You may remember earlier this year when The New York Times broke a little story about General Electric’s tax savvyways and the best tax law firm the universe had ever seen (aka the GE tax department).

The report caused more than a few people to get bent out of shape because the Times said GE was enjoying $14.2 billion in profit while “claim[ing] a tax benefit of $3.2 billion.” What that “benefit” really entailed was a mystery but many people jumped to the conclusion that it was a “refund” andProPublica (possibly a little peeved that they got scooped) tried to set the record straight on the Times story.

Despite all the back and forth, everyone was pissed at GE. The company lost aTwitter joust with Henry Blodget and then a bogus press release went out claiming the company was returning the “refund” of $3.2 billion and the Associated Press ran it. Slightly awkward.

Francine McKenna also did a write-up on KPMG’s role in this little soap opera, as the firm has been the auditor for GE since Bill Taft was maxing out the White House bathtub.

The latest twist comes from a tip we received earlier about a “Preservation Notice” sent to all KPMG employees yesterday from the firm’s Office of General Counsel (“OGC”).

URGENT TARGETED PRESERVATION NOTICE: GENERAL ELECTRIC’S LOAN STAFF ARRANGEMENTS

Please be advised that until further notice from KPMG LLP’s (KPMG or firm) Office of General Counsel (OGC), you are hereby directed to take all steps necessary to preserve and protect any and all documents created or received from January 1, 2008 through the date of this Notice relating or referring to the loaning, assignment or secondment of tax or other professionals to General Electric Company and its direct and indirect subsidiaries, affiliates and divisions (collectively “General Electric’s Loan Staff Arrangements”).

Last March, I wrote the story that highlighted this arrangement. The preservation notice refers to tax and “other loaned staff arrangements” so there may be more like this at GE.

Uh oh.

Based on my reading of the rules, loaning, assigning, or seconding tax or any “bookkeeping” staff is not allowed for the auditor. What’s worse is that KPMG had been sanctioned recently for a similar issue in Australia. I guess they thought the SEC/PCAOB would never go after them in the U.S. and never for trying to “please” such a high-profile client.

The Sarbanes-Oxley Act of 2002 started out tough on tax. The rules regarding prohibited activities by the auditor, intended to preserve their independence, scared the living daylights out of the largest firms. It appeared initially that the SEC would prohibit the tax side of the firms from providing highly lucrative tax advice to their audit clients. Many of those professionals started planning an exit from their firms so they could continue working with long time clients.

A compromise was reached. The result is one of the loosest and most generous exceptions to auditor independence rules on the books.

The Commission reiterates its long-standing position that an accounting firm can provide tax services to its audit clients without impairing the firm’s independence. Accordingly, accountants may continue to provide tax services such as tax compliance, tax planning, and tax advice to audit clients, subject to the normal audit committee pre-approval requirements under 2-01(c)(7).

The Sarbanes-Oxley Act of 2002 also prohibits an auditor from providing “bookkeeping” services to its audit clients.

The rules utilize the previous definition of bookkeeping or other services, which focuses on the provision of services involving: (1) maintaining or preparing the audit client’s accounting records, (2) preparing financial statements that are filed with the Commission or the information that forms the basis of financial statements filed with the Commission, or (3) preparing or originating source data underlying the audit client’s financial statements. Our experience with this definition demonstrates that the concept of bookkeeping and other services is well understood in practice.

In defiance of these provisions, KPMG – GE’s auditor – provides “loaned staff” or staff augmentation to GE’s tax department each year. These “temps” perform tasks that would be otherwise the responsibility of GE staff. Sources tell me KPMG employees working in GE tax have GE email addresses, are supervised by GE managers – there is no KPMG manager or partner on premises – and have access to GE employee facilities. They use GE computers because the software required for their tasks is GE proprietary software.

This type of “secondment” to an audit client is never allowed. KPMG should know better. KPMG was recently sanctioned by the SEC for a similar transgression involving their Australian office.

KPMG Australia and at least one other KPMG member firm outside Australia seconded non-tax professional staff to work at each client’s premises, under the supervision and direction of each client, doing the same types of work that each client’s own employees or managers ordinarily would perform, in violation of the prohibition under Rule 201(c)(4)(vi) against “[a]cting, temporarily or permanently, as a director, officer, or employee of an audit client, or performing any decision-making, supervisory, or ongoing monitoring function for the audit client.”

