Overgrown Hedge

Yesterday’s column at American Banker digs into the accounting for JP Morgan’s reported “hedge”.  I was shocked – OK, not really – that no main stream media outlet had explained the stunning announcement made by Jamie Dimon last Thursday of a $2 billion loss on a series of trades made by the Chief Investment Office in accounting terms. CIO is the group purportedly managing the investment of the bank’s excess deposits.  In London. As in, the low risk sweep function. Uh-huh.

There’s lots of speculation about the nature of the trade itself. The best I’ve seen is the ongoing coverage at FT Alphaville by Lisa Pollack, in particular.

The gist of all the stories is that the CIO was selling protection on the CDX.NA.IG.9 (going long) to balance out the tranches on the high yield index that they’d bought (going short, which turned out to be profitable when Dynegy and AMR Corp defaulted).

In this way the trade would be both a curve play and across indices — one high yield, one investment grade, with the high yield play levered further because it was a tranche. The long on the IG.9 also would have helped to fund the rather expensive short on the high yield tranches.

If you are an expert in this stuff, please get in touch. I’d buy a big steak for someone who can walk me through it, maybe at a quiet table at Gene & Georgetti’s.

I took a long look at the 10K and 10Q and the first clue was the pretty stark statement, all over the place that the credit derivative number, “Represents the net notional amount of protection purchased and sold of single-name and portfolio credit derivatives used to manage both performing and nonperforming credit exposures; these derivatives do not qualify for hedge accounting under U.S. GAAP.”

So from a financial reporting perspective, all the media and trader chatter about “hedge or bet?” is moot.

The bank may now be calling the positions an “economic hedge” but, in hindsight, they look to me like a series of trades designed to generate income that spiraled out of control on incorrect or ignored risk information and lack of control over traders.

“It was there to deliver a positive result in a quite stressed environment,” Dimon said on the May 10 emergency conference call, “and we feel we can do that and make some net income.”

The rest of the American Banker column provides the details.

I left out a discussion of PwC and VAR and risk management and Sarbanes-Oxley because of space limitations at American Banker.  I have been getting a lot of questions about whether or not PwC “audited” the Value-at-Risk or VAR number.

Dimon also admitted on the conference call on May 10 that the bank’s primary risk management tool, Value at Risk or VAR, had failed to signal the magnitude of the looming losses. VAR is a statistical risk measure used to estimate the potential daily loss from adverse market moves. The results are reported to senior management and regulators and they are utilized in regulatory capital calculations.

The first quarter press release reported an average VAR of 67 for the CIO. According to Dimon, CIO implemented a new VAR model on its own recently, which it, “now deemed inadequate.” So CIO went back to the old one, which it “deemed to be more adequate.” The actual VAR number for CIO for the period was 129. There are now reports that the CIO used a different VAR model than the rest of the bank. That sort of negates the argument that CIO was aggregating risks via VAR from the rest of the bank and “hedging” that risk at a portfolio level. There have also been reports that another area of the bank was making the opposite trades that the CIO was making.

As a non-GAAP metric, JP Morgan’s the financial statement opinion provided by auditor PwC doesn’t cover the VAR number or the model that produces it. (The audit opinion doesn’t cover press releases or MD&A either although the auditor has an obligation to review disclosures to make sure they are not misleading or incomplete.) However, as the bank’s primary risk management tool, the VAR model and the policies and procedures around it are certainly reviewed.  It should be on the auditor’s radar as a key indicator of the quality of the bank’s risk management policies and processes. Changing the model for CIO after several years of “adequate” performance for the bank as a whole should raise red flags. Was the model change properly executed, reviewed and approved at the highest levels?

For more about how models can be used to perpetrate fraud or serve as an excuse for reckless negligence, check out the presentation I made earlier this year at the invitation of Emanuel Derman for Columbia University’s Masters in Quantitative Finance Seminar: Modeling For Fraud, Models Behaving Nefariously.

This book is the fourth in a series of compilations from re: The Auditors. This volume focuses on the failure of MF Global on October 31, 2011. MF Global was a broker-dealer and futures commission merchant (FCM).

All of these essays and columns have been previously published in re: The Auditors, Forbes.com, or American Banker. This version does include extensive links to other articles and resources both on and off the sites. Please visit the original columns to view reader comments. The community conversation and information sharing is one of the most valuable parts of the online experience.

Future volumes will cover the business of the Big Four audit firms, corporate governance, risk management and the intersection of financial services and professional services.

The price is $3.99.

Also available : re: The Auditors On Careers: Being A Big Four Partner

This book is the third volume of compilations from re: The Auditors and the second in a series on careers. This volume focuses on the role of the partner in the Big Four public accounting firm and how that person is developed, evaluated, and compensated.

All of these essays have been previously published in re: The Auditors but have been selected and arranged chronologically for your convenience. This version does include extensive links to other articles and resources both on and off the site. Please visit the original posts to view reader comments. The community conversation and information sharing is one of the most valuable parts of the re: The Auditors site.

Future career volumes will cover diversity and inclusiveness, ethics, independence, and professional skepticism, layoffs, and the overtime lawsuits.

Future compilations will cover special topics in auditor litigation, the Ernst & Young/Lehman case, consulting in the Big Four, and a behind the scenes look at the global network construct.

Also available:

re: The Auditors on Careers: A Compilation On Recruiting, Salaries, and the Competitive Employment Landscape

And:  “Unholy Alliance: PricewaterhouseCoopers And Its Relationship With AIG and Goldman Sachs During The Crisis.”

This is not a traditional book but a compilation of all of my writing from 2007 until January of this year on AIG, Hank Greenberg, the asset valuation and collateral conflict between Goldman Sachs and AIG, and PwC’s relationship with two of its most important clients.

All of the chapters are available as posts on this site and Forbes.com, but I thought it might be helpful for some to see them in chronological order, all together.

The package includes thirty-three (33) essays including extensive links, almost 41,000 words, and 180 pages of stories about such characters as Arthur Levitt, Joe Cassano, Eliot Spitzer, and Hank Greenberg. There’s extensive coverage of the litigation related to the earlier AIG crisis for accounting issues occurring between 2002-2005.

You can go here to subscribe to this site via Kindle.

Your feedback and ideas for future e-books will be appreciated.

We are looking forward to your thoughts. My timeline for feedback is asap, but we have a bit of time as we are still searching for more mortgages.

As we discussed, we are researching some $1.1 billion in mortgages identified to date, which were taken out by the CEO of Chesapeake Energy Corp, Mr. Aubrey McClendon. He pledges his share of the company’s oil and gas wells and related equipment, intellectual property and hedging contracts as collateral.

The transactions are done through three separate firms he controls called Jamestown Resources LLC, Larchmont Resources LLC and Chesapeake Investments LP.

The result of Brian’s work, with co-author Anna Driver, is a special investigative report, that came out this past week. The publication of the report last Wednesday moved the Chesapeake stock price to its 52-week low. There have also been calls for CEO McClendon’s ouster and lawsuits filed.

Chesapeake Energy has now agreed to provide additional disclosures to investors.

Talk about impact journalism!

I posted a column on Forbes.com to highlight the report and my quote in it.

You have to wonder whether Chesapeake Energy‘s Board of Directors and General Counsel Henry Hood have been overcome by fumes. The company’s response to inquiries from Thomson Reuters’ special investigation by Brian Grow and Anna Driver is not only disingenuous it’s borderline delusional.

McClendon has borrowed as much as $1.1 billion in the last three years by pledging his stake in the company’s oil and natural gas wells as collateral, documents reviewed by Reuters show.

The loans were made through three companies controlled by McClendon that list Chesapeake’s headquarters as their address. The money is being used to help finance what could be a lucrative perk of his job – the opportunity to buy into the very same well stakes that he is using as collateral for the borrowings.

