Are You Gonna Make My Day? The Auditors And SEC Enforcement

By Francine • Jan 14th, 2010 • Category: Latest, Pure Content, The Case Against The Auditors

Yesterday, Wednesday, was quite a busy day.

Any business news was overshadowed by the devastating news from Haiti. There are a number of ways you can help – from donating via your mobile to the Red Cross to an effort that is local to Chicago, Project Eden.

Please help.

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I watched the Financial Crisis Inquiry Commission hearings in Washington and tweeted quite a bit.  One of the Commissioners, Keith Hennessey, solicited questions for the bankers. I added my suggestions to his site. All in all it was a very interesting exchange.  I’ll write more later.

In the meantime, you can take a look at Mark Leibovich’s article in the New York Times.

In the afternoon, the SEC held a news conference to announce several changes and initiatives in their Enforcement Division.  After a public news conference, a few select bloggers were invited to a special briefing with Robert Khuzami, the Director of the Division of Enforcement.

Doug Cornelius documented the participants and questions here.  Edith Orenstein, Bruce Carton, and Broc Romanek have provided some analysis. My focus, as always, is on enforcement actions against the audit firms and their professionals. The Big 4 (and to a lesser extent the next tier firms) and their partners are still pretty lucky, continuing to dodge any truly deadly SEC enforcement bullets.

My question:

“We have two high profile cases here in Chicago: Deloitte’s lawsuit against their own Vice Chairman Thomas Flanagan for breach of contract related to inside trader charges and the SEC’s recent actions against six Ernst & Young partners regarding the Bally’s fraud. In the Deloitte case, although the lawsuit against their partner was initiated as a result of SEC inquiries at their clients, Mr. Flanagan is reported to have made more than 300 trades over several years. In the Bally’s case, the enforcement actions/settlements are coming more than six years after the fraud occurred.

These delays mean the firms and the professionals can use the excuse, “It’s all behind us,” and remedial actions and disciplinary proceeding lose impact.  How will the changes announced today help make investigations and enforcement actions more timely? ”

Mr. Khuzami answered that I was preaching to the choir. He said he is very focused on bringing investigations and any related actions to a close more quickly.  In fact, he said, when he took his current position, he implemented a new rule that required staff to get his personal permission to extend time lines when filed cases may be approaching their statute of limitations.  In the past it seems it was routine to drag things out as we saw in Madoff. Finally, he reminded me that the timeline is not always in the SEC’s hands when there is a parallel criminal investigation. Mr. Khuzami’s intention is that organizing the SEC Enforcement Division around key issues and the expertise needed to investigate them will accelerate the process and improve it.

It’s a worthy goal…because I know how delays can be tactics rather than just poor follow-through. I was a member of the “PwC the Client” internal audit team in 2005-2006. In retrospect, I realize that some of the frustrating delays in getting reports out and seeing action on my findings were actually strategic moves to get rid of difficult, sensitive issues by diluting them with time.  During my tenure at PwC, I led audits of some interesting internal firm areas, including some legal and regulatory compliance activities.  Most of the reports I wrote were issued.  However, one report in particular went around in circles, being revised, re-revised, back to the first partner’s version, back to my original version, and eventually issued in a very watered down form.

Why?

By the time the merry-go-round stopped, I was dizzy and the partners I had cited for violations had ample time to clean up their act or remove evidence of violation. I was accused of making it all up.

Oh, and also of being a very bad writer.

In the case of the recent settlement by the SEC with Ernst and Young, although six partners were cited in the settlement, three of those partners are now retired.  And, of course, EY repeated the tried and true response to such unpleasantness and the prospect of having a monitor futzing around making a good show of remediating their faults:

Chicago Tribune: Three Ernst & Young partners who were charged remain at the firm. They are Randy Fletchall, who was in charge of its national office in New York, and two based in Chicago, Mark Sever, Ernst & Young’s national director of area professional practice, and Kenneth Peterson, the professional practice director.