KPMG earns approximately 10% of their total fee from GE for tax services not connected to the audit directly or indirectly. GE’s policies state that these engagements, if for more than $1 million dollars, must be pre-approved by the GE Audit Committee. However, these services should never have been provided at all per SEC independence rules -rules that pre-date Sarbanes-Oxley.

KPMG is well known for supporting, as an auditor, aggressive tax strategies.  Recent controversy over long-time audit client Citigroup’s use of deferred tax assets to pump up its profits is one example.  KPMG also once flew too close to the flame as a tax shelter provider. Its advice to private clients on how to pay less to the IRS almost got the firm taken out of the game completely.

So why, for a measly $8-10 million a year, is KPMG playing with fire in providing these low value, low margin, low status services to GE?  It may be that KPMG wants to hold on to the relationship at any cost.

Read the rest of my original story at Forbes.

Read the rest of the Going Concern story here.

Thank goodness for the plaintiffs’ bar and class action lawsuits.

And state attorneys general.

Without them, there’d be very little justice yet – or compensation – for any of the mortgage-related fraud perpetrated during the recent real estate bubble.

Chad Johnson, a partner in the litigation practice at Bernstein Litowitz Berger & Grossmann LLP, posted in the Harvard Law School Corporate Governance and Financial Regulation Forum (on behalf of colleague Ross Shikowitz who wrote the article) that private litigants, in spite of some significant impediments, are picking up the slack for the SEC and Department of Justice.

Now, more than ever, private lawsuits are needed to supplement the existing regulatory structure, both to ensure that shareholders are adequately compensated for their losses and to send a strong message that fraudulent conduct will not be tolerated. Indeed, institutional investors continue to vigorously prosecute suits against the companies and executives at the heart of the mortgage crisis, well after the SEC and DOJ have shuttered their civil and criminal investigations.

While it remains to be seen whether government regulators will eventually force Wall Street executives to answer for their improprieties, it is clear that sophisticated public pension funds will continue to play an essential role in obtaining compensation for injured investors and deterring future wrongdoing by corporate executives.

Even when institutional investors like pension funds try to work within the system, using their significant, long-term shareholder standing to exert influence on corporate boards, they have been turned back. The banks and financial institutions won’t own up to their mistakes and their executives to their culpability willingly.

Eliot Spitzer explains the phenomenon in his recent broadside, “Government’s Place In The Market,” published by Boston Review Books and MIT Press.

“Only government can ensure integrity, transparency, and fair dealing…even though private companies compete, only government can ensure that there is competition. Everyone wants to be a monopolist.”

In January, my column, Accounting Watchdog, described the potential impact on bank stocks of a letter sent to Bank of America, Citigroup, JP Morgan Chase, and Wells Fargo by New York City Comptroller John Liu. This letter, sent on behalf of a coalition of seven major public pension systems, called on the banks’ Audit Committees to launch independent examinations of their loan modification, foreclosure, and securitization policies and procedures.

Liu had proposed these reviews, initially on behalf of the New York City pension plans, back in November. The banks were cold to these proposals, as well as the one in January by the larger coalition. The pension funds called for immediate action.

Time passed with no willingness by the banks’ boards, in particular their Audit Committees, to conduct independent reviews in the normal course of business. So, the coalition submitted shareholder proposals for the banks’ annual meetings. Throughout this period, the boards of the four banks were generally unresponsive to the coalition’s requests to discuss and meet on the proposals. Audit Committee members would not meet with them at all.

It’s a sign of the banks’ unwillingness to own up to the problems we know so much more about now that the only way for these institutional, long-term investors to be heard was to submit an advisory-only  shareholder proposal viewed as antagonistic by the banks’ boards.

“The banks and financial institutions won’t own up to their mistakes and their executives to their culpability willingly.” Chad Johnson

I said at the time that the letter didn’t go far enough. The reviews should also have demanded an accounting of the reserves for loan losses and for litigation. These numbers have been slow to come and, when they did, hard to decipher.

Gretchen Morgenson in the New York Times on January 8: While it is unfortunate that the Bank of America deal won’t recoup much for taxpayers, the resolution could have one important benefit. It might just open the door to a much-needed reckoning of the liabilities created by questionable mortgage practices at the nation’s largest banks. These institutions have not yet made a full and realistic accounting of their liabilities.

I agree.

