INITIAL DECISION RELEASE NO. 295 ADMINISTRATIVE PROCEEDING FILE NO. 3-11748 UNITED STATES OF AMERICA Before the SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 __________________________________ In the Matter of : : KENNETH L. RUBIN, CPA and : INITIAL DECISION MICHAEL W. LEWIS, CPA : September 8, 2005 : __________________________________ APPEARANCES: Jarett B. Decker and Carolann Gemski, for the Division of Enforcement and Office of the Chief Accountant, Securities and Exchange Commission. Martin M. Green and Joe D. Jacobson of Green, Schaaf & Jacobson, P.C., for Kenneth L. Rubin, CPA, and Michael W. Lewis, CPA. Thomas A. Litz of Thompson Coburn LLP for Kenneth L. Rubin, CPA, and Michael W. Lewis, CPA. BEFORE: Robert G. Mahony, Administrative Law Judge. I. INTRODUCTION The Securities and Exchange Commission (Commission) issued an Order Instituting Proceedings (OIP) on November 29, 2004, against Kenneth L. Rubin (Rubin), and Michael W. Lewis (Lewis) (collectively, “Respondents”), pursuant to Rule 102(e) of the Commission’s Rules of Practice (Rule 102(e)). See 17 C.F.R. § 201.102(e).1 The OIP alleges that Rubin and Lewis, as the engagement partner and manager, respectively, for the accounting firm of Rubin, Brown, Gornstein & Co., LLP (RBG), engaged in improper professional conduct during their audit of Eisner Securities, Inc. (ESI), for the year ended December 31, 2000 (2000 audit). The OIP alleges that ESI’s financial statements were not prepared in accordance with generally accepted accounting principles (GAAP), and the audit 1 Rule 102(e)(1), as amended in 1998, was codified by the Sarbanes-Oxley Act of 2002. 15 U.S.C. § 78d-3. report, signed by Rubin in his firm’s name, was not prepared in conformance with generally accepted auditing standards (GAAS). 2 Specifically, the financial statements failed to include an accrual for a contingent liability that resulted from ESI’s offer to settle potential claims of its customers who had funds misappropriated by a former registered representative, Joseph E. Erwin (Erwin). The OIP alleges that, under GAAP, an accrual was required pursuant to Statement of Financial Accounting Standards No. 5 (FAS 5).3 The failure to adhere to GAAP hid ESI’s violation of Section 15(c)(3) of the Securities Exchange Act of 1934 (Exchange Act) and Rule 15c3-1 promulgated thereunder, commonly known as the “net capital rule.” Further, the OIP alleges that Respondents failed to comply with GAAS, as they failed to obtain sufficient competent evidential matter, exercise due professional care, and maintain an attitude of professional skepticism. ESI management disclosed to Respondents, during the planning stages of the audit, that Erwin misappropriated approximately $2 million from his customers’ accounts. The OIP alleges that Respondents received an attorney confirmation letter from outside counsel that contradicted, rather than confirmed, management’s assertion that no customer claims were probable of assertion under FAS 5. The OIP alleges that Respondents, despite the receipt of this letter, failed to conduct any follow-up procedures to obtain additional information regarding the claims of the customers whose funds were embezzled by Erwin. Accordingly, the OIP alleges that Respondents failed to render an accurate audit report. The OIP alleges that on September 26, 2001, more than seven months after the audit report was issued, ESI reported to the Commission and the National Association of Securities Dealers (NASD) that it was in violation of the net capital rule. ESI was placed in liquidation proceedings on October 31, 2001, by the Securities Investor Protection Corporation and voluntarily withdrew its broker-dealer registration under Section 15 of the Exchange Act on December 2, 2001. Due to the conduct described above, the OIP alleges that Respondents engaged in intentional or knowing conduct, including reckless conduct, that resulted in a violation of applicable professional standards, or in the alternative, negligent conduct consisting of a single instance of highly unreasonable conduct that resulted in a violation of applicable professional standards in circumstances in which Respondents knew, or should have known, that heightened scrutiny was warranted. 17 C.F.R. § 201.102(e)(1)(iv)(A)-(B)(1). 2 GAAP are guidelines, established by the Financial Accounting Standards Board (FASB) and other accounting industry authorities, used to measure economic activity and present them in the form of financial statements and related disclosures. See SEC v. Arthur Young & Co., 590 F.2d 785, 788-89 n.4 (9th Cir. 1979). GAAS are a set of standards that govern how auditors should perform an audit. Id. at 788 n.2. They differ in that GAAP involve the measurement, timing of recognition, disclosure, and presentation of financial information, while GAAS govern how auditors verify this information. Id. at 788-89 nn.2 & 4. 3 FAS 5 governs the accounting treatment of contingent liabilities and assets. 