORCEMENT Release No. 1135 / May 19, 1999 Administrative Proceeding File No. 3-9903 ________________________________ : In the Matter of : ORDER INSTITUTING PROCEEDINGS : PURSUANT TO SECTION 21C OF THE MOORE STEPHENS, P.C., : SECURITIES EXCHANGE ACT OF 1934, LINDA F. O'DONNELL, CPA, and : AND RULE 102(e) OF THE ANGELO J. COPPOLINO, CPA, : COMMISSION'S RULES OF : PRACTICE, : MAKING FINDINGS AND IMPOSING : REMEDIAL SANCTIONS : Respondents. : _______________________________: I. 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 Moore Stephens, P.C. ("Moore Stephens"), Linda F. O'Donnell ("O'Donnell"), and Angelo J. Coppolino ("Coppolino") (collectively "the Respondents"). **FOOTNOTES** [1]: 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. 1 II. In anticipation of the institution of these proceedings, the Respondents have each submitted Offers 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, the Respondents, without admitting or denying the facts, findings or conclusions contained herein, except that they admit to the Commission's jurisdiction over them and over the subject matter of these proceedings, consent 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. III. On the basis of this Order and the Respondents' Offers, the Commission makes the following findings: [2] A. RESPONDENTS 1. Moore Stephens (formerly called Mortenson & Associates, P.C.) is a public accounting firm with offices in New Jersey and New York.[3] 2. O'Donnell, a certified public accountant licensed by the States of New Jersey and Florida, is a principal of Moore Stephens. During the period relevant to these proceedings, O'Donnell personally served as audit or concurring partner for audits of the financial statements of four publicly held issuers as to which Moore Stephens' independence was impaired: International Thoroughbred Breeders, Inc. ("ITB"), Chefs International, Inc. ("Chefs"), Crescent Capital, Inc. ("Crescent"), and Primedex Health Systems, Inc. ("Primedex"). 3. Coppolino, a certified public accountant licensed by the States of New Jersey and New York, is also a principal of Moore Stephens. During the period relevant to these proceedings Coppolino chaired Moore Stephens' Accounting and Auditing Committee. In that capacity, he was responsible for audit independence questions raised by Moore Stephens principals. B. FACTS 1. Summary. This auditor independence case arises from the failure of Moore Stephens and some of its principals to comply with established standards of auditor independence in connection with Moore Stephens' audits of the financial statements of seven publicly-held issuers for varying periods between 1992 and 1998, and its preparation and issuance of related audit reports. The firm's independence was impaired because: (i) Dennis Gaito, a principal of the audit firm, as trustee, directly or indirectly owned the securities of these audit clients; (ii) Gaito had investment relationships with directors and principal shareholders of several of the audit clients; (iii) Gaito, as trustee, loaned millions of dollars to a director and principal shareholder of two audit clients, in the director and principal shareholder's capacity as trustee of a second trust; (iv) Charles Falk, another principal of the audit firm and licensed attorney, provided legal services to one of the audit clients and to its controlling shareholder; and (v) the audit firm and its principals had a variety of other direct and material indirect relationships with these audit clients that impaired independence. Angelo Coppolino, a principal of the audit firm, was consulted as chair of the firm's Accounting and Auditing Committee concerning the firm's (and Gaito's) independence with respect to these audit clients, and without performing reasonable inquiry permitted the firm and Gaito to go forward as auditors to those audit clients; and Linda O'Donnell, a principal of the audit firm, was the engagement partner for the audits of the financial statements of several of those audit clients, knowing of Gaito's involvement with those audit clients' securities. 2. Financial Interests in Moore Stephens' Audit Clients. a. Gaito As Trustee of Brennan Trusts. For over 15 years, Gaito and his firm Moore Stephens were the auditors for First Jersey Securities, a brokerage firm owned and operated by Robert E. Brennan. Gaito also served Brennan in various other capacities such as director, bank account signatory, registered agent or trustee for a variety of Brennan-related entities. Additionally, Gaito and Moore Stephens served as Brennan's personal accountants. On January 28, 1992, Brennan created three trusts, sometimes referred to as "the Children's Trusts" to benefit his three adult sons -- the REB Trust for Robert E. Brennan, Jr., the KAB Trust for Kevin A. Brennan, and the Christopher Trust for Christopher Brennan. Brennan had another Moore Stephens principal (Charles Falk, a CPA and lawyer who provided legal services to Brennan) do the legal work to set up the trusts. In the trust instruments creating the three Children's Trusts, Brennan appointed Gaito as trustee of each of the three trusts. While Brennan also appointed his long-time friend Ronald Riccio as co-trustee, Gaito assumed nearly complete responsibility for managing the trusts.[4] Brennan suggested to Gaito certain securities for purchase by the Children's Trusts, and Gaito made the investment decisions. The trusts were initially funded with donations of $10,000 each. Upon assuming control of the Children's Trusts, Gaito had them buy securities of two "blind pool" issuers, using funds loaned to them by a Brennan controlled entity. The blind pools then completed reverse acquisitions, and the market price of the securities rose dramatically. After just two months, the Children's Trusts sold securities in just one of the issuers for more than $4.3 million. b. Gaito's Interest in Crescent, Taft and Airshield Composites. Gaito reinvested the Children's Trusts' proceeds from the sale of these blind pool securities, and by August 1992, the trusts' portfolios held securities of Crescent Capital Inc., and Taft Capital Inc. Crescent was a Bethesda, Maryland company that operated a fast-food franchise in the United Kingdom. Taft was another blind pool incorporated in Delaware that was then in the process of trying to acquire a manufacturer of golf clubs and accessories. By July 1992, Gaito had reinvested some of the Children's Trusts' proceeds in the securities of Century