The size and nature of the loans raise concerns about whether McClendon’s personal financial deals could compromise his fiduciary duty to Chesapeake investors, according to more than a dozen academics, analysts and attorneys who reviewed the loan agreements for Reuters…

Chesapeake said McClendon’s loans are “well disclosed” to company shareholders. General Counsel Hood cited two references in the company’s 2011 proxy. In them, the firm refers to McClendon’s personal “financing transactions,” including one in a section entitled “Engineering Support” that discusses McClendon’s use of Chesapeake engineers to assess well reserves.

Nowhere in Chesapeake proxy statements or SEC filings does the company disclose the number, amounts, or terms of McClendon’s loans. Veteran analysts of the company said they were never aware of the loans until contacted for this article.

“We believe the disclosures made by the company have been appropriate under the circumstances, particularly since the disclosure of the loans is not required in any event,” Hood said in a statement.

You may wonder where the SEC is in all this. Don’t the rules require disclosure of related party transactions regardless of “materiality”?

McClendon’s loans – backed not by stock but by stakes in company wells – aren’t covered by the SEC rule. “Because they have decided to compensate him with a business interest, it kind of falls through the cracks,” says Francine McKenna, an accounting expert and author of the accounting-related blog re: The Auditors.

As a result, no SEC regulation precludes McClendon from using his well plan stake as loan collateral. The SEC declined to comment on the McClendon loans.

The SEC may not be specifically requiring disclosure of the complicated relationship between McClendon and EIG, between EIG and Chesapeake, and between Chesapeake and all the investors in EIG hedge funds that count on McClendon staying alive and in charge of Chesapeake. However, the audit industry regulator, the PCAOB, has proposed a new auditing standard that will require auditors to take a closer look:

Several news reports confused the source of the loans, the source of the collateral, and how the  loans were used. The loans were made by a banks and private equity firms not Chesapeake. They were made using McClendon’s interests in the wells as collateral. The most recent ones were used by McClendon to purchase the participations in the wells via a special purpose vehicle  - a legal entity set up in partnership with the private equity firm EIG so that the well participations could be converted to an asset held an EIG hedge fund.

Since he co-founded Chesapeake in 1989, McClendon has frequently borrowed money on a smaller scale by pledging his share of company wells as collateral. Records filed in Oklahoma in 1992 show a $2.9 million loan taken out by Chesapeake Investments, a company that McClendon runs. And in a statement, Chesapeake said McClendon’s securing of such loans has been “commonplace” during the past 20 years.

But in the last three years, the terms and size of the loans have changed substantially. During that period, he has borrowed as much as $1.1 billion – an amount that coincidentally matches Forbes magazine’s estimate of McClendon’s net worth.

The $1.1 billion in loans during the past three years breaks down this way:

In June 2009, McClendon agreed to borrow up to $225 million from Union Bank, a California lender, pledging his share of wells as collateral.

In December 2010, he borrowed $375 million from TCW Asset Management, a private equity firm.

And in January 2012, McClendon borrowed $500 million from a unit of EIG Global Energy Partners, a private equity firm formed by former TCW executives.

In one document provided to me by Reuters for my review, EIG Chief Operating Officer Randy Wade makes a pitch to the New Mexico State Investment Council for an investment in a new hedge fund his firm has created.

Mr. Wade responded that they have known Chesapeake Energy for 25+ years and provided pre-IPO financing for them in the late 1980s. He explained that Chesapeake’s chairman Aubrey McClendon has the personal right to invest, for a 2.5% interest, in every well that Chesapeake drills during a calendar year. In fall 2008, Mr. McClendon didn’t have liquidity to participate in the program in 2009, at which point EIG entered into discussions with him and ultimately came up with an SPV called Larchmont, which is in Fund XIV and is the analogy to Fund XV’s first investment. He said EIG set up a new entity and made a senior secured loan to the entity, and McClendon contributed his rights to participate in the 2009 drilling program at Chesapeake with an option on 2010, which EIG ultimately exercised.

He said EIG sweeps 100% of the cash flow generated by those projects until EIG has gotten all of its money back plus a 13% realized return; and in perpetuity EIG has a 42% net profit interest in all of the leases for which a well was drilled with EIG’s capital. To put it into context, 2,500 wells were drilled in this program, which ended in 2010, and this is the largest most diversified drilling program EIG has ever participated in. Fortunately, EIG had taken a fairly conservative underwriting approach on reserves and production; and while it is still early in the program, generally they are 25%-40% outperforming their base case.

Reuters reports that several state pension plans are counting on McClendon staying healthy, and on the job, at Chesapeake. That’s the only way these investments pan out for them.

An investment management firm that has loaned hundreds of millions of dollars to Chesapeake Energy Corp.(CHK.N) Chief Executive Aubrey McClendon raised money for its most recent investment fund from 19 institutional investors, including some of the largest U.S. public pension funds, according to a private equity research firm.

The list of state pensions that put money into the $4.1 billion EIG Global Energy Partners fund include ones from Alaska, Connecticut, Louisiana, Maryland, Minnesota, Missouri and Texas, according to research firm Preqin. Other large investors in the EIG Energy Fund XV were insurance giant MetLife and a Teamsters pension plan.

Chesapeake Energy’s auditor is PricewaterhouseCoopers. The auditor is paid less than $3 million to prepare an opinion on this challenging company. Sometimes you can be paid too little to be sufficiently skeptical…

Aubrey McClendon was also named an Ernst & Young Entepreneur of the Year last year.

With Democrats like Representative Carolyn Maloney of New York, who needs the Republicans? When special interests pursue self-interested legislation  – or seek to block legislation that affects their interests  – Maloney waves the jobs and economic growth flag for campaign contributors rather than defending investors.

Maloney voted for the JOBS Act in spite of the fact the bill destroys investor protections hard-won after the Enron fraud in the Sarbanes-Oxley Act. Maloney also recently spoke up on behalf of the audit industry instead of investors during a hearing held by the House Subcommittee on Capital Markets and Government Sponsored Enterprises. PCAOB Chairman Jim Doty testified about several agency initiatives to increase auditor independence, transparency, and accountability for auditors behaving badly. Maloney joined Republican Congressmen who pushed back hard on Doty and the PCAOB, the audit industry regulator, accusing the regulator of  “mission creep” and “overreach”.

Maloney represents Manhattan’s East Side and Queen’s West Side, the home of the financial services industry including the US headquarters of all of the Big Four accounting firms. Maloney serves on three key subcommittees of the House Committee on Financial Services because she, “believe[s] one of my chief tasks is to maintain the preeminence of New York City as the world’s financial center.” Maloney is “committed to defending the health of our financial institutions so that they can lead our economic recovery.”

But, in my opinion, she’s no expert on financial services or accounting policy.

Maloney’s real interests show up at the most inopportune moments. Back in 2000, before the Enron scandal, Richard Baker, a Louisiana Republican, ran the House Subcommittee on Capital Markets. He was very worried at the time about Fannie Mae and Freddie Mac. Baker saw the writing on the wall with the mortgage giants, behemoth Government Sponsored Enterprises (GSEs) that were eventually nationalized under a conservatorship in September of 2008 because of the significant losses they racked up from subprime mortgage securitization. Taxpayers are still paying the bill for the inattention by so many for so long to the accounting manipulation, fraud, and excessive risk taking at the GSEs that put both public companies into receivership.

Baker convened hearings and the undersecretary for domestic finance at Treasury at that time, Gary Gensler, offered his views during one of them on the Housing Finance Regulatory Improvement Act. Baker’s bill proposed removing the $2.5 billion line of credit available to Fannie and Freddie from Treasury. Gensler came out in favor of cutting off Fannie and Freddie. According to Gretchen Morgenson and Josh Rosner in their recent book, Reckless Endangerment, the Subcommittee on Capital Markets at that time was dominated by two factions.

“First were the “housers”—true believers in government subsidies for housing and supporters of Fannie and Freddie as the best vehicles to provide them. Equally zealous, though, were the members who received campaign contributions funded by the companies as well as the ribbon-cutting ceremonies for projects in their districts.”