2 A hearing was held in St. Louis, Missouri, on April 4 and 5, 2005.4 The Division of Enforcement and the Office of the Chief Accountant (collectively, the “Division”) submitted fifteen exhibits and called Respondents and one expert witness.5 Respondents did not submit any exhibits and called Rubin and two expert witnesses.6 The parties submitted posthearing briefs and proposed findings of fact and conclusions of law.7 In their posthearing brief, Respondents argue that they did not violate any applicable professional standard, as their audit was performed in accordance with GAAS. They contend that their inquiries to ESI management were appropriate, as was their reliance on management’s representation that no accrual was necessary for Erwin’s theft of customer funds. Respondents also argue that they followed applicable GAAS procedures by requesting that ESI’s outside counsel confirm management’s position that no accrual was necessary for any pending litigation involving Erwin’s former customers. Since outside counsel’s letter failed to indicate any unasserted claims were probable of assertion and that ESI would vigorously defend the two asserted claims, Respondents argue that the attorney confirmation letter provided sufficient evidential matter to support management’s assertion that no accrual was necessary. To the extent that management’s representations or outside counsel’s confirmation of those representations were false, Respondents argue that they were misled. Accordingly, Respondents concede that although the financial statements were not in conformance with GAAP, they still adequately performed the audit procedures required by GAAS. (Resp. Br. 22.) Had management or its outside counsel disclosed ESI’s settlement offers, Respondents contend, they would have insisted that a contingent liability accrual be included in the financial 4 In a joint motion and stipulation (Joint Stipulation), the parties notified this Office that the official transcript of the hearing contained numerous transcription errors. See Joint Stipulation (filed June 8, 2005). The parties jointly prepared a listing of errors and proposed corrections of the transcript (Errata Sheet), which they represent is their best efforts to correct the transcript with reasonable accuracy. See Joint Stipulation at Ex. B. The official transcript was ordered amended by the Errata Sheet pursuant to Rule 302(c) of the Commission’s Rules of Practice, 17 C.F.R. § 201.302(c). See Kenneth L. Rubin, Admin. Proc. 3-11748 (June 8, 2005) (unpublished). Thus, all citations to the transcript in this Initial Decision will refer to the official transcript as amended by the Errata Sheet. 5 The Division’s Exhibit 13 contains various American Institute of Certified Public Accountants (AICPA) auditing standards. Exhibit 13 is subdivided into 13 subsections, labeled as Exhibits 13A through 13M. 6 Respondents submitted two expert witness reports, which were entered into the record as the Division’s Exhibits 9 and 10. 7 Citations to the transcripts are noted as “(Tr. __.).” The Division’s exhibits are noted as “(Ex. __.).” The Division’s posthearing brief is noted as “(Div. Br. __.),” and Respondents’ posthearing brief is noted as “(Resp. Br. __.).” 3 statements. Thus, Respondents assert they committed no violation under Rule 102(e) and request this proceeding be dismissed. (Resp. Br. 11-27.) II. FINDINGS OF FACT The findings and conclusions herein are based on the record, my observation of the testifying witnesses, all arguments, proposals of facts, as well as the relevant statutes and regulations. Preponderance of evidence was applied as the standard of proof. See Steadman v. SEC, 450 U.S. 91 (1981). All arguments, proposed findings, conclusions, and contentions set forth by the parties were considered and only those consistent with this Initial Decision are accepted.8 A. Background Rubin, age 47, is a resident of St. Louis, Missouri. He graduated from the University of Illinois at Urbana-Champaign with a bachelor’s degree in accountancy in 1979. (Tr. 197.) He is a licensed certified public accountant (CPA) authorized to practice in Missouri. Rubin joined RBG in 1979 and was promoted to manager in 1983. He became an audit partner in 1986. (Tr. 198.) Lewis, age 35, is also a resident of St. Louis, Missouri. He graduated from Southeast Missouri State University in 1992 with a bachelor’s degree in accounting. (Answer ¶ 2; Ex.10 at 3.) Like Rubin, he is a licensed CPA authorized to practice in Missouri. (Answer ¶ 2.) He joined RBG in 1992, was promoted to manager in 1998, and, subsequent to the 2000 audit, was promoted to audit partner on June 1, 2004. (Answer ¶ 2; Tr. 14-15.) RBG is an accounting and business consulting firm based in St. Louis, Missouri. The firm has more than 250 employees, which places it among the fifty largest accounting firms in the country. (Ex. 10 at 1.) ESI, formerly headquartered in St. Louis, Missouri, was registered with the Commission as a broker-dealer pursuant to Section 15(b) of the Exchange Act on May 15, 1996. Since its establishment, ESI has retained RBG as its independent auditor.