Funding, Inc. another blind pool incorporated in Delaware. In July 1992 Century Funding (hereafter "Airshield Composites") effected a reverse acquisition with Airshield Composites, a manufacturer and distributor of "air fairing systems" for the trucking industry. In July 1992, Moore Stephens became the auditor of Airshield Composites. Around the beginning of August 1992, Moore Stephens was given the opportunity to become the auditor of both Crescent and Taft -- other companies that Gaito, as trustee, had chosen for investment of the Children's Trusts' funds. Around this time, Moore Stephens had only about 20 public companies as audit clients, several of these affiliated with Brennan or First Jersey Securities. Gaito asked Coppolino whether Gaito's position as trustee of trusts that invested in securities issued by audit clients would impair Moore Stephens' independence as to these clients. On August 6, 1992, Coppolino consulted the AICPA Ethics Division, which responded that independence would indeed be impaired if a member of an audit firm, acting as trustee, purchased even one share of the securities of one of the firm's audit clients. The AICPA Ethics Division stated that independence would be impaired in this situation even if the investment was not material, and even if the member of the firm who was the trustee signed a document formally stating that he would leave to his co-trustee all investment decisions regarding the securities of the firm's audit clients. Consistent with the firm's procedure, a summary of this consultation with the AICPA Ethics Division was included in the firm's "consultation" file. O'Donnell was present when Gaito and Coppolino discussed the conclusion that Moore Stephens' independence would be impaired if a trust for which Gaito was trustee were to invest in securities issued by audit clients. Gaito and Brennan discussed the problem, and less than a week following the AICPA Ethics Division's clear advice concerning impairment of independence, a plan emerged to evade Moore Stephens' independence obligations. The plan involved having Brennan create, on August 12, 1992, a new trust called the "Family Investment Trust," for the collective benefit of all three Brennan sons. The idea was that the new trust would be what Brennan has termed a "receptacle for stocks that created the conflict for" Moore Stephens. Brennan has explained that he viewed it as an "enormous benefit" to have Gaito remain as trustee for Brennan's sons, but that Brennan did not want Gaito's involvement to prevent the sons' trust assets from being invested in securities issued by companies that were Moore Stephens clients. The Family Investment Trust was formed to be a "receptacle" for those securities of the Children's Trusts that would openly impair Moore Stephens' auditor independence. Brennan appointed only Riccio as trustee of the new trust, but Brennan cannot recall ever consulting with Riccio about investments for the trust. In the instrument creating the Family Investment Trust, Brennan decreed that Gaito would be the successor trustee, who would automatically be asked to take over if Riccio died or resigned. And in a companion document executed the same day as the trust instrument, Riccio appointed Gaito as the signatory for the new trust's bank accounts. Gaito discussed this new arrangement with Coppolino. Only days before, the AICPA Ethics Division had advised Coppolino that Gaito could not, as trustee, invest in the firm's audit clients. Yet notwithstanding this negative advice, neither Coppolino nor Gaito bothered to consult again with the AICPA and made no reasonable inquiry before proceeding with the Family Investment Trust arrangement. Indeed, Moore Stephens' consultation file reveals no evidence of any inquiry concerning this question. Within weeks after creation of the Family Investment Trust, Gaito had the three Children's Trusts execute contracts to transfer their securities of Crescent, Taft, and Airshield Composites -- one of which Moore Stephens already had as an audit client, and the others Moore Stephens wanted to obtain as audit clients -- to the new Family Investment Trust. On September 9, 1992, Gaito had the Christopher Trust transfer Taft and Airshield Composites securities. On September 22, 1992, Gaito had the KAB Trust transfer Taft securities. On September 25, 1992, Gaito had the KAB Trust transfer Airshield Composites securities. On October 8, 1992, Gaito had the Christopher Trust transfer Airshield Composites securities. On October 15, 1992, Gaito had the KAB Trust transfer Crescent securities. On October 16, 1992, Gaito had the REB Trust transfer Crescent and Airshield Composites securities. And on October 16, 1992, Gaito had the Christopher Trust transfer Crescent securities. In the case of each of these transfers of securities, the Family Investment Trust did not actually pay the Children's Trusts for the securities. Instead, the contracts stipulated that payment would not be made for a year after the sale. Payment was never made on one of the contracts, the October 15, 1992 contract, in which the KAB Trust transferred Crescent securities for $126,010; Gaito simply "canceled" the debt in January 1998. While the first of the contracts (the September 9, 1992 contract to transfer Taft and Airshield Composites securities) contained an "escrow" clause that gave the right to perfect a security interest in the transferred securities, Gaito omitted this escrow clause from the later contracts during September and October. As the Family Investment Trust had no other assets to use for payment, the Children's Trusts' economic interest in the Crescent, Taft, and Airshield Composites securities remained essentially the same as before the purported transfers of the securities. c. Gaito's Interest in ITB and Chefs. Around the same time that Gaito made these arrangements for holding the Crescent, Taft, and Airshield Composites securities, a decision was made to invest a substantial portion of the Children's Trusts' funds in the securities of existing Moore Stephens audit clients -- again using the vehicle of the Family Investment Trust as an intermediary. Instead of having the Children's Trusts invest directly in securities of existing Moore Stephens audit clients, the plan was to have the Children's Trusts loan cash to the Family Investment Trust, which would then itself invest in the securities of Moore Stephens' audit clients. At or about the time Gaito and Coppolino discussed