Huron Consulting, Its Executives and PwC; All’s Well That Ends WellBy Francine • Jul 23rd, 2012 • Category: Pure Content, The Big 4 And Consulting
The Huron Consulting case is a great one if you would like to see examples of almost everything that’s wrong with the audit industry, the regulation of the industry and “reforms” like Sarbanes-Oxley.
On Monday August 3, 2009, Huron Consulting shares lost more than two-thirds of their value after Huron said it would restate more than three years of earnings because the company classifed payments to non-shareholders of acquired companies as goodwill rather than compensation expense. Gary Holdren, once a senior Arthur Andersen partner and a member of its executive committee, resigned immediately as Huron’s chairman and CEO. The chief financial officer Gary Burge and chief accounting officer Wayne Lipski also left the company.
(Holdren now works for the only still-sitting CEO to have been the subject of a SOx Section 304 clawback, Dan Ustian at Navistar.)
The “misreported costs related to acquisitions” caused the restatement of financial results for 2006, 2007, 2008 and the first quarter of 2009 and a reduction in income for the period of approximately $56 million.
On Friday July 20, 2012 the SEC announced it had settled charges against Huron, its CFO Burge and its Controller Lipski in return for fines and promises to be good in the future with no admissions of guilt by any of the parties. Huron paid a $1 million penalty and the CFO and Controller will pay a total of about $300,000 in fines and restitution. Fines paid by the CFO are labeled a disgorgement, not Sarbanes-Oxley Section 304 clawbacks, in spite of the fact Huron restated several years of financial statements as a result of the “misreported costs”. Huron indemnified the former executives for defense costs, but it is not obligated to reimburse them for monetary penalties.
Chicago’s own Thomas Cimino at Vedder Price, attorney to former Huron CEO Gary Holdren, also announced on July 20, that the SEC had, “terminated its case against Mr. Holdren and determined not to pursue what have become known as “innocent executive” clawback claims against him in this matter.”
Huron Consulting, the CEO, CFO and Controller also settled a shareholder class action suit against them in May of 2011 for $27 million, all paid by Huron’s insurance carrier, and 474,574 shares of Huron stock provided by the company valued at the time at $11 million. This was the only recovery for Huron Consulting shareholders.
PricewaterhouseCoopers, Huron’s auditor, was originally named in some of the shareholder suits but the auditor was dropped as a defendant from the consolidated amended complaint by the co-lead counsel, Bernstein Litowitz Berger & Grossmann LLP.
Another suit, In Re: Huron Consulting Group, Inc., Shareholder Derivative Litigation against officers, directors and PricewaterhouseCoopers was dismissed by the circuit court for failing to adequately plead demand futility. The plaintiff lost an appeal in March of 2012.
On August 4, 2009, my post “Huron Consulting: Go On, Take The Money And Run” talked about the history of Huron Consulting, the Arthur Andersen pedigree of its founders, and the business environment Huron was operating in post- Sarbanes-Oxley.
You can’t say the warning signs weren’t there. Huron Consulting had not yet been reviewed by Audit Integrity and so did not make it to their 300 Worst Companies for Corporate Governance Risk list that I blogged about in March of 2009 but Audit Integrity did publish a report in April 2009 that spelled out the situation very clearly.
I wrote favorably about Huron a few times prior to August 2009 as an independent alternative for GAAP/IFRS advice. Certainly they had many qualified professionals. Companies should not ask auditors, for sure, to give prospective advice on accounting treatment for transactions. One of the most fundamental, longstanding principals of auditor independence and objectivity is that auditors are not supposed to audit their own work.
Companies are supposed to be staffed with sufficient accounting expertise or be willing to buy it from the appropriate independent service provider such that their auditor is not later opining on their own advice. Not having sufficient accounting technical expertise can turn into a material weakness in internal controls in their Sarbanes-Oxley assessment. See Navistar’s material weaknesses in internal control during their darkest period or GM’s a few years ago for examples of that.