As one of the most contentious hearings ended, Representative Carolyn Maloney piped up with a closing question for Franklin Raines, Fannie Mae’s chief executive, that seemed to ignore the point of the hearings – Fannie and Freddie were already overextended.

“I think it would be appropriate to bring the GSE structure to childcare, an area that has been failed by the private markets. I would like to know, would Fannie and Freddie be opposed to having the authority to buy childcare facility mortgages?”

Maloney’s quest to use the GSEs to fund childcare facility mortgages went nowhere in 2000. She sponsored variations of the bill repeatedly  in the following years. In 2006 it was called H.R. 5207, the Children’s Development Commission Act (Kiddie Mac). Maloney ignored what everyone else who was close to the financial services industry saw at that time: The mortgage industry was headed for a crash, led by subprime. By 2006, some of the big mortgage originators who fed Fannie Mae and Freddie Mac like New Century and Countrywide had started to falter.

These days Carolyn Maloney is pushing jobs and growth, growth and jobs, and protecting the interests of the venture capitalists, bankers, and “job creators” who woudl love to repeal the Sarbanes-Oxley Act. Maloney recently supported the Jumpstart Our Business Start Ups Act (JOBS Act) which goes a long way towards erasing the gains investors made in Sarbanes-Oxley.

Some Democrats who voted for the JOBS Act as a jobs bill, including Maloney, are now backpedaling.  ”I don’t see it as a great jobs bill,” Rep. Carolyn Maloney (D-N.Y.) told MSNBC’s Chris Hayes. “I don’t see it creating a lot of jobs.”

When Chris Hayes confronted Maloney with SEC Chairman Mary Schapiro’s objections to the removal of significant investor protections in the JOBS ACT, Maloney said Schapiro could write a letter to all Senators and Congressmen explaining her objections and they would consider a bill to address them.

Maloney also told the panelists that day, “I think it’s very difficult to take on the financial interests.”

I guess it wasn’t enough for SEC Commissioner Schapiro to send a letter with her concerns to the Senate Banking Committee before they took up the bill that the House passed with bipartisan support. That bipartisan support included votes from current House Committee on Financial Services ranking member Rep. Barney Frank, Rep. Maloney, and Rep. Maxine Waters. Rep. Capuano was the only Democrat voting no on this bill in committee.

In her letter to Senators Johnson and Shelby, SEC Commissioner Schapiro said the Jumpstart Our Business Startups (JOBS) Act, HR 3606, passed by the House would weaken investor protections by, for example, exempting emerging growth companies from the internal control audit opinion provisions of Section 404(b) of Sarbanes-Oxley. Schapiro believes the Section 404(b) internal controls requirement “has significantly improved the quality and reliability of financial reporting and improved investor protections and, therefore, believe this change is unwarranted.”

Instead of carefully considering growing public objections to the bill, the Senators expedited its passage instead. There was no bill mark-up session and no further hearings. SEC Chair Mary Schapiro did not testify and neither did any of the SEC Commissioners.

I attended the bill markup session for H.R. 3606, “Reopening American Capital Markets to Emerging Growth Companies Act of 2011″ by the House Committee on Financial Services on February 16^th.  Republican Congressman Garrett, the Committee Chairman, led a quick discussion of proposed amendments to the bill. Carolyn Maloney had none. In fact, Maloney was absent for much of the discussion because this was the same day as a Senate hearing on birth control. Maloney’s protests about, “Where were the women?” at that hearing dominated the evening news and play repeatedly as a video on her website. Instead of looking out for the investor, Maloney was focused on a soundbite and a photo op.

Maloney’s focus on women’s issues is the excuse given by many for giving her a pass on otherwise generally corporatist positions on everything else. As a woman and a progressive Democrat, I take Democratic legislators’ support for women’s health, anti-domestic violence, and pay equality issues for granted. I give Maloney no extra credit points for strongly supporting these initiatives. Maloney is a drive-by Democrat who does the warm and fuzzy blanket stuff and supports financial services and business legislation based on who has buttered her bread.

Maloney sought to repeal the protections of Sarbanes-Oxley early on. According to reports in the Huffington Post on October 28th, 2009, Rep. Carolyn Maloney sponsored the original bill to repeal SOx 404 internal control audit requirements for companies with market capitalization less than $75 million. This loophole applied to about 55% of publicly traded firms. Maloney’s amendment, co-sponsored with Rep. Scott Garrett, a New Jersey Republican, was to be attached to a bill pending in the House Financial Services Committee, the Investor Protection Act of 2009,.

The permanent exemption for companies under $75 million in market capitalization was passed under Dodd-Frank in July of 2010. The audit industry otherwise escaped any mention or sanction in Dodd-Frank, in spite of their failure to warn investors of problems at the bank who failed, were bailed out or acquired by healthier banks. In particular, legislation to repeal the exemption from aiding and abetting liability in securities litigation for third-parties like auditors never made it into Dodd-Frank.

Employees of KPMG, PwC, and Deloitte were among House Committee on Financial Services ranking member Barney Frank’s top 25 contributors leading up to the passage of Dodd-Frank, 2009-2010. During the 2008 election year, all of the Big 4 contributed to Frank’s reelection campaign.

The JOBS Act exempts “emerging growth companies” – that’s companies with up to $1 billion in revenue – from SOX 404(b) internal controls audits for five years or until they exceed the revenue threshold. That’s bad for the business of the accounting/audit industry. The additional provision that reduces required audits at the time of IPO filing for “emerging growth companies” from three years to two also takes food off auditors’ tables. The audit industry said nothing during the debate about the impact those provisions would have on investors. They would have appeared greedy. The auditors learned the hard way after the Sarbanes-Oxley Act was passed not to oppose public company executives who push for less regulation and less cost just because reducing investor protections may harm the true client – investors.  After all, it’s company executives and Audit Committees who hire auditors and their consulting and tax professionals and pay their bills, not shareholders.

Representative Carolyn Maloneycontinues to be a member of the House Financial Services Subcommittee on Capital Markets and Government Sponsored Enterprises. The latest incarnation, under the leadership of Rep. Garrett, recently held a hearing to discuss pending proposals and current challenges facing the auditing and accounting industries. (I guess the firms fal under this subcomittee because the audit firms are government sponsored enterprises by way of their exclusive franchise for providing stock exchange mandated and SEC mandated audits of public companies and because there’s a a stated “too few to fail” policy?)

Jim Doty, Chairman of the PCAOB, Jim Kroeker of the SEC, and Leslie Seidman of FASB answered questions from Committee members. Among the issues discussed was HR 3503, co-sponsored by Reps. Lynn Westmoreland (R-GA) and Barney Frank (D-MA) which would amend the Sarbanes-Oxley Act of 2002 to make Public Company Accounting Oversight Board disciplinary proceedings open to the public and a bill sponsored by Rep. Michael Fitzpatrick (R-PA) that would prohibit the PCAOB from mandating firm rotation. The bill, sponsored by Rep. Michael Fitzpatrick (R., Pa.), hasn’t yet been introduced.

The Wall Street Journal’s Michael Rapoport tells us:

According to data from the Center for Responsive Politics, which tracks campaign finance, Rep. Fitzpatrick has gotten major contributions from PricewaterhouseCoopers and Deloitte during the 2012 election cycle. PwC is his 10th-biggest contributor throughout his career in Congress, and the accounting industry has given him a total of $108,779 over his entire career.

Rep. Scott Garrett (R., N.J.), who is chairman the capital-markets subcommittee, has also benefited from the industry’s contributions. KPMG is his fourth-largest contributor throughout his career, and PwC is his 12th-largest. The accounting industry has given him $152,904 over his career.

Rep. Maloney is skeptical about the PCAOB’s request to make disciplinary proceedings against audit firms and auditors public. The Sarbanes-Oxley law bars the PCAOB from making such proceedings public unless both parties consent. That’s inconsistent with how the SEC handles similar sanctions against audit firms and auditors for violating securities laws. The PCAOB has said this allows audit firms to drag out legal proceedings for years while keeping audit committees and investors in the dark about auditor negligence and bad behavior.