the new "receptacle" trust arrangement, Gaito also asked Coppolino whether Moore Stephens' independence would be impaired if, instead of holding audit client securities directly, the Children's Trusts lent money to another trust, which invested the funds in the securities of public companies which were audit clients of Moore Stephens. He further told Coppolino to assume that in each case it would be Riccio, Gaito's co-trustee for the Children's Trusts, who would make the decision to loan Children's Trust assets to the Family Investment Trust and to invest those funds in the securities of audit clients. However, Coppolino understood that the loans would be made explicitly to consummate investments in securities issued by audit clients. As to this question too, Coppolino did not repeat the effort undertaken in the first instance of inquiring of the AICPA whether such arrangement would be permissible under the independence rules. Nevertheless, after only superficial consideration, Coppolino told Gaito that the firm's independence would not be impaired if the Children's Trusts loaned monies to an intervening trust that invested the loan proceeds in the securities of audit clients of Moore Stephens. On October 22, 1992, just two months after its formation, the Family Investment Trust made its initial purchases of securities issued by two existing Moore Stephens audit clients -- ITB (a New Jersey racetrack operator founded by Brennan) and Chefs International, Inc. (a New Jersey restaurant operator). Both Brennan and Riccio were directors of ITB; Brennan was also ITB's controlling shareholder, chairman and chief executive officer. Riccio, the Family Investment Trust's sole trustee, had minimal involvement in the purchases of ITB and Chefs securities. A broker made an unsolicited phone call to Riccio and informed him that ITB and Chefs securities were available for purchase. Gaito then told Riccio that Gaito could arrange loans from the Children's Trusts to the Family Investment Trust to give it the money to purchase the securities. Gaito personally signed each of the checks making the loans from the Children's Trusts to the Family Investment Trust. Without these loans from the Children's Trusts, the Family Investment Trust would not have had the funds to purchase the ITB and Chefs securities. Between October 1992 and February 1993, the Children's Trusts loaned approximately $4.1 million of trust funds, without security, to the Family Investment Trust. During that same period, the Family Investment Trust used approximately $3.9 million of this amount to purchase ITB and Chefs securities, as well as additional Crescent securities; Gaito signed the checks paying for the securities. While she was auditing the financial statements of ITB, O'Donnell became aware that cash from the Children's Trusts had been used to acquire ITB securities through the Family Investment Trust. Although she learned that Coppolino had expressed a view that independence would not be impaired, O'Donnell made no other effort to investigate the facts of the investment or the basis (or lack thereof) for Coppolino's view with regard to independence. d. Gaito's Interest in Primedex and FJS Properties. In or before October 1993, Brennan donated approximately 4 million warrants of Primedex Health Systems, Inc. to the Family Investment Trust. Primedex, based in Los Angeles, was a provider of services related to medical imaging. Riccio was a director of Primedex. In 1993 or 1994, Brennan and/or his wife Patricia donated securities of FJS Properties Fund LLP to the Family Investment Trust. FJS Properties was a publicly held partnership that owned and operated an apartment complex in Florida. During this time, Moore Stephens continued as auditor of Primedex and FJS Properties. Gaito as trustee of the Children's Trusts continued to be the principal creditor of the Family Investment Trust. Gaito, as bank signatory of the Family Investment Trust, also continued to disburse that trust's assets. e. Management of the Trusts As a Single Entity. At the time the Family Investment Trust began operations in October 1992, it was funded virtually entirely with loans from the three Children's Trusts. During the years following, all of these trusts operated as effectively a single entity, with funds moving among the trusts without regard to each beneficiary's separate interest. At the beginning of the period, the three Children's Trusts loaned unequal amounts to the Family Investment Trust, with the Christopher Trust loaning $1,551,134, the KAB Trust loaning $1,669,061, and the REB Trust loaning $1,810,422, as of early 1993. Five years later, the amounts of the loans remained unequal, with the Christopher Trust owed $1,000,000, the KAB Trust owed $1,376,010, and the REB Trust owed $1,550,000. Yet, at that time, Gaito decided to completely forgive all amounts that the Children's Trusts were owed by the Family Trust.[5] The forgiveness conferred a benefit on the Family Investment Trust of a total of $3,800,000, representing the entire outstanding debt owed by the Family Investment Trust to the Children's Trusts. As the Brennan sons' interests in the Family Investment Trust were equally divided, with each son sharing equally, the unequal forgiveness by the Children's Trusts resulted in a preference of the son who had loaned less over other sons who had loaned more. Any supposed separation between these trusts was likewise disregarded in 1997 when Gaito had one of the Children's Trusts -- the KAB Trust -- pay $700,000 in cash to the Family Investment Trust in return for the worthless stock of Airshield Composites, a company that was defunct and whose corporate charter had been dissolved more than a year before. Gaito determined the amount to be paid by the KAB Trust for this worthless stock. This transaction had the effect of moving assets held in a trust vehicle purportedly for one Brennan son into a different trust vehicle benefitting all three sons. f. Materiality of Interests in Audit Clients. A material amount of the Children's Trusts' assets consisted of loans that depended on the performance of the Family Investment Trust's securities holdings for repayment. For example, as of December 31, 1993, notes receivable from the Family Investment Trust represented approximately 59% of the Christopher Trust's assets, 39% of the KAB Trust's assets, and 46% of the REB Trust's assets. As of August 7, 1995, notes receivable from the Family Investment Trust