On September 30, 2010, before the SEC issued its letter to bank CFOs reminding them to follow the standards and book adequate reserves, I wrote that Bank of America had admitted it had “repurchased, during 2009, $13.1 billion of loans from first lien securitization trusts as a result of modifications, loan delinquencies or optional clean-up calls.”

I couldn’t easily see what the actual reserves were for estimated future liabilities and how they came up with a number given the total loans sold by type and the current claims by various parties. I said it’s time for someone, perhaps the SEC, to demand more detailed disclosure about reserves for repurchase risk.

When I challenged the SEC to push harder on the reserves issue they stepped up. But disclosures are still not complete.

Here’s an excerpt from the New York City Comptroller’s shareholder proposal that did appear in the Bank of America proxy document dated March 30, 2011:

…Resolved, shareholders request that the Board have its Audit Committee conduct an independent review of the Company’s internal controls related to loan modifications, foreclosures and securitizations, and report to shareholders, at reasonable cost and omitting proprietary information, its findings and recommendations by September 30, 2011.

The report should evaluate (a) the Company’s compliance with (i) applicable laws and regulations and (ii) its own policies and procedures; (b) whether management has allocated a sufficient number of trained staff; and (c) policies and procedures to address potential financial incentives to foreclose when other options may be more consistent with the Company’s long-term interests.

Board’s Response to Proposal 7

The Board recommends a vote AGAINST Proposal 7 for the following reasons:

• our company has already taken significant steps to ensure that appropriate internal controls are in place, including additional controls and processes we have implemented following a comprehensive self-assessment of our foreclosure processes, as well as an environment of heightened regulatory scrutiny by state and federal authorities, including certain bank supervisory authorities ;

• we actively manage the loan modification and foreclosure processes to ensure that we have strong internal controls over our mortgage service operations;

• we have been a leader in providing foreclosure alternatives, assisting homeowners and constituent groups to resolve home loan issues through loan modifications or other solutions where possible; and

• our company has already provided extensive public disclosure regarding the requested information, which makes the report sought by the proposal unnecessary.

In each case where the Comptroller’s shareholder proposal made it to an April Annual Meeting agenda, management recommended a “no” vote for the proposal.

The proposals all failed to gain a majority vote.

At Bank of America, the shareholder proposal gained a strong 40% “yes” vote. At Citigroup, the “yes” vote was just shy of 30% and at Wells Fargo a little less than 23%. At JP Morgan Chase the coalition’s proposal did not make the Annual Meeting Agenda because a similar proposal, according to the JPM Chase Board, was in line ahead of theirs.

Michael Garland, Executive Director for Corporate Governance for the New York City Comptroller, told me that his office will continue to press for the independent reviews. These reviews, the Comptroller insists, should not be performed by the banks’ auditors since, “we do not consider the existing audit firm to be independent since they previously signed off on the internal controls.”

New York City Comptroller John Liu: “ Our pension funds are long-term investors. We’re going to be around a lot longer than any of the management or the board members of these banks. As shareholders we will continue to insist bank boards clean house until we see independent audits of their mortgage and foreclosure practices.”

Other interested parties have been pressing since the spring of 2011 for reviews of, and changes and improvements to, the banks’ policies, procedures, and processes around loan modifications, foreclosures, and securitizations. There have also been several calls for more transparency, and honesty, in the banks’ allocations of reserves for loan losses and litigation.

On May 12, FDIC Chairman Sheila Bair testified before the Committee on Banking, Housing, and Urban Affairs of U.S. Senate:

Serious weaknesses identified with mortgage servicing and foreclosure documentation have introduced further uncertainty into an already fragile market.The FDIC is especially concerned about a number of related problems with servicing and foreclosure documentation. “Robo-signing” is the use of highly-automated processes by some large servicers to generate affidavits in the foreclosure process without the affiant having thoroughly reviewed facts contained in the affidavit or having the affiant’s signature witnessed in accordance with state laws.

The other problem involves some servicers’ inability to establish their legal standing to foreclose, since under current industry practices, they may not be in possession of the necessary documentation required under State law. These are not really separate issues; they are simply the most visible of a host of related problems that we continue to see, and that have been discussed in testimony to this Committee over the past several years…

Our examiners participated with other regulators in horizontal reviews of these servicers, as well as two companies that facilitate the loan securitization process. In these reviews, federal regulators cited “pervasive” misconduct in foreclosures and significant weaknesses in mortgage servicing processes. Unfortunately, the horizontal review only looked at processing issues. Since the focus was so narrow, we do not yet really know the full extent of the problem.