“I understand the concern … but I also want to hear whether there is any concern that by making these proceedings public, we are unnecessarily harming the reputation of a firm before any official action is taken. Personally, I don’t think we should do so unless there is an official action taken.”

Maloney isn’t crazy about mandatory auditor rotation, either.

“Aren’t there other ways to boost auditor independence without putting in an arbitrary requirement that may disrupt the relationship between the firms and companies they audit?  It may affect the cost and quality of the audits, too.”

Those talking points could have come directly from the audit firms. In fact, they probably did.

“Mandatory firm rotation will not improve audit quality and its cost cannot be justified. “

PwC’s Bob Moritz in testimony to the PCAOB on March 21, 2012

“Ernst & Young…does not support mandatory firm rotation. In our view, it is not a necessary or constructive means to promote auditor skepticism, and we are aware of no evidence that it will improve audit quality…A mandatory audit firm rotation model would not only give rise substantial costs and disruptions, but would also impair audit quality and undermine sound corporate governance – all to the ultimate disadvantage of investors. We believe the mandatory re-tendering approach suffers from the same or even greater flaws.”

Steven Howe, Ernst & Young in testimony to the PCAOB on March 21, 2012

“Given the significant costs and disruption, the lack of evidence linking engagement tenure to audit quality, and, most importantly, the risk that mandatory rotation is actually a detriment to audit quality, we oppose mandatory firm rotation.

PCAOB enforcement proceedings currently are confidential under Sarbanes- Oxley, because Congress understood that auditors belong to a profession in which a good reputation is essential and publication of unproven charges may end an individual auditor’s career or audit firm’s existence.”

Barry Melancon, President of the AICPA, the audit industry trade organization, in testimony before the House Subcommittee on Capital Markets and Government Sponsored Enterprises, March 28, 2012

Maloney is at the top of the list of Democrats receiving campaign contributions from the auditors, second only to Brad Sherman of California, a CPA and Big Four alumni. Sherman has pocketed $49,500 from the industry already in 2012. Maloney, who counts the Big Four US headquarters amongst her district’s constituents, has accepted $28,500 in 2012. The accounting industry has given her $176,000 over her twenty-year career according to OpenSecrets.org, more than either Republicans Garrett or Fitzpatrick.

Looks to me like it’s the audit firm money, not Carolyn Maloney, doing the talking.

Last week was Groupon’s big week, although not in a good way. What happened? Well, the premier source of daily deal dish got knocked down a few more pegs after announcing a revision to 4th quarter earnings and the announcement by management that there was a material weakness in internal controls over financial reporting that was causing their disclosure controls to be ineffective. Groupon went public just a few months ago, last November, and the annual report was the company’s first filing as a public company.

Here’s one of the few journalists who got the details right, Jonathan Weil of Bloomberg, explaining why, in this case, the news was especially bad:

Didn’t Groupon know before its initial public offering that its controls were weak? A company spokesman, Paul Taaffe, declined to comment. Let’s assume for the moment, though, that its executives did know. Even then, they wouldn’t have had to tell investors beforehand.

That’s because there is no requirement to disclose a control weakness in a company’s IPO prospectus. Groupon would have had no obligation to disclose the problem until it filed its first quarterly or annual report as a public company — which is what it did. Sandbagging IPO investors in this manner is perfectly legal, it turns out.

The reason lies with a gaping hole in the Sarbanes-Oxley Act, which Congress passed in 2002 in response to the accounting scandals at Enron Corp. and WorldCom Inc. That statute had two main sections related to companies’ internal controls, which are the systems and processes that companies are supposed to have in place to ensure the information they report is accurate. Those provisions apply only to companies that are public already, not ones that have registered for IPOs.

One section, called 302, requires public companies’ top executives to evaluate each quarter whether their disclosure controls and procedures are effective. The other section, known as 404, is better known. It requires public companies in their annual reports to include assessments by management and outside auditors about the effectiveness of their internal controls over financial reporting. Congress left it to the Securities and Exchange Commission to write the rules implementing those provisions.

Here’s where it gets tricky. Groupon reported the weakness in its financial-reporting controls through a Section 302 disclosure, not a Section 404 report. In other words, the problem was serious enough that it amounted to a shortcoming in the company’s overall disclosure controls.

Groupon won’t have to comply with Section 404’s requirements until its second annual report, due next year, under an exemption the SEC passed in 2006 for newly public companies. Likewise, Groupon’s auditor, Ernst & Young LLP, to date has expressed no opinion on the company’s internal controls in its audit reports.

From the moment Groupon announced the revision on March 30, there were two important facts that almost all major media financial journalists got wrong:

1) The announcement of lower revenue and lower income for the fourth quarter was a revision of an earnings release, not a restatement. Groupon never filed a 10Q so there was no SEC filing to restate. Fessing up to the right numbers in the annual report was the first time the company was bound to report those numbers and, at that time, they corrected previously announced earnings for the 4th Quarter.

2) Management made the assessment of the material weakness in internal controls over financial reporting that caused disclosure controls to be ineffective, not auditor Ernst & Young. Ernst & Young deserves no credit for the announcement, nor any blame, just yet, for the fact that the weaknesses had to be finally admitted. There is no transparency regarding the auditor’s agreement or disagreement previously with Groupon, any public documentation of their discussions or any reason to believe Ernst & Young either encouraged or discouraged Groupon to get their act together sooner.

We just don’t know.

What we do know is that Ernst & Young signed the fourth clean audit opinion when it signed the audit report included in Groupon’s annual report. With the three audited financial statements included in the S-1, we can assume that control weaknesses Ernst & Young was aware of, if they were aware of any, were not serious enough in their opinion to qualify the audit opinion.

Because I was very busy with some other projects when the Groupon announcement came out I chose to be quoted regarding Groupon, rather than to blog about it, last week. I also tried to use Twitter to alert fellow journalists and the readers that the reporting had mistakes.

I was asked to comment on the Groupon story by three media outlets: the Marketplace radio program on PRI/NPR, Phil Rosenthal at the Chicago Tribune, and Crain’s Chicago Business.

I haven’t seen the story in Crain’s yet, but it Here’s the Crain’s link. It was nice to have two local media outlets notice they had someone who writes about these issues right here in Chicago where Groupon is based.

Marketplace’s Heidi Moore, who I follow on Twitter, wrote a short piece and my comment is strictly color. You can read the text and listen here.

The Tribune piece is extensive and Phil Rosenthal does a great job explaining why Groupon’s success or failure means a lot to the Chicago tech scene.  I get a long quote:

“As a Chicagoan, I’m really sad, because we’re proud when somebody does good here,” said Francine McKenna, an expert on the accounting and auditing industry who writes the Accounting Watchdog column for Forbes. “We love promoting our companies, especially homegrown success stories, and this is embarrassing.

“Because they’re growing so fast, because they’re trying to take a less conservative approach when they’re developing these numbers, because they want to shine the best possible light on what they’re doing, they got caught short. There was nothing they could do but admit they screwed up.”

To be honest, I’m holding back a bit on this subject because Groupon is a small part of a larger piece I’m wrapping up, hopefully, for the next issue of Forbes Magazine.  So let me make a few comments that did not make it to the magazine piece.

The role of the auditor, Ernst & Young, is confusing to experts, let alone the average investor or business reader.  Should the firm have caught Groupon’s errors before or after the IPO? Did Ernst & Young catch Groupon’s errors before the IPO and now?  Did Ernst & Young influence Groupon management’s decision to make the painful acknowledgement that they were caught short in the return reserves department and had to revise revenue and earnings? We’ll never know.

Here’s what Groupon management admitted in the annual report:

“…management concluded as of December 31, 2011 that our disclosure controls and procedures were not effective at the reasonable assurance level due to a material weakness in our internal control over financial reporting, which is described below.