The other three from the Chicago office are no longer with the firm. They are Thomas Vogelsinger, the area managing partner until October 2003, William Carpenter, engagement partner for the 2003 audit, and John Kiss, the engagement partner for the 2001 and 2002 audits…In a statement [Ernst & Young] said, "These settlements allow us and several of our partners to put this matter behind us and resolve issues that arose more than five years ago.”

While we’re at it…  A few more comments about the Ernst & Young/Bally’s enforcement actions.

Jim Peterson over at Re: Balance comes down, I think, in sympathy with Ernst & Young and what he sees as the make-work required by the settlements.

What messages are sent to the profession’s quality and risk functions? Ought they to reduce the exposure of their senior personnel, by hanging out the line operators to struggle on their own? And by the way, who would aspire to the headaches of a consultative role, if only to finish a long career by dangling from the SEC’s noose?

One of E&Y’s undertakings in Bally is to re-visit, under the scrutiny of an outside examiner, its documentation of higher-level issue consultations.  So, under a sanction that only a bureaucrat could love, Ballywill impel the Big Four’s national office boffins to “re-audit” information they receive from the field, and to build a fortress of memoranda to defend against the assaults of later second-guessing.

Let’s take a look back at the Ernst & Young risk and quality process employed in this case by the three partners who remain at the firm. They are leadership partners whom others look to for advice and guidance.  Rather than being independent, experienced, objective consultants with a “buck stops here” attitude of upholding firm, professional, and legal/regulatory standards, these three were portrayed in the SEC press release of the settlement as conflicted and self interested.  The SEC shames them, and in very damningly specific terms, because they were clearly seeking to protect not only their colleagues’ reputations but their own.

Ernst and Young now has three strikes against them for SEC enforcement actions, sanctions, and fines related to independence violations. Two of the three leadership partners held leadership and committee positions in the AICPA and PCAOB.

Famous Floyd Norris at the New York Times quotes an anonymous “veteran SEC official” who says he believes the EY/Bally’s sanctions are the first time an audit firm’s National Practice Partner was cited by the SEC. This “official” admits he had not checked the records. Floyd quotes him anyway.

Not true.

Floyd…next time call me.

Mr. Fletchall, who remains with Ernst, was in charge of resolving technical accounting issues in the United States. He was censured by the commission.

A veteran S.E.C. official, speaking on condition he not be named because he had not checked records for the entire history of the commission, said he knew of no previous enforcement cases in which a partner of a major firm was cited for his actions as head of a national office.

Back in September of 2007 I wrote about KPMG and Xerox and an SEC investigation that had been going on since 2003 that also named their National Practice Partner as a defendant.  Mr. Conway had also been a partner on the account. The fraudulent activities had occurred in 1997-2001.  KPMG finally settled the SEC case in 2005 and the shareholder litigation in early 2008. The sanctions against Mr. Conway were more severe than Mr. Fletchall’s.  Is he already back auditing again?  Did he ever leave KPMG? The firms are so forgiving of bad accountants.

A re: The Auditors reader, commenting on the Flanagan inside trader case, made the following observation and I responded as best I could:

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Mr. Khuzami:  If I don’t start seeing faster, stronger, more decisive once-and-for-all enforcements against the audit firms and their partners, I’m going to start believing that the snowjob is more often due to evil plans rather than benign neglect.

Main Page Photo Credit “Do you feel lucky, punk?” Clint Eastwood Dirty Harry (1971)


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19 Responses »

  1. Hi Francine,

    Congratulations on being invited to the SEC’s special briefing about their new Enforcement Division initiatives. It’s always good to see a girl from Chicago doing well! Especially an Irish one (you are aren’t you?)

    I love how you call the Big Four on the carpet and really get the word out about their repeated failures to do the jobs the investing public and regulators expect of them.

    I know Mr. Khuzmani isn’t the right one to talk with about righting the fundamental flaw in the whole financial audit system, but who is?