In April 2011, the Office of the Comptroller of the Currency (OCC), the Federal Reserve Bank (Fed), and the Office of Thrift Supervision (OTS)  - the IndyMac regulator – ordered fourteen large mortgage servicers to overhaul their mortgage-servicing processes and controls, and to compensate borrowers harmed financially by wrongdoing or negligence.

An article in Thomson Reuters’ News and Insight on May 19 describes the problems some were having with the setup of this Consent Order, specifically the way the “independent” reviews required by the Order were expected to be performed.

U.S. regulators are pinning their hopes on independent consultants picked by large U.S. banks to uncover the true depth of foreclosure misconduct seen at lenders. Regulators are close to signing off on these consultants, which are expected to include Promontory Financial Group, Treliant Risk Advisors and PricewaterhouseCoopers…

The key thing is that the independent consultant needs to recognize that the client is the regulators… and not the bank,” said Joe Evers, a large bank deputy comptroller at the OCC. “They need to be taking direction from us and they need to be meeting our expectations.”…

One issue is who would do the review if not the consulting firms. Regulators say they don’t have the manpower, and so they are looking for firms with the required expertise. Senator Reed suggested the regulators at least hire the firms directly rather than approve the banks’ choices. Evers said regulators decided not to take this approach because it would have raised government contracting issues that could have slowed when the reviews begin. He said the agency also has had success using third party reviews in past enforcement actions.

The problem with this approach and the inherent conflicts of interest should be obvious to all but the most naïve observers.

It’s a joke for any government agency, especially one says they’re in the enforcement versus the supervision business, to defend an approach that allows the entity found guilty of wrongdoing to select the consulting firm that tells them how bad they were and how much they have to pay for the bad behavior.

It’s not like the agencies – Treasury, the General Accounting Office, the Federal Reserve, the SEC, and others like them – don’t have procurement teams that contract with professional services firms on a direct basis all the time. One only has to look at the assistance that all the Big four audit firms  - and lawyers and other consultants – provide to the Federal Reserve Bank, The SEC and the Treasury on the TARP program and related initiatives as a result of the crisis. The process, controls, and the rationale for direct contracting is already in place.

And let me assure OCC spokesperson Evers that audit firms like PwC will not look at the regulators as their clients instead of the banks unless someone makes them. They know where their bread is buttered and where their next meal is coming from.

The SEC and the PCAOB, the audit industry regulator, have said so.

The reforms from early this decade notwithstanding, I believe more can and should be done to emphasize the importance of independence and the auditor’s duty to shareholders and the public. It is integral to the foundation of the reason for requiring an audit in the first instance…I’m not suggesting that the role of an auditor should be that of an adversary; but it also cannot be, either in fact or in appearance, that of an advocate for the management of the company it audits. In a world where the mantra “the client is always right” can be typed in to Google and return over 8 million results in .30 seconds, I would suggest it is time to give serious consideration to changing the perceived “client” in audit relationships.

Auditors are, after all, paid by the clients they are charged with policing. As in other professions, auditors want to advance in their chosen profession which often means keeping the client happy and growing their business.

Auditor independence requirements serve as counterweights to those forces. One example of those counterweights may be found in the SEC rule that says an accountant will not be considered to have the necessary independence from its audit client if an audit partner earns or receives compensation based on selling non-audit services to the audit client. The purpose of this rule is to keep auditors singularly focused on the quality of their audits and not on nurturing a relationship that will make management more receptive to cross-selling efforts.

Despite those requirements, PCAOB inspection reviews of partner evaluation and compensation processes find examples of seemingly unrestrained enthusiasm — in partners’ self-evaluations, in their supervisors’ evaluations of their performance, and in agreed performance goals — for selling services to audit clients…We don’t see these problems in all the files we look at, but we have seen them in sufficient number to raise troubling questions, not the least of which are whether these audit partners are unaware of, or simply unconcerned about, the independence rule that should make such considerations irrelevant to their compensation, and why a firm would allow such unawareness or unconcern to continue unabated.

So let’s look at the proposed consulting firms. Promontory Financial Group, Treliant Risk Advisors and PricewaterhouseCoopers are professional services firms that serve the large banks directly on other consulting assignments.

The banks that must be reviewed are their existing or target clients.