represented approximately 40% of the Christopher Trust's assets, 42% of the KAB Trust's assets, and 49% of the REB Trust's assets. Similarly, a material amount of the Family Investment Trust's assets came from loans from the Children's Trusts. The Family Investment Trust's shareholdings were material to these audit clients of Moore Stephens. For example, the Family Investment Trust beneficially owned (i) approximately 10% of ITB's outstanding securities as of January 14, 1993 (as shown by the trust's Schedule 13D); (ii) approximately 7% of Chefs' outstanding securities as of December 24, 1992 (as shown by the trust's Schedule 13D); (iii) approximately 45% percent of Crescent's outstanding securities as of December 31, 1993 (as shown by Crescent's Form 10-K); (iv) approximately 13% of Taft's outstanding securities as of December 31 1993 (as shown by Taft's Form 10-K); (v) approximately 9% of Primedex's outstanding securities as of October 31, 1993 (as shown by Primedex's Form 10-K); and (vi) approximately 9% of FJS Properties' outstanding securities as of December 31, 1995 (as shown by FJS Properties' Form 10-K); (vii) approximately 21.5% of Airshield Composites' outstanding securities as of December 31, 1992 (as shown by the trust's Schedule 13G). g. Moore Stephens' Audits of These Clients. Moore Stephens audited ITB's financial statements and issued audit reports for the following fiscal years: (i) FYE 6/30/92 (with O'Donnell as engagement partner and Gaito as concurring partner); (ii) FYE 6/30/93 (with O'Donnell as engagement partner and Gaito as concurring partner); (iii) FYE 6/30/94 (with O'Donnell as engagement partner and Gaito as concurring partner); (iv) FYE 6/30/95 (with O'Donnell as engagement partner and Gaito as concurring partner); and (v) FYE 6/30/96 (with O'Donnell as engagement partner and Gaito as concurring partner). Moore Stephens audited Chefs' financial statements and issued an audit report for the following fiscal years: (i) FYE 1/31/93 (with Gaito as concurring partner); (ii) FYE 1/31/94 (with O'Donnell as concurring partner); (iii) FYE 1/31/95; (iv) FYE 1/31/96 (with Gaito as concurring partner); (v) FYE 1/31/97; and (vi) FYE 1/31/98. Moore Stephens audited Crescent's financial statements and issued an audit report for the following fiscal years: (i) FYE 12/31/93 (with Gaito as engagement partner and O'Donnell as concurring partner); (ii) FYE 12/31/94 (with Gaito as engagement partner and O'Donnell as concurring partner); (iii) FYE 12/31/95 (with O'Donnell as concurring partner); and (iv) FYE 12/31/96 (with O'Donnell as engagement partner and Gaito as concurring partner). * Moore Stephens audited Taft's financial statements and issued an audit report for the following fiscal years: (i) FYE 12/31/92; and (ii) FYE 12/31/93. Moore Stephens audited Primedex's financial statements and issued an audit report for the following fiscal years: (i) FYE 10/31/92 (with O'Donnell as engagement partner); (ii) FYE 10/31/93 (with O'Donnell as engagement partner); (iii) FYE 10/31/94 (with O'Donnell as concurring partner); (iv) FYE 10/31/95 (with O'Donnell as concurring partner); (v) FYE 10/31/96; (vi) FYE 10/31/97; and (vii) FYE 10/31/98. Moore Stephens audited FJS Properties' financial statements and issued an audit report for the following fiscal years: (i) FYE 12/31/94; (ii) FYE 12/31/95; (iii) FYE 12/31/96; and (iv) FYE 12/31/97. Moore Stephens audited Airshield Composites' financial statements and issued an audit report for FYE 12/31/92. Moore Stephens performed these services while its independence was plainly impaired. Yet for each of these companies, in each year in which it performed audit services, Moore Stephens misrepresented to public shareholders that it was issuing its audit report as an "independent" auditor. h. Independence Compliance Procedures. Every year Moore Stephens personnel were required to initial the firm's compliance document titled "Independence Compliance Confirmation," representing that each was familiar with the firm's independence policies; that "[p]rohibited investments are not held"; "[p]rohibited relationships do not exist, and transactions prohibited by Firm policy have not occurred." Also, to reflect that they had read it, Moore Stephens personnel were required annually to sign an internal memorandum which stated, in part, that the "SEC has expressed its concern about instances where employees have . . . invested in securities of clients," and identified Moore Stephens' publicly traded clients, including those in which the Children's Trusts had an interest. In initialling the Independence Compliance Confirmation and signing the internal memorandum identifying publicly traded clients, the respondents did not identify the independence issues implicated by the investments and relationships described herein. **FOOTNOTES** [2]: The findings herein are made pursuant to the Respondents' Offers and are not binding on any other persons or entities in these or any other proceedings. [3]: Moore Stephens, P.C. is a member of Moore Stephens North America, Inc., a network of over 30 accounting firms, which in turn is a member of Moore Stephens International Limited, a network of over 165 accounting firms in 75 countries. Neither of these networks is a party to this proceeding. [4]: Although the Children's Trust instruments empowered the co-trustees to exercise their specified responsibilities independently, Brennan has testified that, in appointing Gaito and Riccio as co-trustees, he was looking to Gaito (Brennan's accountant) to "manage the trusts" and "make investment decisions," and that he was looking to Riccio (a law school dean) for the "human side" to be a friend and advisor to his sons. [5]: The trust instruments for the Children's Trusts allowed their trustee Gaito to loan trust funds, but the instruments did not allow him to effectively give the trust funds away by forgiving the loans. At the time of the forgiveness, January 1998, the Division's investigation of Moore Stephens was well under way, and only a month earlier, Gaito had been questioned about the effect of these loans on his and Moore Stephens' independence. 