Huron Consulting’s business model and value proposition is based on being experts in complex accounting and the standards and regulations that guide the treatment of complicated issues for SEC, tax and and external financial reporting purposes. That expertise was a double-edged sword once litigation began.
Judge Elaine Bucklo used the Huron executives’ accounting prowess against them when denying their motion to dismiss the class action suit in August of 2010:
Defendants’ lengthy and notably fact-intensive argument about the “complexity” of the accounting principles at issue is misplaced in the context of this dispute. To begin with, if anyone could have understood the requirements under GAAP for treating acquisition-related expenses as goodwill, it was defendants. At the very least, once defendants became aware of the “side agreements” among selling shareholders (if, indeed, defendants were not active participants in the creation of such agreements, as discussed below), they certainly had the wherewithal to appreciate that the redistribution of Huron’s acquisition-related payments could materially affect Huron’s accounting for those payments.
“When the facts known to a person place him on notice of a risk, he cannot ignore the facts and plead ignorance of the risk.” Makor Issues & Rights, Ltd. v. Tellabs Inc., 513 F.3d 702, 704 (7th Cir.2008) (citing AMPAT/Midwest, Inc. v. Illinois Tool Works Inc., 896 F.2d 1035, 1042 (7th Cir.1990)).
Yet in this case, with knowledge of the side agreements and the understanding that purportedly “complex” accounting principles guided the treatment of such agreements, defendants not only went ahead to account for Huron’s payments to the selling shareholders just as if no side agreements existed, but also failed to disclose the agreements to their independent auditors. It would be a remarkable coincidence indeed if the very agreements that undermined defendants’ favorable accounting treatment were the items defendants innocently omitted from review by Huron’s auditors.
The other side of the expertise coin is the winning position taken by Holdren’s attorney, Thomas Cimino and, apparently, the SEC. Cimino told me this morning that the SEC “did not assert any allegations of wrongdoing against Gary Holdren. The SEC also determined to drop any claim against Mr. Holdren for clawbacks of incentive-based bonuses, stock awards or stock sale profits.” While Huron touted itself as having a number of consulting experts in the area of technical accounting standards, Cimino articulated Holdren’s position that the restatement “was the result of a single accounting mistake on a very complicated issue at a company with an otherwise perfect record.”
The SEC must have decided that an unintentional mistake occurred given the fairly light sanctions imposed on CFO Burges and Controller Lipski. The SEC’s decided to make the charges against Lipski, Burge and Huron a “books and records” violation using Sections 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the 1934 Exchange Act rather than associating the material, multiyear accounting misstatement with a Section 10b-5 fraud charge.
Cimino also pointed out to me that another publicly-traded consulting firm that sells technical accounting expertise, FTI Consulting, corrected its accounting in 2009 for “immaterial” errors related to payments made in conjunction with acquisitions. The FTI Consulting auditor is KPMG.
Stuff, apparently, happens.
From FTI’s 2009 10-K:
In the third quarter of 2009, we concluded an internal re-examination of our contingent acquisition payments and related accounting treatment. As a result of this review, we discovered an immaterial error which impacted previously reported results for 2008, 2007 and 2006 related to certain contingent acquisition payments made in connection with the purchase of previously acquired businesses. The payments were made upon the achievement of required performance conditions as specified in the related purchase agreements. These purchase agreements allowed for a portion of the contingent payment to be paid to employee benefit trusts (“EBT”) or designated employees who at the time were deemed to be shareholders of the acquired entity. After further analysis, we concluded that neither the EBT nor the designated employees who received contingent payments qualified as original selling shareholders of the acquired businesses. As such, distributions made from the EBT or to these designated employees should have been recorded as compensation expense and not capitalized as part of the purchase price of the applicable acquisition. We revised our previously reported financial information in our Form 10-Q filing for the quarterly period ended September 30, 2009 to reflect the impact of the correction of the immaterial error… The impact of the correction of the immaterial error was a decrease to net income and diluted earnings per share of $2.1 million and $0.04 per share, $3.5 million and $0.08 per share; and $0.8 million and $0.02 per share for the years ended December 31, 2008, 2007 and 2006, respectively.