In connection with the preparation of our financial statements for the year ended December 31, 2011, we concluded there is a material weakness in the design and operating effectiveness of our internal control over financial reporting as defined in SEC Regulation S-X. “

Groupon says they are deficient in:

• Controls over monthly financial close process and procedures
• Controls to insure accounts were complete and accurate and agreed to detailed support
• Controls over account reconciliations to identify errors and omissions in journal entries
• Controls over timely, effective review of estimates, assumptions and related reconciliations and analyses, including those related to customer refund reserves

That’s a lot of weakness. I find hard to believe these weaknesses only showed up in the last month or so of the year, after the IPO and multiple S-1 filings. Could Ernst & Young have stopped the IPO? Could the SEC have stopped the IPO?

One proposal that the audit industry regulator, the PCAOB, has on the table that could help in the future – but maybe not for pre-registration filings and auditor opinions – is the Auditor’s Discussion and Analysis. (The italics are my comments back to the PCAOB, the audit industry regulator under the SEC.)

b. In what ways, if any, could the standard auditor’s report or other auditor reporting be improved to provide more relevant and useful information to investors and other users of financial statements? Two places where the current report could be improved are:

1. Development of a clearing house of auditor names attached to public company audit engagements worldwide with their biographies and information about sanctions, suspensions and litigation against them.  I’m not so concerned about seeing a name on a printed report as knowing who is responsible for that audit over time and their qualifications and professional history.

2. The addition of an auditor’s “Disclosure and Analysis” would be priceless. It should be addressed directly to shareholders, not the Audit Committee, and be written in the style of Warren Buffet’s letter to shareholders.  It should state where the auditors and management disagreed and which one prevailed.  It should focus on judgments, estimates, and the range of practices especially regarding interpretation of key accounting standards amongst that issuer’s peer group.

c. Should the Board consider expanding the auditor’s role to provide assurance on matters in addition to the financial statements? If so, in what other areas of financial reporting should auditors provide assurance? Auditors should provide explicit assurance on MD&A. They are already required by standards to communicate with the Audit Committee regarding the adequacy of required disclosures. Interim Auditing Standard AU 380 requires auditors to determine whether all audit-related matters are communicated to the committee.

Potential Alternatives for Changes to the Auditor’s Report

A. Auditor’s Discussion and Analysis

Questions

5. Should the Board consider an AD&A as an alternative for providing additional information in the auditor’s report? Yes

a. If you support an AD&A as an alternative, provide an explanation as to why. See above 1.b.

b. Do you think an AD&A should comment on the audit, the company’s financial statements or both? Both. Provide an explanation as to why. Should the AD&A comment about any other information? The quality of management’s D&A and any disagreements in that regard over sufficiency or quality of disclosures.

c. Which types of information in an AD&A would be most relevant and useful in making investment decisions? I think information about how the issuer compares in key metrics, disclosures, aggressive interpretation of standards, and use of models and estimates to their peers would be very useful.  In some industries, one auditor has an audit relationship with several major companies, addresses similar issues, evaluates similar approaches and either sees consistent or inconsistent results. This type of discussion and comparison would be very useful to identify outliers and anomalies as well as instances of collusion amongst companies with significant business with each other.

Another factor to consider is the auditor’s responsibility right now with regard to disclosure or reporting of fraud and illegal acts – if errors and misstatements rise to that level even pre-IPO.  I’ve written previously that auditors are not very quick to tattle-tale on the executives of the companies they audit.  The audit firms prefer to work it out internally and over time. There’s just too much money at stake both as an auditor and as a consultant. We do not know what Ernst & Young’s fees from Groupon – or Zynga or Facebook – are yet.  The first proxies are not out.  But we do know how much money was at stake with some other clients that have had issues:

• Ernst & Young was paid more than $150 million in fees by Lehman for 2001 to bankruptcy in 2008 according to the New York Attorney General complaint against Ernst & Young for fraud regarding lack of disclosure of Lehman’s issues.
• Google paid Ernst & Young $13 million in 2010 and 2009. Google’s proxy did not explain how Ernst & Young could reduce its fee for audit services to this high-risk company by $1 million in 2010. Google is a serial subject of SEC investigations for its accounting for stock options and taxes. The company recently settled a Department of Justice criminal investigation over the illegal use of its AdWords program by Canadian pharmacies. Ernst & Young did charge Google $500 thousand more in 2010 to address those tax issues.
• UBS, home of a recent rogue trader scandal, paid Ernst & Young $63 million in 2011 for their the audit, $12 million for audit-related activities such as assurance and attest services, control and performance reports, advisory on accounting standards, transaction consulting including due diligence, and tax advisory.  Ernst & Young also earns another $32 million for services performed on behalf of UBS investment funds, many of which have independent fund boards or trustees.
• News Corp, where executives are accused of paying illegal bribes and hiding those payments on the balance sheet, paid Ernst & Young almost $35 million dollars in 2010 and about $31 million in 2009.  The increase equals about 10% more for more tax consulting services, which make up almost half – $16 million – of the total fees paid to EY by News Corp. That, to me, is a serious indictment of EY’s independence as auditor.

Getting back to Groupon and their erroneous earnings release and uncontrolled S-1s…

According to a recently published academic paper entitled, Pro forma disclosures, audit fees, and auditor resignations:

Pro forma disclosures are non-GAAP disclosures; however, under the provisions of SAS 8, auditors are still responsible for ensuring that no overtly misleading voluntary disclosures are released to investors. That is, auditors are required to review voluntary disclosures and prevent any misleading or overtly optimistic information from being released. In addition, auditors are potentially responsible for ensuring consistency of pro forma reporting in voluntary disclosures, such as press releases, with any pro forma numbers included in mandated disclosures, such as SEC 10-K or 10-Q reports (PwC Dataline 2010-03).

I know I expect the auditors to be earning their fees by looking out for investors. But maybe that’s just pie in the sky.

The video is Glen Hansard and Marketa Irglova singing “You must have fallen from the sky” from The Swell Season.

Original main page art from this site.

sciss

My column today at American Banker is about the PCAOB’s auditor rotation and auditor independence concept release and its impact on banks.  My favorite lines that made it in are probably these:

Audit firm CEOs say mandatory rotation would distract them from audit quality assurance and force the partners to focus on responding to constant requests for proposals and marketing activities. The auditor firms would rather collect oligopolistic fees from a government-mandated franchise without having to compete or justify those fees.

I have opposed mandatory auditor rotation proposals, here and in the UK, for a reason that goes deeper than whether it’s the right thing in an ideal world. It is. But we are not living in an ideal world. I wrote a more lengthy post on the subject in Forbes last August when the subject first came up again. Earlier last summer, in July, I wrote here about audit reform proposals, in general, and I was quoted in the FT’s Agenda on the subject.

Auditor rotation is a suggestion that comes up over and over with no resolution.The Financial Times’ Agenda (subscription only) explored the pros and cons of the issue. I was quoted and so were a few other notables such as Denny Beresford, who currently chairs the Audit Committees at Fannie Mae and Legg Mason.

I get the last word with this quote:

But even Francine McKenna, an outspoken critic of the industry, does not advocate mandatory term limits. “In a perfect world, if we had enough firms and if we had enough capacity and ability to go around, then it would be a wonderful idea,” she says. “But I think, practically speaking, it would make things worse. Trading one potentially corruptible firm for another potentially corruptible firm doesn’t really help.”

Instead, McKenna advocates radically changing the industry structure. “My personal feeling is we’re not going to get a good audit until we take it out of the companies’ hands and put it into the hands of an agency that controls the fees and controls who does the work,” she says. “You can’t have companies paying for audit firms directly.”

Here are some additional anecdotes that did not make it to the American Banker column due to space:

This past Thursday, New York federal judge Lewis Kaplan sent the New York Attorney General’s case against Ernst & Young back to state court where it was originally filed. New York prosecutors claim Ernst & Young violated the Martin Act, an ancient state law used effective by former New York attorney general and governor Eliot Spitzer to prosecute securities fraud. The Attorney General seeks return of the $150 million in fees that Ernst & Young earned as Lehman’s auditor from 2001 until its bankruptcy filing in 2008.