2 3. Gaito's Investment Relationship With Audit Client Directors, And His Loans (as trustee) to Riccio (as trustee) While Riccio was a Director of Audit Clients. a. Gaito's Investment Relationship with Director Brennan. Moore Stephens' independence was also impaired by Gaito's investment relationship with Brennan, a director of two audit clients. Brennan was a director, chairman, chief executive officer, controlling shareholder, founder and member of the audit committee and executive committee of ITB, an audit client of Moore Stephens. Separately, Brennan was a director of FJS Properties, another audit client of Moore Stephens. Brennan was also the controlling partner of the general partner of FJS Properties. Gaito's investment relationship with Brennan was material and long-standing. Brennan appointed Gaito as trustee to manage millions of dollars of the Children's Trusts' assets for Brennan's adult sons. Within months of his appointment as trustee, Gaito made millions for the trusts by investing their assets in Brennan-related blind pool offerings. Brennan then set up the Family Investment Trust as a "receptacle" to invest funds of the Children's Trusts in securities of Gaito's audit clients (including ITB). Brennan appointed Gaito as successor trustee of the Family Investment Trust (which Gaito also served as bank signatory), and Gaito loaned millions of dollars from the Children's Trusts to fund the investments in the name of the Family Investment Trust. As events progressed Gaito discussed investments with Brennan, and Gaito issued the checks for Family Investment Trust stock purchases. b. Gaito's Investment Relationship with Director Riccio. Moore Stephens' independence was further impaired by Gaito's investment relationship with Riccio, also a director of two audit clients. Riccio was a director of ITB, an audit client of Moore Stephens and Gaito. At various times, Riccio was also a member of ITB's audit committee, related party transactions committee, executive compensation committee, and litigation committee. Separately, Riccio was a director of Primedex, another audit client of Moore Stephens. At various times, Riccio was also a member of Primedex's audit committee and compensation committee. Gaito and Riccio had a clear and material investment relationship. They were co-trustees of the Children's Trusts. In this capacity, they were jointly responsible for managing millions of dollars of trust investments. And a substantial portion of these assets were invested in loans the proceeds of which were used to purchase securities of ITB, of which Riccio was a director. c. Gaito's Loans (as trustee of Children's Trusts) to Riccio (as trustee of Family Investment Trust), While Riccio was a Director of Audit Clients. Moore Stephens' independence was also impaired by the Children's Trusts' loans to Riccio as trustee of the Family Investment Trust. As described above, Gaito as trustee of the Children's Trusts loaned over $4 million to Riccio as trustee of the Family Investment Trust. Indeed, Gaito personally signed each of the checks drawn on the Children's Trusts' accounts. Riccio was a director of ITB, an audit client of Moore Stephens. Riccio was also a director of Primedex, another audit client of Moore Stephens. Additionally, Riccio, as trustee of the Family Investment Trust, was a principal shareholder of several of Moore Stephens' audit clients. 4. Falk's Legal Advice To ITB and To Brennan. 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. 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 legal 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 the trust instruments for the Children's Trusts and the Family Investment Trust. C. LEGAL ANALYSIS 1. The Requirement of Auditor Independence. The Supreme Court has made it clear that an independent auditor "assumes a public responsibility transcending any employment relationship with the client [and] 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" (United States v. Arthur Young & Co., 465 U.S. 805, 817-18 (1984) (emphasis added)). The Exchange Act (§§12 and 13(a)(2)) requires that financial statements filed with the Commission must be certified by "independent" accountants. Regulation S-X (Rule 2-01) provides: (i) that "the Commission will not recognize any certified public accountant or public accountant as independent who is not in fact independent"; (ii) that, in assessing an auditor's independence, the Commission "will give appropriate consideration to all relevant circumstances, including evidence bearing on all relationships between" the auditor and the audit client; and (iii) that the accountant's report must state whether the audit was conducted in accordance with GAAS (generally accepted auditing standards). The Commission and GAAS view independence as impaired where an auditor has either a "direct" or a "material indirect" financial interest in a client. And the Commission and GAAS view both the fact and the appearance of auditor independence as essential for investors to have confidence that an audit represents a wholly unbiased examination of management's presentation of the corporate financial picture. GAAS specifically requires auditors to "avoid situations that may lead [others] to doubt their independence." 2. Auditor Independence Was Impaired By Gaito's Interests (as trustee) in Audit Clients. The Commission's Regulation S-X (Rule 2-02(b)(1)) requires an auditor's reports on a public company's financial statements to state "whether the audit was made in accordance with generally accepted auditing standards." The second general standard of GAAS requires an auditor to be independent, and independence "shall be considered to be impaired" if, among other situations, during "the period of a professional engagement or at the time of expressing an opinion" the auditor or audit firm was "a trustee of any trust [that] had or was committed to acquire any direct or material indirect financial interest in" the audit client (AICPA Interpretation 101-1(A)(2)). Gaito's position as co-trustee of the Children's Trusts impaired Moore Stephens' independence because the Children's Trusts had a direct and material indirect financial interest (through the "receptacle" Family Investment Trust) in Moore Stephens' audit clients. During the period of Moore Stephens' professional engagements, the Children's Trusts continued to have an interest in Crescent, Taft, and Airshield Composites securities. Gaito's transfer of these securities from the Children's Trusts to the Family Investment Trust pursuant to contracts that deferred payment for the securities for a year, and that gave the Children's Trusts the right to assert a security interest in some of the securities, did not substantially alter the Children's Trusts' economic interest in these securities. The