PricewaterhouseCoopers is still the auditor for Huron Consulting, in spite of allowing a material misstatement to be booked for multiple years that forced its client to have to restate. But were they really unaware? Should PwC have done more? Did PwC give Huron Consulting the advice that led them down the wrong path?
From my post, PwC and Huron Consulting: Goodwill Too Good To Be True, on August 10, 2009:
The headlines give one the impression that a sudden cataclysmic event triggered an unfortunate deluge of unanticipated but not necessarily undeserved negative consequences.
The Huron Consulting Audit Committee of the Board of Directors “finds out” (From whom? A whistleblower? Internal audit? An angry exec who hadn’t received one of the “kickbacks”) about some payments to executives as a result of acquisitions that had not been accounted for properly and the result is a long list of “complex matters that demand extraordinary combinations of financial, technical, and industry expertise”:
- An announcement of restatements of several years of financial statements with a significant impact to net income,
- The resignation of the CEO, CFO and Chief Accounting Officer,
- An unprecedented one day drop in stock price,
- The filing of several class action lawsuits,
- The disclosure of an SEC inquiry on another serious accounting issue, revenue recognition,
- Concerns voiced by analyst regarding the ability of the company to continue as a “going concern.”
However, the warnings signs and red flags were there. Not only had there been independent analysts who sounded alarms, but their auditors, PwC are in there all the time, including providing due diligence for acquisitions and “consulting regarding financial accounting and reporting standards.” In fact, PwC earned more from audit-related and tax fees than from the audit itself.
From the  latest proxy:
The SEC complaint is even more confusing about why PwC did not immediately start digging and questioning the approach Huron and its acquisitions were using to pay and record payments to non-owner acquired employees.
From the SEC’s Accounting and Auditing Enforcement Release No. 3394 dated July 19, 2012 against Huron and its former CFO and Controller:
From May 2005 through July 2008, Huron acquired ten consulting firms, including: Speltz & Weis, LLC (“S&W”); MSGalt & Company, LLC (“Galt”); Wellspring Partners LTD (“WP”); and Callaway Partners, LLC (“Callaway”).
In January 2008, Huron’s independent accountant (“Auditor”) discussed SEC Staff Accounting Bulletin (“SAB”) Topic 5T, which referenced accounting principles applicable to the Redistributions, with Huron, Burge and Lipski. Thereafter, Huron, Burge and Lipski did not determine the full impact of the accounting principles referenced in SAB Topic 5T on the Company’s financials. More specifically, although Burge and Lipski analyzed certain Redistributions, their analysis was inadequate. Also, although they knew about other Redistributions, and other previously contemplated Redistributions, they did not revisit them. Finally, they did not adequately consider or determine whether there were any additional prior Redistributions or contemplated Redistributions that needed to be analyzed.
(Why can’t even SEC lawyers get it right? Referring to the auditor, PwC, as an “independent accountant” who also gives accounting advice about prospective transactions is the epitome of the collaborative approach between auditor and management rather than an independent, objective and professionally skeptical approach. Even the SEC seems to be condoning it.)
Turns out that PwC advised, via email, that the redistributions to WP and Galt SSHs should be expensed.
On January 4, 2008, Engagement Manager emailed SAB Topic 5T to Lipski and External Reporting Director, and stated that he believed that under it, SSHs would be “holders of an economic interest” in Huron and that the Earn-Out redistributions to the Three Non-SSHs would need to be expensed because “the payment[s] [are] caused by a relationship that is not completely unrelated to Huron and . . . benefits Huron.”
Huron expensed what they knew about but it turns out that the CFO and Controller did not follow up to see if the acquired company paid more than what they told them about – they did – and neither did PwC. Those amounts were not recorded as expense.
During the Callaway acquisition negotiations, Burge, Lipski, and others at Huron learned from an acquisition due diligence report that the Callaway SSHs had a written plan that awarded acquisition sales proceeds to non-SSHs (“Callaway Awards”).