GE has used KPMG as their auditor since 1909. That longstanding relationship meant no one blinked when KPMG started providing prohibited non-audit services to GE’s tax department. After I wrote about this lapse, the engagement ended. Fannie Mae fired auditor KPMG in 2006, then sued the firm after a $9 billion financial statement fraud. KPMG was Fannie Mae’s auditor for 36 years.

PwC is still the auditor of AIG, the insurance company that was taken over by the US government after AIGs dispute with another PwC auditee, Goldman Sachs, boiled over. AIG shareholders have sued PwC more than once over the years including most recently for its role in AIG’s issues during the financial crisis. PwC paid $97.5 million for a case related to AIG’s 2005 era accounting problems. PwC’s relationship with AIG started more than thirty years ago. PwC has been Goldman Sachs’ auditor since at least 1996, three years before its IPO in 1999. PwC’s former CEO, Jim Schiro, chairs Goldman Sachs’ audit committee.

Tim Carmody, a staff writer at Wired, called and asked for my thoughts on the Facebook S-1, their IPO filing with the SEC dated February 1, 2012.

Carmody, I think, expected me to have some criticisms about Facebook’s accounting. After all…

so much depends

upon

being more

open

connected with

the world

don’t be chicken

livered.

Most initial news accounts of the Facebook S-1 focused on CEO Mark Zuckerberg’s Stalinist-like stranglehold on the stock, the strategy, and the board. Carmody waited a few weeks to file his story, after recording an hour of our conversation on the phone a few Saturday afternoons ago, and got lucky. Apple announced some significant to changes in their corporate governance that contrast sharply with Facebook and Zukerberg’s one-man band approach.

Apple has bowed to investor demands to give shareholders greater influence over the election of directors, a move that will make it far harder for other leading US companies to ignore calls to improve corporate governance standards.

The technology group had disregarded a shareholder vote at last year’s annual meeting calling for the change, but faced renewed pressure from Calpers, the largest US public pension fund, to introduce majority voting for seats in the boardroom at its Thursday meeting…Calpers’ push for change at one of the fastest growing and most popular US companies had become the centrepiece of a campaign for boardroom accountability. Its victory reflects a growing investor consensus in favour of the corporate governance agenda.

Facebook, on the other hand, is a “controlled company.”

Carmody explains:

Between his own stock holdings and agreements with early investors including DST Global Ltd and Accel Partners, CEO/founder Mark Zuckerberg controls a majority interest in the company. This gives him total control over approving the board of directors as well as any acquisition or mergers. He also has the ability to appoint his own successor, even after his death.

Because of Zuckerberg’s control, Facebook qualifies as a “controlled company,” meaning that it is not required to have a majority of independent directors or a separate nominating committee. Zuckerberg effectively has the ability to select anyone he chooses inside or outside Facebook to serve on the board, and then use his controlling interest to approve his own choices.

Facebook has two-tiered stock; private Class B shareholders hold ten times the voting power per share accorded to publicly-traded Class A stock. If Class B shareholders ever lose a controlling interest in the company, the governance structure shifts again; only the board of directors will be able to fill vacancies within its own body, director elections will become staggered (making it even more difficult to vote in an all-new-board), and it will take a supermajority vote to change the company’s by-laws.

Anyone who invests in Facebook under these terms is basically putting their money into a blind trust. They have no say over strategy, over the board – not that shareholders have much influence over the Board of Directors anyway but we can pretend – and there is no dividend. One can only hope for capital appreciation. Like Berkshire Hathaway. Except unlike Warren Buffett, Mark Zuckerberg is probably not kicking the bucket any time soon.

It doesn’t make a hill of beans what the accounting looks like. Investors in the social media/social gaming IPOs are looking for the “pop”, the short term price rise, or medium terms share price appreciation that makes them all smug and satisfied about getting in on a good thing. And in the long term we’re all dead.

What’s really changed from more than a year ago when the private placement by Goldman Sachs fell apart other than we now know Ernst & Young has been with them for a while as auditor and IPO guide? Not much.

So let’s summarize Facebook’s strategy of being a private public company from the perspective of the investor:

• Facebook limits access to their financial information.

• Goldman will manage the SPV used to market “shares” of Facebook to outside investors. Goldman has access to Facebook’s books but your access is through Goldman.

• Facebook likes to say they have $2 billion in revenues but who is testing the quality and veracity of those revenues?  Advertising revenue is one thing – although notoriously easily manipulated from an accounting perspective as we saw in the Time-Warner case.  But “transaction revenue” from equally opaque companies such as Zynga is like cotton candy – potentially all fluff.

• Facebook’s CEO wants absolute control of the company so he can “realize his vision.”

• Facebook thinks regulatory control over the securities markets, accounting requirements that protect investors, and legal compliance with these laws and regulations is a “distraction.”

• Facebook’s CFO is not an accountant, not a CPA and has no public accounting experience. What’s wrong with that? It may be barely tolerable when a company is in startup mode, but this is a big global company that has to be run, run well, and run according to GAAP.

• Facebook has no requirement to have independent directors on its board who protect the interests and rights of this growing class of outside investors.  Oh, wait… Goldman Sachs can look out for them.

• Facebook has no requirement to be audited as long as it’s a private public company. It’s notoriously difficult for outsiders to find out who their service providers are – the audit firm or consultant that’s currently reviewing financial and IT controls over the production of financial reporting for investors. Given the amount of outside investment, I’m sure one of the largest global audit firms is advising them. But their reports, and any concerns they may have about controls or corporate governance, are not public nor do they go to the SEC. Facebook is not subject to Sarbanes-Oxley including whistleblower and CEO/CFO certification requirements. Given estimates of Facebook’s “valuation” and expected market capitalization post-IPO, isn’t it a good idea to make sure they’re ready for prime-time?

In the S-1, Zuckerberg describes the “unique culture and management approach” of Facebook as “The Hacker Way.”

I don’t know about you, but I’m skeptical of this approach as it applies to finance, accounting, corporate governance, and internal controls.

But that’s not what this company or its board is focused on.

Carmody quotes me:

“Their audit committee chairman, Erskine Bowles, is a politician,” McKenna added. “That tells you a lot about how they plan to resolve any differences in opinion” with the SEC, IRS or other investigative bodies.

Many others were critical of the board composition. There are no women and, gee, think about all those women playing Farmville and Mafia Wars and sharing recipes, photos of their kids and complaints about their husbands, and passing along news from their high school reunions.

Carmody quotes me again:

“Notice I didn’t say anything about how there are no women on the board,” McKenna told Wired. “I’d much rather have another guy with real financial knowledge than a token woman.”

There’s more, including my comments about Facebook’s auditor Ernst & Young. Please read the rest of Tim’s excellent piece at Wired, “Apple Gives Shareholders More Input; Will Facebook Get the Message?”

Photo Source

The Private Securities Litigation Reform Act of 1995 (Public Law 104- 67) added Section 10A to the Securities Exchange Act of 1934 (15 U. S. C. 78j- 1). Section 10A reporting requirements first became effective for fiscal years beginning on or after January 1, 1996.

The GAO[1] prepared a report in February 2000[2] and again in September 2003 at the request of Congress, regarding the audit industry’s compliance with Section 10A. The GAO also reported the statistics for SEC enforcement actions under Section 10A.

The February 2000 report stated that six Section 10A reports had been submitted by audit firms through December 14, 1999. Records from the SEC’s Office of the Chief Accountant show that during the period December 15, 1999 through May 15, 2003 – four years of turmoil in the markets and in the accounting industry – an additional 23 Section 10A reports were submitted.

From the inception of the 10A reporting requirement in 1996 through May 15, 2003, a total of 29 Section 10A reports were submitted to the SEC. The reports cover a variety of potential illegal acts, including improper revenue recognition, unusual capital transactions relating to stock warrants, inadequate financial statement disclosures, and failure to disclose expenses relating to stock options.