Children's Trusts also had an interest in the ITB and Chefs securities (and additional Crescent securities) purchased in the name of the Family Investment Trust. Gaito financed the purchases of these securities by loans from the Children's Trusts. Gaito deposited the loaned funds in the Family Investment Trust's account (as bank signatory of that trust) and wrote checks for its purchase of these securities. And the Children's Trusts bore the risks involved in these investments, as the Family Investment Trust's ability to repay its loans to the Children's Trusts was largely dependent on the success of these investments. In substance, the Family Investment Trust was nothing more than an intermediary (what Brennan himself called a "receptacle") in the investment of Children's Trust assets in securities of Moore Stephens audit clients. The Children's Trusts likewise had an interest in the Primedex and FJS securities held in the name of the Family Investment Trust. Nearly half of the corpus of the Children's Trusts was invested in loans to the Family Investment Trust, and virtually all of those funds were invested in securities of Moore Stephens audit clients. The substantial indebtedness between the trusts gave the Children's Trusts a material indirect interest in all of the Family Investment Trust's assets, and further impaired Moore Stephens' independence. 3. Auditor Independence Impaired By Gaito's Investment Relationships With Audit Clients' Directors and Loans (as trustee) to Riccio (as trustee). Auditor independence "shall be considered impaired" if the auditor or audit firm had "any joint, closely held business investment . . . with any officer, director, or principal stockholder" of the audit client that was "material" in relation to the net worth of the auditor or audit firm (AICPA Interpretation 101-1(A)(3)). Gaito had a longstanding investment relationship with Robert E. Brennan, a director of two Moore Stephens audit clients, ITB and FJS Properties. Brennan appointed Gaito as trustee of the Children's Trusts, to manage millions of dollars for Brennan's sons. Moreover, Gaito invested Children's Trust funds in Brennan related blind pool offerings. Brennan further appointed Gaito as successor trustee to the Family Investment Trust, and Gaito, as bank signatory, issued checks for Family Investment Trust stock purchases. Gaito similarly impaired Moore Stephens' independence by his investment relationships with Riccio, through their co- trusteeship of the Children's Trusts, and through Gaito's loans, as trustee of the Children's Trusts, to the Family Investment Trust to purchase securities issued by Primedex and ITB, two issuers of which Riccio was a director. In addition, auditor independence "shall be considered impaired" if the auditor or audit firm had "any loan to . . . any officer, director, or principal stockholder" of the audit client (AICPA Interpretation 101-1(A)(4)). This absolute prohibition of loans is not subject to any materiality limitation. Riccio was not only a director of ITB and Primedex, but also, as trustee of the Family Investment Trust, he was a principal shareholder of several of Moore Stephens' audit clients. Gaito's $4 million in loans (as trustee of the Children's Trusts) to Riccio (as trustee of the Family Investment Trust) impaired Moore Stephens' independence. 4. Auditor Independence Impaired by Legal Services Provided By Moore Stephens Principal Falk. 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." By acting as attorney to Brennan and ITB, Falk impaired Moore Stephens' independence from ITB. 5. Auditor Independence Otherwise Impaired. Regulation S-X (Rule 2-01) 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 the 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." In this connection, the particular prohibitions contained in Regulation S-X (Rule 2-01) are stated simply as "examples" of the kinds of relationships that will be found to impair auditor independence. AICPA Interpretation 101-1, dealing with auditor independence, likewise provides that the particular prohibitions there stated are simply "examples" and "are not intended to be all-inclusive." And it is likewise a cardinal principle of auditor independence that an auditor cannot do indirectly what he or she cannot do directly. In this case, the long-standing and intertwined relationship that Moore Stephens and Gaito had with their audit clients through Brennan-created trusts and other ties involving Brennan created a situation in which Moore Stephens' independence was plainly impaired in both fact and appearance. 6. Coppolino and O'Donnell Violated the Independence Rules. Coppolino failed to comply with Rule 2-02 of SEC Regulation S-X. Without making sufficient inquiry, he concluded that the Children's Trusts' financial interests in Moore Stephens audit clients would not impair the firm's independence. Under the circumstances, he should have analyzed the issue with heightened scrutiny. First, Coppolino had obtained authoritative guidance that a direct investment by the Children's Trusts was unequivocally prohibited, even if Gaito were not to make the trust investment decisions. Second, Gaito's new proposal was an attempt to accomplish indirectly what could not be done directly. Third, he was opining on auditor independence, an issue of critical importance, under circumstances where an erroneous response would forseeably impact reporting on the financial statements of a number of publicly traded companies for years. Although Gaito's second proposal plainly merited heightened scrutiny, Coppolino gave it much less. By personally participating in audits of ITB, Chefs, Crescent, and Primedex when she knew of the loans and investments by the Family Investment Trust that impaired Moore Stephens' independence, O'Donnell failed to comply with Rule 2-02 of SEC Regulation S-X. O'Donnell relied entirely and without inquiry on the view expressed by Coppolino that independence would not be impaired. As engagement partner on each of the ITB audits, O'Donnell was principally responsible for assuring that Moore Stephens' audits complied with GAAS, including assuring herself that the independence requirements had been met. She too knew that the direct investment of Children's Trust assets in audit clients was unequivocally prohibited. She knew that the investment of Children's Trust assets in audit clients was accomplished indirectly by transferring the funds through the Family Investment Trust. Moreover, she knew of Brennan's position at ITB and Riccio's position at ITB and Primedex. Notwithstanding her responsibility as engagement partner, she merely accepted Coppolino's statement regarding independence without attempting to understand the basis for it, the authority on which it was based, or how it could be reconciled with the guidance that had previously been received from the AICPA. 