(PwC’s additional “audit related fees in 2007 and 2008 included amounts for due diligence on acquisitions. PwC therefore knew about Callaway’s plans to redistribute sales proceeds to non-shareholders of the acquired company.)
PwC was in the middle of the discussions about acquired companies, contingent earn-outs to be paid as re-distributions to non-owners of the acquired companies and the accounting treatments being discussed for those payments. However, PwC did not, it seems, perform any additional testing or demand additional backup for all amounts recorded to goodwill related to the numerous acquisitions that occurred during this period resulting in multiples years financials being materially misstated.
Maybe all that consulting and tax fee income was getting in the way of their audit objectivity, independence and professional skepticism.
KPMG was also earning fees for providing its client, FTI Consulting, with technical accounting advice related to transactions during the period of acquisitions that caused that company’s restatement for the same issue.
From the FTI Consulting 2009 Proxy:
Audit fees are fees we paid KPMG for the audit and quarterly reviews of our consolidated financial statements, assistance with and review of documents filed with the SEC, comfort letters, consent procedures, accounting consultations related to transactions and the adoption of new accounting pronouncements, and audits of our subsidiaries that are required by statute or regulation. In 2007, approximately $1,407,000 in fees were incurred for audit (including the audit of internal controls over financial reporting), statutory audit and quarterly review services provided in connection with periodic reports filed under the Exchange Act… (for a total of $1,550 thousand). Audit-related fees ($392 thousand) principally include professional services related to assistance in financial due diligence for our acquisitions of other businesses. Tax fees ($510 thousand) primarily include tax compliance and planning services.
PwC had also been repeatedly criticized by the PCAOB for its auditing of goodwill. From my August 10, 2009 post, PwC and Huron: Goodwill Too Good To Be True:
PwC is inspected by the PCAOB every year. The 2006 report issued in October of 2007 cites a deficient audit (out of six cited) where,
“the Firm failed to sufficiently test certain assumptions that management used in its goodwill impairment test…there was no evidence in the audit documentation, and no persuasive other evidence, that the Firm had evaluated the appropriateness of the projections, other than by making inquiries of management.”
Again in the 2007 report, issued in June of 2008, six deficiencies were cited. One faulted PwC for failing to test the underlying data and the calculation of an award allocation related to a goodwill impairment analysis.
“The Firm also failed to assess whether the methodology was applied consistently from year to year and whether the incorporation of the award allocation into the [goodwill impairment] analysis was appropriate.”
In another deficiency cited in the 2007 report, PwC
“…failed to test certain of management’s key assumptions supporting an assertion that payments following the modification of contingent consideration after a significant acquisition represented additional purchase price rather than employment compensation to the sellers or other current-period expense. They also failed to identify and address that the modification rendered the issuer’s disclosure of the agreement inaccurate.”
In the report for 2008, all of the deficiencies cited were as a result of inadequate evidence to support opinions related to goodwill impairment.
“…In some cases, the deficiencies identified were of such significance that it appeared to the inspection team that the Firm, at the time it issued its audit report, had not obtained sufficient competent evidential matter to support its opinion on the issuer’s financial statements. The deficiencies that reached this degree of significance are described below, on an audit-by-audit basis, with the exception of similar deficiencies that were observed in multiple audits and are therefore grouped together…In four audits, due to deficiencies in its testing of goodwill for possible impairment, the Firm failed to obtain sufficient competent evidential matter to support its audit opinion.”
Will PwC ever be held accountable by the PCAOB or the SEC for its advice, potentially violating the Sarbanes-Oxley independence requirements, or its negligence in not following up on the red flags that were presented by the questions and discussions early on related to so many acquisitions in such a short time?
Huron Consulting is now a very different firm.
Jonathan Weil at Bloomberg sums it up:
The [SEC] deal caps a remarkable act of corporate self-immolation. One of Huron’s main businesses had been providing forensic-accounting advice to other companies, including those under SEC investigation for accounting fraud. The company sold part of its disputes-and-investigations practice in 2010 and shuttered the rest.