In the 2003 report, the AICPA attributed the low level of 10A reporting to the reasons they cited as stated in the 2000 GAO report: In most cases, management or the board of directors, often with the participation of internal or external counsel, took timely and appropriate action to address a situation involving an illegal act when it was brought to their attention by auditors.

According to SEC officials in 2003, all Section 10A reports from 1996 to 2003 were investigated. Of the 29 SEC registrants named in the reports as of 2003, 10 were the subject of active SEC enforcement investigations, 8 had actions brought against them by the SEC, and 11 reports were closed without formal action being taken by the SEC.

Injunctive actions and administrative proceedings were filed in 8 cases alleging violations such as (1) failure to disclose transactions in public statements to shareholders and the SEC, (2) inclusion of fraudulently- valued assets on financial statements filed with the SEC, (3) underreporting the value of inventory resulting in an understatement of expenses and liabilities and an overstatement of income, and (4) improper revenue recognition and understatement of expenses.

A violation reported under Section 10A may be closed without formal action being taken by the SEC because the registrant is no longer publicly traded, has a very small dollar amount of assets, or is no longer doing business. In certain instances, after discussions with the SEC, the registrants took remedial action, which the SEC found satisfactory, such as obtaining a review of the registrant’s quarterly financial statements filed with the SEC.

In 2002, the American Institute of Certified Public Accountants (AICPA) issued a new audit standard for detecting fraud, Statement on Auditing Standards (SAS) 99: Consideration of Fraud in a Financial Statement Audit. The AICPA believed SAS 99 would substantially change auditor performance, thereby improving the likelihood that auditors will detect material misstatements in financial statements due to fraud by placing an increased focus on exercising professional skepticism throughout the audit. The new standard required auditors to identify and consider risks of material misstatement due to fraud when planning and performing the audit through brainstorming among audit team members, inquiring of management, performing analytical procedures, considering inappropriate reporting of revenue and management override of internal controls, evaluating internal controls that address the identified risks of fraud, and assessing throughout the audit and at the completion of the audit the risk of fraud based on the results of auditing procedures.

The new standard also required auditors to communicate about fraud to management, the audit committee, and others, and to document the auditors’ consideration of fraud. SAS 99 was adopted and effective for audits of financial statements for periods beginning on or after December 15, 2002. The PCAOB, the regulator for the auditing industry established by the Sarbanes-Oxley Act in 2002, updated the standard the first time with Auditing Standard No. 5, adopted in 2007. The PCAOB revised the standard further in December 2010 as AU Section 316: Consideration of Fraud in a Financial Statement Audit.[3]

The Sarbanes-Oxley Act of 2002 also contains a number of provisions aimed at improving the quality of audits of public companies including more audit committee involvement with the auditor, a requirement for auditors to attest to management’s assessment of internal controls over financial reporting, a requirement for audit partner rotation, prohibition of certain non-audit services to audit clients, prohibition of providing audit services to a company that employs as a top official a previous member of the audit engagement team, and greater penalties for failure to report fraud.

Rule 240 10A-1 states that auditor reports under Section 10A must be submitted to the SEC’s Office of the Chief Accountant. The report must be in writing and identify the registrant and the auditor and the date that the registrant received the Section 10A report from the auditor. In addition, the report must include either a copy of the auditor’s report or a summary of the report including a description of the act that the auditor has identified as a likely illegal act and the possible effect of that act on the financial statements. The rule is based on the premise that the reports under Section 10A are supposed to assist the SEC in performing its enforcement responsibilities and therefore, the auditors’  reports are nonpublic.

After receiving and logging the Section 10A reports, the Office of the Chief Accountant forwards the reports to the Division of Enforcement, which conducts investigations into possible violations of federal securities laws and prosecutes the SEC’s cases. The reports are also forwarded to other divisions within the SEC, including the Division of Corporation Finance, which reviews the financial statements and other financial reports filed by SEC registrant companies. The Office of the Chief Accountant and the Division of Enforcement monitor the progress on any investigation initiated or facilitated by a Section 10A report.

Auditors are still getting used to an external regulatory regime under the PCAOB since 2002 versus the self-regulatory regime they operated under with the AICPA, their trade organization, as the rulemaker and enforcer. Frauds did not end after the Sarbanes-Oxley Law was enacted. It’s now apparent that fraud drove many of the financial crisis failures. The subprime crisis turned into a credit crisis then a full blown financial crisis. Major industrial and financial services companies in the United States and abroad were bailed out, forcibly acquired, and effectively nationalized in order to survive.

During that time, no warning bells for shareholders and society as a whole, in the form of “going concern” opinions, were sounded. As financial crisis litigation has increased, we are now seeing, almost four years later, the extent to which accounting fraud, disclosure fraud, and accounting manipulation played a role in these failures. We have also seen a record number of enforcement actions for illegal acts by corporations and individuals under the Foreign Corrupt Practices Act.

Section 10A is not mentioned very often in enforcement actions against auditors. Frankly, there are few enforcement actions against auditors at all compared to the number of enforcement actions against client company executives. But 10A has been mentioned recently on two specific occasions.

“The reliability of global capital markets depends on auditors fulfilling their obligation to investors to perform robust audits, resulting in well-founded audit reports. Two of the PW India firms, PW Bangalore and Lovelock, repeatedly violated PCAOB rules and standards in conducting the Satyam audits. These confirmation deficiencies contributed directly to the auditors’ failure to uncover the Satyam fraud.”

James R. Doty, PCAOB Chairman

On April 5, 2011, the Securities and Exchange Commission (SEC) and the Public Company Accounting Oversight Board (PCAOB) announced settled disciplinary orders against five firms, members of the PricewaterhouseCoopers LLP (PwC) global network, for violations of PCAOB rules and standards and for violations of federal securities laws as well as improper professional conduct by PW India while PW Bangalore served as auditor of record for Satyam.

In addition, the SEC also sanctioned the PW India firms for, “violation of Section 10A(a) of the Exchange Act by failing to conduct procedures designed to provide reasonable assurance of detecting illegal acts that would have a direct and material effect on the determination of financial statement amounts.”

Technically, this was not an enforcement action for, “failing to report likely illegal acts that have a material impact on a company’s financial statements,” but instead for failing to perform the audit in such a way that those illegal acts have a high likelihood to be detected. The SEC, and the PCAOB which filed a simultaneous enforcement action, chose to believe that PW India was ignorant of the illegal acts. The jury is still out, literally, in India, on whether the Price Waterhouse India auditors were aware of the illegal act, complicit in the fraud with executives, and did not report them or were simply incompetent as the SEC would lead us to believe.

On October 3, 2011, the PCAOB issued Staff Audit Practice Alert No. 8, Audit Risks In Certain Emerging Markets.

In the Alert, the PCAOB warned that although authorities in many emerging market countries were taking steps to improve investor protection, the PCAOB, “has observed from its oversight activities some conditions in audits of certain companies in emerging markets that indicate heightened fraud risk. Other situations have come to light in recent corporate filings with the Securities and Exchange Commission (“SEC”) and in SEC orders suspending trading in securities of certain companies in emerging markets.”

In just two months in 2011, more than 24 companies with their principal place of business in the People’s Republic of China (“PRC”) filed Forms 8-K with the SEC reporting auditor resignations, accounting irregularities, or both.[4] “In some instances, the auditor’s letter of resignation stated that the auditor resigned because of circumstances that could constitute illegal acts for purposes of Section 10A of the Securities Exchange Act of 1934 (“Exchange Act”).” [5]

The SEC took action, including instituting stop order proceedings against two PRC-based companies.[6] Additional auditor resignations, recorded on Form 8-K, have occurred.[7]

• How many of the auditors associated with the 24 companies with their principal place of business in the People’s Republic of China that filed 8-Ks also filed 10A reports? Did the auditors who mentioned, “circumstances that could constitute illegal acts for purposes of Section 10A of the Securities Exchange Act of 1934,” file 10A reports with the SEC?
• Did the auditors of the two PRC-based companies where the SEC issued stop order proceedings perform their duties under Section 10A or did they fail to conduct procedures designed to provide reasonable assurance of detecting illegal acts that would have a direct and material effect on the determination of financial statement amounts?
• Will we see any SEC enforcement actions against these auditors for failing to detect these illegal or fraudulent acts via proper audits and failure to report the illegal acts to the SEC?
• Did the auditors do their job in China?