PricewaterhouseCoopers (PwC) is the auditor of two of the banks that must be reviewed – Bank of America and JP Morgan Chase. That’s an independence conflict that can’t be overcome. PwC can not be involved in the reviews at these banks. Recently, retired PricewaterhouseCoopers’ Chairman Sam DiPiazza joined Citigroup as a Vice Chairman in the Institutional Clients Group and a member of the bank’s strategic advisory board. There’s another conflict for PricewaterhouseCoopers.

Where PwC is not serving a bank as auditor - namely Citigroup and Wells Fargo - they are already serving as a consultant. These three consulting firms want consulting business from these banks, now and in the future. If PwC is allowed to participate in reviews at Bank of America and JP Morgan Chase, PwC’s will seek to protect their audit relationships and avoid highlighting their own or their clients’ serious errors.

PwC will also seek to protect their fellow Big Four audit firm – KPMG – which audits Citigroup and Wells Fargo, owner of Wachovia one of the large mortgage originators. Although each audit firm has their own level of tolerance for client’s bad behavior and for accepting clients’ “judgments and estimates” there’s a least common denominator bottom line that keeps all the firms in line at all their large financial services clients.

As we saw during the crisis, any one of the Big Four auditors could at any time, by virtue of failure, acquisition, or merger, become the auditor of any of their fellow firm’s clients. No firm wants to inherit a client that’s too far out on the edge. As a result the largest firms are all as good – and as bad  – as each other in enforcing the standards in the most controversial areas.

In addition, given the firms’ self-insured status using a captive offshore vehicle that all the largest firms participate in, litigation against one audit firm as a result of finding mortgage fraud at their client hurts them all – in the pocketbook as well as reputationally.

The plans for independent reviews required by the banks’ Consent Order with the OCC, OTS, and the Fed are due July 13. Additional self-assessments were orderd for all banks, not just those under the consent decree.  Those are due September 30. According to HousingWire’s Jon Prior, the reports of the reviews will not be made public. Would it be possible keep the reports secret if the regulators had contracted for the reviews directly?

I think not.

On June 13, the Huffington Post’s Shahien Nasiripour disclosed that New York State Attorney General Eric Schneiderman had turned up the heat on Bank of America and other banks, servicers, and trustees of the mortgages that were securitized.

New York Attorney General Eric Schneiderman has targeted Bank of America, the biggest U.S. bank by assets, in a new probe that questions the validity of potentially thousands of mortgage securities and their associated foreclosures, two people familiar with the matter said.The investigation, which began quietly in recent weeks, is part of a larger inquiry that is scrutinizing whether mortgage companies and Wall Street firms took the necessary steps under New York state law when creating mortgage-backed securities.

There was a movement by all the state attorneys general to force a global settlement on the banks to remedy the wrongs of the crisis, in particular with regard to bad documentation and unjust foreclosures. That effort has repeatedly been hit by defections and roadblocks.

From William Greider in The Nation on June 28:

As facts about the banks’ ugly behavior gathered headlines, the fifty state attorneys general came together to demand reforms. The effort was chaired by Democrat Tom Miller of Iowa and actively coached by Washington officials from the Justice Department and HUD. The Obama administration is eager to get a settlement, fearing that state-by-state litigation will injure the banks and maybe derail the foreclosure process.

The AGs first suggested a settlement of $20–25 billion—even though the true public loss would probably be much greater—plus a commitment from the banks to clean up their procedures. In exchange, the AGs would agree to release the banks from potential liabilities that states might pursue. The banks’ counteroffer was a trivial $5 billion, which suggests that they are not taking the AGs too seriously.

[New York Attorney General Eric] Schneiderman agreed to participate with other AGs, but warned from the start that New York would refuse to give up its right to hold banks liable—to sue and collect damages or impose court-ordered reforms. Other strong states, including California and Massachusetts, evidently agree. That alone would presumably doom the deal-making, since any settlement that does not include New York and California would probably not be worth much to the bankers.

In January, Bank of America settled with Fannie Mae and Freddie Mac over repurchases but there are several other suits outstanding with the Federal Home Loan Banks and private investors. Bank of America recently caved in to another group of investors. On June 29, the Financial Times FT Alphaville blog reported that a settlement had been reached between Bank of America and some bondholders.

…several news outlets (the Wall Street Journal had it first, and here’s the FT) reported last night on the expected $8.5bn settlement reached between the bank and the aggrieved parties, and earlier this morning BofA confirmed the details in a statement.