7. The Respondents Engaged in Improper Professional Conduct. The Respondents engaged in improper professional conduct under the negligence standards of Rule 102(e)(1)(ii) of the Commission's Rules of Practice, as defined in Rule 102(e)(1)(iv)(B). 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." 3 a. Respondents' Conduct was Highly Unreasonable In Circumstances Where Heightened Scrutiny Is Warranted The rules that say independence is impaired by direct or material indirect interests by trusts in the securities of audit clients are axiomatic. On the facts of this case, the violation of those rules was highly unreasonable conduct. Had O'Donnell participated in even a single audit where independence was thereby impaired, 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). Coppolino's misguided conclusion that independence would not be impaired by the Children's Trusts' financial interests in Moore Stephens audit clients also constituted highly unreasonable conduct. Coppolino's highly unreasonable conduct was a cause of more than a half decade of compromised audits of the financial statements of numerous publicly held audit clients of Moore Stephens. b. Moore Stephens Engaged in Repeated Instances of Unreasonable Conduct, Each Resulting in a Violation of Applicable Professional Standards Through the activities of several of its principals, Moore Stephens engaged in repeated instances of unreasonable conduct, each resulting in a violation of the independence standards, including: (i) Gaito's direct or indirect ownership, as trustee, of audit client securities; (ii) Gaito's investment relationships with directors and principal shareholders of several Moore Stephens audit clients; (iii) Gaito's loans, as trustee, to a director and principal shareholder of audit clients, in that director and principal shareholder's capacity as trustee of a second trust; (iv) Falk's legal services to Moore Stephens audit client ITB and its controlling shareholder; and (v) Moore Stephens' and some of its principals' other direct and material indirect relationships with audit clients. By certifying that several of its audits were conducted in accordance with GAAS, in spite of the numerous investments and relationships described above which impaired its independence, Moore Stephens' repeated instances of unreasonable conduct indicate a lack of competence to practice before the Commission that is being addressed in this remedial proceeding. 4 IV. FINDINGS On the basis of this Order and the Offers submitted by Moore Stephens, O'Donnell, and Coppolino, the Commission finds that the Respondents 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. V. In view of the foregoing, the Commission has determined that it is in the public interest to accept the Respondents' Offers. Accordingly, IT IS HEREBY ORDERED, effective immediately, that 1. The Respondents, 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. The Respondents are 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. Coppolino and O'Donnell, or any firm with which they are or become associated in any capacity, shall remain members of the SEC Practice Section of the American Institute of Certified Public Accountants Division for CPA Firms ("SEC Practice Section") as long as they appear or practice before the Commission as independent accountants. b. Moore Stephens shall remain a member of the SEC Practice Section as long as it appears or practices before the Commission as an independent accountant. c. The Respondents 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 they appear or practice before the Commission as independent accountants. d. Within twelve months of the date of this Order, Respondents O'Donnell and Coppolino 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. e. Respondent Moore Stephens shall retain, within 30 days of the entry of this order, an independent consultant designated by the Commission (the "Consultant"), to review Moore Stephens' practices, policies and procedures with regard to maintaining and preventing the impairment of the firm's professional independence. The joint understanding of the Commission and Moore Stephens concerning this review is outlined in Annex A hereto. Moore Stephens, its partners, agents and employees shall cooperate with that review and provide the Consultant with such information as the Consultant deems reasonably necessary to complete its review. Within 60 days of its retention, the Consultant shall prepare a report of its review and make recommendations for changes to Moore Stephens' policies and procedures designed to maintain and prevent the impairment of the firm's professional independence. The report shall include any information suggesting that Moore Stephens' independence may have been impaired in any audits in addition to those that are the subject of this Order. The Consultant shall deliver that report to Moore Stephens and the Commission. The Consultant shall have the option to seek an extension of time by making a written request to the Commission Staff. f. Within 30 days of the issuance of the Consultant's report, Moore Stephens shall implement any and all reasonable recommendations made by the Consultant. The Commission's Office of the Chief Accountant shall be the final arbiter of the reasonableness of any recommendation. g. Twelve months after the issuance of the Consultant's report, Moore Stephens shall retain the Consultant, or if it is unavailable a successor Consultant designated by the Commission, to conduct a follow-up review of Moore Stephens' implementation of the recommendations resulting from the Consultant's report and its practice under those recommendations. The joint understanding of the Commission and Moore Stephens concerning this review is likewise outlined in Annex A. Moore Stephens, its partners, agents and employees shall cooperate with that follow-up review and provide the Consultant with such information as the Consultant deems reasonably necessary to complete its review. Within 60 days of its retention, the Consultant shall prepare a report of that follow-up review and recommend any additional changes to Moore Stephens' policies and procedures that it deems appropriate. The Consultant shall deliver that report to Moore Stephens and the Commission. 