Investors count on the auditors as the last defender of shareholder interests before regulators and the lawyers get involved. I wanted to see if the auditors had at least warned the SEC of potential frauds and illegal acts, in particular during the period leading up to the 2008 financial crisis bailouts.

I checked with the GAO in June of 2011 to see if anyone in Congress had asked for an update since 2003 on Section 10A reporting by auditors. Chuck Young, Managing Director of Public Affairs said, “No, we have not done any review since the one in 2003.”

So I prepared a Freedom of Information Act (FOIA) request in June and then again in October for the same information Congress and the GAO had previously requested from the SEC. The first request I made covered the entire period since the last report to Congress, 2003, until the present. It also referred to a tracking system that the 2003 report said would be implemented to help track these submissions by auditors and the SEC’s actions on them.

5) It was reported to the GAO in May 2003 that the Division of Enforcement was developing a computer tracking system for referrals of Section 10A reports, as well as complaints concerning possible financial reporting violations. Please attach any status reports that document the development progress and eventual implementation of this “computer tracking system”.

Unfortunately, the helpful response from the SEC to my initial request was that a request for data for the period May 16, 2003 through May 31, 2011 was too extensive, especially because the above referenced “computer tracking system” had not yet been implemented.

So I revised my request to cover just the years since January 1, 2007 as a start. The idea was to replicate the statistics the GAO had prepared, at least. If I could also see the underlying reports and data, all the better.

In December the SEC responded to my request, but refused to provide information about three of the four inquiries. They cited confidential treatment of investigatory materials or they told me to do my own investigating. I will appeal. I can also appeal to the House Financial Services Committee’s Subcommittee on Oversight and Investigations. Maybe the Congressmen will make a new request to the GAO to update this important oversight report since it’s not been done during the post-Sarbanes-Oxley era and now post-financial crisis period.

It’s quite surprising that the one substantive response from the SEC I did get was to my FOIA inquiry regarding the number and case numbers of SEC actions filed, by year, between January 1, 2007 and September 30, 2011 against auditors for alleged violations of Section 10A for failing to report likely illegal acts materially impacting on a company’s financial statements.

The SEC replied that, “ a search was conducted of the Commission’s various systems of records, but did not locate or identify any information responsive to your request.”

There are still many unanswered questions about how and why the financial crisis frauds occurred. New frauds, such as the Chinese reverse merger frauds, took advantage of a public listing loophole that the SEC and auditors missed. All these investor losses occurred under the supposedly watchful eyes of auditors, who are paid dearly to protect shareholders but in many cases are either complicit, incompetent, or both.

Dear SEC, Please send me the following records:

SEC Response:

As was mentioned in our letter of October 25, 2011, the FOIA was not intended to compel agencies to become ad hoc investigators for requestors whose requests are not compatible with their own information retrieval systems.[8] Nor does the FOIA require agencies to conduct legal research and answer questions disguised as FOIA requests.[9] Consequently, we have processed the portions of your request where responsive records exist; however, we did not process the portions wherein questions are posed.

(1)  Please provide the number of Section 10A submissions, by year, from January 1, 2007 through September 30, 2011 and a copy of each report filed that identifies the registrant and the auditor and the date that the registrant received the Section 10A report from the auditor. The filing should include either a copy of the auditor’s report or a summary of the report including a description of the act that the auditor has identified as a likely illegal act and the possible effect of that act on the financial statements.

(2)  Please provide the status of the SEC actions on those 10A reports that were filed, by year, between January 1, 2007 and September 30, 2011.

SEC Response: After consulting with Commission staff, we have determined the following: With respect to items 1 and 2 of your request, responsive records are withheld in their entirety under FOIA Exemptions: 5 U.S.C. § 552 (b) (3) and 7(A), 17 CFR § 200.80 (b) (3) and (7) (i).

The internal records which consist of material pertaining to Rule 240 10A-1 are protected form disclosure under FOIA Exemption 3. Exemption 3 permits the withholding of documents specifically exempted from disclosure by another Federal statute. Section 240.10A-1 states in part, that records submitted under this section, “shall be deemed to be an investigative record and shall be non-public and exempt for disclosure pursuant to the Freedom of Information Act to the same extent an for the same periods of time that the Commission’s investigative records are non-public and exempt for disclosure under among other applicable provisions, 5 U.S.C. 552 (b) (7) and 17 CFR 200.80 (b) (7).” See, 17 CFR § 240.10A-1.

In addition, with respect to on-going enforcement activities pertaining to any f the 10A submissions, the records are protected form release under Exemption 7(A), which protects form disclosure records compiled for law enforcement purposes, the release of which could reasonably be expected to interfere with enforcement activities.

(3)  Please provide the number and case numbers of SEC actions filed, by year, between January 1, 2007 and September 30, 2011 against auditors for alleged violations of Section 10A for failing to report likely illegal acts materially impacting on a company’s financial statements.

SEC Response: With respect to Item 3 of your request, based on the information you provided in your letter, a search was conducted of the Commission’s various systems of records, but did not locate or identify any information responsive to your request.

(4)  Please provide the number of 8-Ks filed for auditor changes each year 2007-2010 and the number of requests for additional information from the registrants as needed to clarify matters reported on 8-Ks for auditor changes.

During this period, did the Division of Corporation Finance identify any significant potential violations of SEC laws and regulations as a result of auditor changes, or forward any matters to the Division of Enforcement for further investigation? How many were identified or forwarded, by year January 1, 2007 to September 30, 2011?  Please include status reports of these investigations, if any.

SEC Response: Finally, with respect to Item 4 of your request, a significant portion of the information sought is publicly available on our website at www.sec.gov under the section “Filings and Forms.” Specifically, anyone can search the EDGAR database for Form 8-Ks filed during any year, and for staff comment letters and response letters for any filings filed during 2007-2010. The Commission does not maintain a retrieval system designed for culling data based on the information cited in your request.

[2] U.S. General Accounting Office, Securities Exchange Act: Review of Reporting Under Section 10A, GAO/AIMD-00-54R (Washington, D.C.: Feb. 4, 2000).

[3] The PCAOB was established pursuant to the Sarbanes-Oxley Act of 2002 (Act) to oversee the audits of public companies that are subject to the U.S. Federal securities laws. As provided for by the Act, the PCAOB will set professional standards (including auditing, attestation, quality control, ethics, and independence standards) to be used by public accounting firms registered with the PCAOB in the preparation and issuance of audit reports of public companies.

[4] See letter from SEC Chairman Mary Schapiro, dated April 27, 2011, to the Chairman of the House Subcommittee on TARP, Financial Services, and Bailouts of Public and Private Programs, Congressman Patrick McHenry, at http://s.wsj.net/public/resources/documents/BARRONS-SEC-050411.pdf.

[5] See the discussion in the section in the PCAOB Alert on illegal acts.

[6] See SEC Press Release, Stop Order Proceedings Instituted Against China Intelligent Lightning and Electronics, Inc., and China Century Dragon Media, Inc. (June 13, 2011) at: http://www.sec.gov/news/press/2011/2011-127.htm

[7] See, e.g., Longtop Financial Technologies Limited, Form 6-K (May 23, 2011), Exhibit 2 at: http://www.sec.gov/Archives/edgar/data/1412494/000095012311052882/d82501 exv99w2.htm.

[8] Blakey v. DOJ, 549 F. Supp. 362, 366-367 (D.D.C. 1982).

[9] Satterlee v. IRS, No. 05-3181, 2006 WL 3160963, at *3 (W.D. Mo. Oct. 30, 2006).

Main page photo source: Adventures of a Ghanian