The key driver of the expected loss is the representations and warranties provision of $14.0 billion, including $8.5 billion for the settlement agreement on legacy Countrywide mortgage repurchase and servicing claims, and an additional $5.5 billion increase in the company’s representations and warranties liability for non-GSE exposures and, to a lesser extent, GSE exposures.

The company also expects to record $6.4 billion in other mortgage-related charges in the second quarter of 2011…

Audit firms PricewaterhouseCoopers and KPMG, as well as the other two members of the Big Four, are all around this crisis – in the banks, the ratings agencies, and in the regulators. And there’s a pervasive revolving door between the regulators and the banks and institutions they regulate, as well as between the regulators, the regulated, and the auditors and attorneys that serve us as watchdogs and guardians of the public interest.

But the Taylor, Bean & Whittaker convictions prove that mortgage fraudsters can be prosecuted.

The best way to get truly independent assessments of how much is wrong with the processes and the paperwork and how much compensation should be paid is for regulators to step up and take direct responsibility for the problem.

Independent individuals and firms, people who are not beholden to the large banks and financial institutions, do exist. Many next tier and regional or boutique firms have the expertise and are not in the day-to-day business of auditing or taking on large projects with these institutions.

It’s time for the regulators to build a more permanent task force of public servants rather than private profiteers to tackle these issues. The problems are really big, they’re going to get worse before they get better, and they’re going to be around for a long time.

The main page image comes from this site and this essay on the challenges to the criminal justice system, penned in 1997.

Post Script: This was a great movie about plaintiffs’ lawyers.

Post Post Script:  When I told readers in January to sell or short the banks – in particular Bank of America – the bank’s closing price was $14.667.  On Friday July 1, Bank of America closed at $11.09.

It’s not an easy issue to understand.  And it was conflated with the realization that banks were foreclosing on homeowners without following due process, without having legal title, without following the law.  John Carney, who runs CNBC’s blog NetNet, explains the problem that occurs when too many issues have to be explained in too short a time, to too many people who have too little patience for details:

There’s a lot of confusion about why fears of put-back exposure at some of our largest banks seemed to spring up so quickly following the revelations about problems in foreclosure proceedings.

Conceptually, these are two different problems. Banks using robo-signers who were fraudulently claiming to have reviewed loan documents has no necessary connection to the idea that purchasers of mortgage-backed securities may have the right to force banks to buy them back.

But the two problems were linked by a common thread: concern that the fraudulent foreclosure practices were a cover-up for a deeper problem in identifying and documenting the ownership of many mortgages…So that was how we got from the foreclosure fiasco to the put-back panic. Now, of course, we’ve discovered that there are many more sources of put back liability than just missing assignments. But those missing assignments are what got the ball rolling.

Readers know I have been talking about repurchase risk since 2007 and New Century.

Foreclosuregate does not have a direct relationship to auditors other than forcing them to make sure banks and other financial services companies like mortgage servicers make more and better disclosures than in the past.

Interestingly enough – and I say this risking the possibility it may sound conceited – I think the SEC is paying attention to what I’ve been saying.  I challenged the SEC at the end of September to look at the banks’ disclosures regarding repurchase risk and other contingencies:

Bank of American admits “representations and warranties expense” as well as losses of $1.5 billion for repurchases of loans from first lien securitization trusts under their representations and warranties and corporate guarantees.  In addition, they’d already repurchased an additional $13.1 billion based on mods, delinquencies and other “clean-up”.

However, I can’t easily see anywhere in either bank what the actual reserves are for estimated future liabilities and how they come up with a number given the total loans sold by type and the current claims by various parties. I think it’s time for someone, perhaps the SEC, to demand more detailed disclosure about reserves for repurchase risk.

That should be easy, in particular, for JPM, BAC, Goldman Sachs, AIG, and Barclays for claims against them by the Federal Home Loan Banks (FHLB) and Freddie Mac.  That’s because PwC is on both sides of the equation, as auditor for all of these banks and AIG and as auditor of Freddie Mac and all twelve of the FHLB.

The SEC has now issued a “Dear CFO” letter strongly encouraging issuers to make sure disclosures are clear and sufficient.  Edith Orenstein explains it all for you at the Financial Executives International blog:

The SEC’s ‘Dear CFO’ letter sent to public companies in October, 2010, posted on the SEC’s website October 29, addresses “Accounting and Disclosure Issues Related to Potential Risks and Costs Associated with Mortgage and Foreclosure-Related Activities or Exposures.”