5 h. Within 30 days of the issuance of the Consultant's report of its follow-up review, Moore Stephens shall implement any and all reasonable recommendations made by the Consultant. The Commission's Office of the Chief Accountant shall be the final arbiter of the reasonableness of any recommendation. By the Commission. Jonathan G. Katz Secretary 6 MEMORANDUM TO THE CONSULTANT The purpose of this memorandum is to outline for the Consultant the joint understanding of the Securities and Exchange Commission and of Moore Stephens P.C. concerning the review to be made of Moore Stephens' existing practices, policies and procedures with regard to maintaining and preventing the impairment of the firm's professional independence. Moore Stephens will execute an engagement letter to the Consultant in accordance with the terms of this memorandum. The review will be conducted pursuant to an Order of the Commission entered May 19, 1999, and is intended to be a comprehensive review of the issues that, in the course of Moore Stephens' existing business, present the potential for impairing the firm's independence or the appearance of independence, and the firm's practices, policies and procedures to identify such issues and resolve them in a fashion that insures that independence is maintained. The Consultant shall reasonably design its review in a fashion that in its judgment will efficiently accomplish the objectives of the review in accordance with the requirements described below. The Consultant shall confer with the staff of the Commission while designing and conducting its review. The Consultant may also solicit and consider suggestions from Moore Stephens. The Consultant shall examine Moore Stephens' existing business activities so as to gain an understanding of the scope of Moore Stephens' practice as an independent public accountant for issuers, brokers, dealers, investment advisors, investment companies and other persons that file financial reports with the Commission ("Public Audit Clients"). The Consultant shall also conduct such inquiry as is reasonably necessary in its judgment to gain an understanding of the type of relationships that exist between Moore Stephens, its partners and professional staff on one hand, and its Public Audit Clients, their officers, directors, controlling shareholders and employees on the other hand, that may impair independence or the appearance of independence. The scope of that inquiry shall include, but not be limited to, possible impairment of independence or the appearance of independence in circumstances involving Moore Stephens, its partners or professional staff: (i) directly or indirectly owning securities of Public Audit Clients; (ii) maintaining investment relationships with directors, officers, controlling shareholders or other control persons of Public Audit Clients; (iii) borrowing or loaning money or securities from or to Public Audit Clients; (iv) borrowing or loaning money or securities from or to directors, officers, controlling shareholders or other control persons of Public Audit Clients; (v) providing legal services to Public Audit Clients, or their directors, officers, controlling shareholders or other control persons; (vi) providing other services to Public Audit Clients, or their directors, officers, controlling shareholders or other control persons that may impair independence or the appearance of independence; or (vii) maintaining other direct or material indirect relationships with Public Audit Clients that may impair independence or the appearance of independence. The Consultant shall document the results of its activities pursuant to this paragraph. The Consultant shall examine the existing practices, policies and procedures that Moore Stephens utilizes to maintain its professional independence. That examination shall include analyzing Moore Stephens' existing method of: i) identifying relationships, services or other activities which may impair independence or the appearance of independence, and ii) bringing all the relevant facts concerning such matters to the attention of a responsible official within the firm for review and determination. The Consultant shall identify any deficiencies or weaknesses in the firm's existing procedures for identifying activities which impair independence, and develop a means to correct the deficiencies or weaknesses including, if necessary, requiring training or the institution of other new practices, policies and procedures. The Consultant shall also examine Moore Stephens' existing practices, policies and procedures for analyzing and resolving issues where there is a possible impairment of independence or of the appearance of independence. The Consultant shall identify any deficiencies or weaknesses in Moore Stephens' practices and procedures for analyzing and resolving such issues, and develop a means to correct such deficiencies or weaknesses. In evaluating existing practices, policies and procedures, and developing any recommendations, the Consultant shall consider whether responsible Moore Stephens officials are designated to resolve all issues that involve a possible impairment of independence, whether those officials possess sufficient expertise regarding the kinds of activities that may impair independence, whether appropriate outside authorities are consulted as part of the process of resolving independence issues, and whether that process, including the analysis and ultimate resolution of all issues regarding a possible impairment of independence or the appearance of independence, is fully documented. In the follow-up review the Consultant shall examine Moore Stephens' implementation of the recommendations resulting from the Consultant's initial report. In addition, the Consultant shall examine Moore Stephens' practice since the adoption of those recommendations in sufficient depth to gain an understanding whether they have been effective to insure that all circumstances that relate to a possible impairment of independence or the appearance of independence are identified on a timely basis, presented to responsible Moore Stephens personnel for review and properly resolved. Based on that review, the Consultant shall develop additional procedures, if necessary, to address any deficiencies or weaknesses noted. 7