Michael G. Horsey, CPA, Michael D. Watson, CPA, and Sallie D. Feldman, CPA

In Separate Administrative Proceeding, SEC Sues Outside Auditors for Improper Professional Conduct

On November 18, 2002, the Securities and Exchange Commission filed a civil injunctive action in the United States District Court for the District of New Jersey alleging that MERL Holdings, Inc.com ("MERL"), a New Jersey-based company, and Ed Johnson ("Johnson"), its chairman, president and CEO, violated the antifraud provisions of the federal securities laws by engaging in a multi-faceted fraud designed to raise money in the public markets. The Commission's Complaint alleges that MERL inflated its assets and financial results in two of the company's registration statements filed with the Commission and disseminated to investors.

The Complaint alleges that Johnson orchestrated the fraudulent scheme in four ways. First, MERL and Johnson artificially inflated the value of assets that MERL had acquired from Hanold School Stores, Inc. ("Hanold"), in exchange for shares of MERL's preferred stock. The Complaint alleges that MERL's treatment of the Hanold assets was improper and violated Generally Accepted Accounting Principles ("GAAP").

Second, the Complaint alleges that MERL and Johnson improperly consolidated Essex Industries, Inc. ("Essex") in MERL's 1997 and 1998 financial statements. Essex was the only bona fide operating entity in MERL's financial statements and accounted for all of the company's revenue recorded in its 1997 and 1998 income statements. Essex also comprised virtually all of MERL's assets in 1997 and most of 1998. The Complaint alleges that MERL's consolidation of Essex was improper because, among other reasons, MERL had been specifically enjoined by a Virginia state court from exerting any control over Essex. The company's consolidation of Essex's results in its financial statements therefore violated GAAP.

Third, the Complaint alleges that the Management's Discussion and Analysis ("MD&A") sections of both registration statements materially mischaracterized the financial health of MERL. The Complaint alleges that an objective view of the company was that it was in dire financial straits because of severe liquidity issues, drastically declining sales, disappearing customers and numerous legal problems. The Complaint alleges that as chairman, president and CEO, Johnson had a clear view of MERL's bleak position, yet improperly painted a prosperous and optimistic picture of the company and neglected to disclose any of the liquidity problems or negative sales trends in the MD&A sections of the registration statements.

Fourth, the Complaint alleges that MERL amplified its financial irregularities by issuing false press releases, which materially misrepresented the financial condition of MERL.

Finally, the Complaint alleges that Johnson benefited from his fraudulent scheme by avoiding losses or becoming unjustly enriched by selling MERL stock while in possession of material nonpublic information concerning these accounting irregularities.

The Commission's Complaint seeks to enjoin MERL and Johnson permanently from violating the antifraud provisions of the federal securities laws, Section 17(a) of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934, and Rule 10b-5 thereunder, and seeks civil monetary penalties against Johnson. The Complaint further seeks to bar Johnson permanently from serving as an officer or director of any public company and also seeks under Section 603 of the Sarbanes-Oxley Act of 2002 to bar him permanently from any future participation in the offering of any penny stock. Finally, the Complaint seeks disgorgement, prejudgment interest and penalties from Johnson for insider trading.

Simultaneously with the filing of the Complaint, the Commission entered a settled administrative order related to certain of the conduct described in the Complaint. Without admitting or denying the Commission's findings, three of MERL's independent auditors, Michael G. Horsey, CPA, the engagement partner, Michael D. Watson, CPA, the concurring review partner, and Sallie D. Feldman, CPA, the audit manager, consented to an order pursuant to Rule 102(e) of the Commission's Rules of Practice, finding that each engaged in improper professional conduct. The order denies Horsey, Watson and Feldman the privilege of appearing or practicing before the Commission as accountants for periods of two years, ten months and six months, respectively. See SEC Administrative Proceeding File No. 3-10937, dated November 18, 2002.

SEC Complaint in this matter