Letter Lists Specific Disclosures ‘To Be Considered’

Issued by staff of the SEC’s Division of Corporation Finance, the October 29 ‘Dear CFO letter’ contains a lengthy list of specific disclosures that “should be considered” in connection with mortgage (and mortgage securitization and sale-related) and foreclosure related activities…

John Carney at CNBC NetNet has now gone back to repurchase risk, and tied it all together in a bow for us. In particular, he mentions Citigroup and Bank of America and has given me credit for having been on KPMG’s case for a while:

As my colleague Ash Bennington and I have explained at length, we think that the historical size of claims and payouts may not be a good guide to future claims and payouts…To put it differently, it’s as if we’ve made all sorts of new discoveries about the territory but Citi insists on pointing at an old map.

Where does the confidence in the map come from? It could be that Citi is taking assurance from the work of its auditors, KPMG. But this assurance could be misleading. As Francine McKenna of the blog Re:TheAuditors points out, KPMG has a long history of approving poor disclosures when it comes to repurchase risk.

McKenna first reported on poor disclosures at a KPMG audited company in 2007. That company was New Century. It hadn’t disclosed anything about repurchase risk in earlier filings with the Securities and Exchange Commission. But, suddenly, it was revealing that banks were demanding that it buy back mortgages it had sold. If all the mortgages were put back to the company, New Century said it would be on the hook for $8.4 billion.

Later, in an article for Business Insider, McKenna reported that Wells Fargo was not reporting the quantity and quality of its repurchase risk.

Maybe Treasury married KPMG all over again because they’re cheap compared to what Goldman and AIG are paying PwC, for example.

Maybe KPMG knows this client best – a dubious honor. KPMG has been on the scene of Citi’s crimes and misdemeanors all over the world for 41 years.

Maybe Treasury feels like a mother who puts up with a gold digging daughter-in-law because daughter-in-law saw mom kissing the tennis pro and mom knows her son has slept with the baby-sitter…

From Citigroup’s most recent proxy:

Does any single stockholder control as much as 5% of any class of Citi’s voting stock?

As of December 31, 2009 (i) the U.S. Treasury continues to hold approximately 7.7 billion shares, or approximately 27%, of Citi’s common stock, (ii) the U.S. Treasury and the Federal Deposit Insurance Corporation (FDIC) continue to hold an aggregate of approximately $5.3 billion of Citi’s trust-preferred securities, and (iii) the U.S. Treasury continues to hold three warrants exercisable for an aggregate of approximately 465.1 million shares of Citi’s common stock.

The US Treasury is Citigroup’s largest common shareholder, owning 7.7 billion shares, or about 27% of the company. Donald Marron at WallStreetPit.com tells us how Treasury voted its shares:

“Treasury announced that it would retain the discretion to vote only on core shareholder issues, including the election of directors; amendments to corporate charters or bylaws; mergers, liquidations and substantial asset sales; and significant common stock issuances. At the time of the exchange, Treasury agreed with Citigroup that it would vote on all other matters proportionately…”

KPMG has served as Citigroup’s auditor since 1969. In my recent post about rampant repurchase risk, I said Citi is now KPMG’s sole toehold on Wall Street.

Fees to KPMG for audit, audit related and tax compliance work at Citi were more or less flat from 2007-2009.

This seems quite odd given the tumultuous times we’ve had the last two years. Auditors are supposed to assess the additional risk of fraud and material misstatement associated with events like a global economic crisis, taking on taxpayers as significant shareholders (November 2008) and the credit chaos in industry and sovereign capital markets.

But KPMG and the US Treasury have almost as much history together as KPMG and Citi.

While the US Treasury, via the IRS, was scaring the living daylights out of KPMG over tax shelter abuses in 2005 and the Department of Justice was considering indicting the firm, KPMG was busily auditing the Department of Justice and the US Mint.  In 2007 and 2008 KPMG also audited the Department of Treasury’s Financial Management Service.

Re: The Auditors, November 28, 2006:

KPMG is negotiating with the Department of Justice about its troubles while Department of Justice is negotiating with KPMG, their auditors, regarding their audits of DOJ financial statements… in addition to the “too few to fail” doctrine at work here, there was also an attitude on the part of KPMG of, “Hey DOJ losers, who are you to call us a mismanaged, uncontrolled mess?”

At the last moment, the Department of Justice changed their mind about putting KPMG effectively “out of business” over the tax shelter sins.