    As long as the auditees are the ones selecting, managing and paying the auditors, investors, government regulators and the general public will continue to receive financial information that’s been distorted and manipulated, even if not downright fraudulent.

    Even the PCAOB’s own annual investigations show that the Big Four on a regular basis flat out just don’t do the audit work they were commissioned to do. They either respond that they actually did do the work, but somehow didn’t document it, or they politely tell the PCAOB to “pound sand,” (my words of course).

    I’ll have more on what I think about the PCAOB’s effectiveness, (or lack thereof), in a blog post later this week.

    Thanks for doing such a great job keeping up the crusade!

    Ciao for Now,

    Sara McIntosh

  2. Oops, sorry about the typo on Mr. Khuzami’s name. Gotta watch those slippery fingers. . .

  3. [...] of work to do to improve their independence compliance function and are still subject to PCAOB and SEC enforcement actions and potential [...]

  4. [...] [...]

  5. [...] now disturbed the peace of a nascent “recovery.”  Why did it take so long for the media, the regulators and the legislators to acknowledge what some of us have known for a while? “Gentlemen, not one of [...]

  6. [...] argument that slow and weak sanctions by the SEC, even slower secret disciplinary proceedings by the PCAOB, private causes of action against [...]

  7. [...] Most accounting industry professionals certainly don’t see lawyers as part of the solution. The SEC’s Enforcement Division is comprised principally of attorneys who formerly represented corporations. The audit firms are [...]

  8. [...] but civil penalties and sanctions will be meted out to culpable individuals only and only after many years of investigation when the story and the deterrent effect have been significantly di… Civil penalties against audit firms as a whole will be severely rationed.  The private right of [...]

  9. [...] timing based on the SEC’s handling of the Bally’s sanctions.  Even with a slam dunk case, the SEC waited six years before they settled with EY.  The eventual sanctions against six Ernst & Young partners for [...]

  10. [...] getting really tough to keep track of all the partners under SEC sanctions. Hell, even famous Floyd Norris and his undercover buddy at the SEC couldn’t do it.  It’s easier if you keep the guys in “time-out” on the payroll [...]

  11. [...] has now disturbed the peace of a nascent “recovery.”  Why did it take so long for the media, the regulators and the legislators to acknowledge what some of us have known for a [...]

  12. [...] Most accounting industry professionals certainly don’t see lawyers as part of the solution. The SEC’s Enforcement Division is comprised principally of attorneys who formerly represented corporations. The audit firms are [...]

  13. [...] amount of time that’s passed since the audits, almost three years, allowed PwC to pull out the tried and true, “That was in the past, everything is fine now,” [...]

  14. [...] firms clearly have a sympathetic ear at Mary Schapiro’s SEC. Will this new stacked Board withdraw Acting Chairman Goelzer’s request to Congress to amend [...]

  15. [...] list of advisory services that can be performed by auditors of companies subject to Sarbanes-Oxley, the level of enforcement of these independence prohibitions is practically nil. Not only are the regulators loathe to single out a firm for large [...]

  16. [...] being the only effective deterrent for audit failure given the lack of effective regulation and minimal enforcement - gives the firms carte blanche to continue conducting business with the failure rate we saw in [...]

  17. [...] audit firm. In my opinion, if a combined fine of $7.5 million is a record, that only proves how lackluster prior SEC enforcement against foreign registered audit firms has been. It also shows how crippled the PCAOB has been to [...]

  18. [...] but civil penalties and sanctions will be meted out to culpable individuals only and only after many years of investigation when the story and the deterrent effect have been significantly di…Civil penalties against audit firms as a whole will be severely rationed.  The private right of [...]

  19. [...] the timing based on the SEC’s handling of the Bally’s sanctions. Even with a slam dunk case, the SEC waited six years before they settled with EY.  The eventual sanctions against six Ernst & Young partners for [...]

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