Details of the deal were announced at a Gonzales news conference on Aug. 29, 2005. The resolution, Gonzales said, “reflects the reality that the conviction of an organization can affect innocent workers and others associated with the organization, and can even have an impact on the national economy.”

This decision cemented the US government and general global regulatory posture of  “too few to fail” with regard to the largest audit firms.  What makes you think the US Treasury would ever force its close friend KPMG out of Citi?

This article was originally posted at GoingConcern.com May 5, 2010.

Back in February, I reminded you of the good things about the Sarbanes-Oxley Act.

“When the Sarbanes-Oxley Act was passed in the summer of 2002, largely as a rushed reaction to Enron, it did get a few key things right.  Notwithstanding the long debate we’ve had about cost/benefit or why it didn’t prevent the subprime crisis or large frauds such as Satyam and Madoff, both of which are derivative discussions for later, there were a few important changes that still make a difference.”

Section 201-209 had a significant impact on the audit firms because it prohibited auditors from providing certain other services to their audit clients.  This change was the result of a long simmering debate about auditor independence but made possible, finally, by the ‘cornered-the-market” behavior of Arthur Andersen as auditor, internal auditor, and chief consultant for Enron.

From the Wall Street Journal in February of 2002:

“…The push to outsource oversight of Enron’s internal-audit function came out of discussions from Enron’s audit committee in the early 1990s, according to depositions. Robert K. Jaedicke, the audit committee’s longtime chairman and former dean of Stanford University’s Graduate School of Business, favored the idea of an “integrated audit,” Mr. Hooten said in his deposition.

Mr. Jaedicke’s attorney, W. Neil Eggleston, said in an interview that Mr. Jaedicke agreed that outsourcing oversight of Enron’s internal-audit function, where Andersen auditors reviewed checks and balances, was a good idea because Andersen’s expertise would provide more “real-time analysis” of whether Enron’s controls were effective.

Andersen had a clear leg up in winning the business. Since 1986, Andersen had been auditor of Enron and its predecessor company. Jack Tompkins, who had headed Andersen’s Houston office for years, was Enron’s chief information and accounting officer during the early 1990s when the contract was being pursued.

The Enron outsourcing business was a big prize. Andersen’s original proposal included a five-year guaranteed contract, $18 million in net fees for Andersen and “value-billing opportunities” of as many as 44,400 guaranteed consulting hours, as well as potential savings for Enron of $12 million over five years, according to a deposition by Michael L. Bennett, Andersen’s world-wide head of assurance and business advisory.

Once it won the contract, rather than physically separate internal and external auditors working at Enron to prevent conflicts of interest, Andersen encouraged a “culturization” of the work teams, bringing the auditors together on the same floor at Enron, Mr. Bennett said in the deposition.”

The US-based academics mentioned in my February post used the same arguments as were made to sell Andersen as an internal audit outsourcing vendor to Enron. They suggested that rolling back the prohibition on auditors also acting as internal auditors of their clients might be better for us:

1) More efficient and effective teams given the external auditors’ extensive knowledge of their clients. The study actually contends, “the knowledge of a company that an external auditor gains from internal auditing lowered the chances of publishing misleading or fraudulent financial results.”

2) Cost savings to client (via leverage over auditor re: fees) from combining the teams and gaining “synergies” from having same firm do both.

3) Promotion of a “consultative” approach that would benefit both client and vendor. In fact, I reported in February that the audit firms were rolling their internal audit practices back into the external audit/assurance practices. No more pretending to be true “strategic” consulting/advisory teams.  This is certainly more efficient and cost effective for the firms, especially if they can use the same staff for both external and internal audit engagements.

If you thought the discussion was pure rhetoric, you were mistaken. KPMG (and PwC who also proposed on Rentokil but lost) has now rationalized, rhetoricized, and revisited the best practice based restrictions for their new client Rentokil. Rentokil is not listed on a US exchange and, therefore, not subject to the Sarbanes-Oxley restrictions.  The UK, where Rentokil is listed, has a gentleman’s agreement with regard to auditor independence for non-audit services.

From a paper by Eleanor Dart of the Cardiff (UK) Business School:

“In 2004, the Auditing Practices Board issued ‘Ethical Standards for Auditors’ (updated in 2008). These standards are less permissive than previous guidelines and must be followed by all members of professional accounting bodies who engage in auditing activities. The standards include a 10% limit on audit firm income from any one listed company client, audit engagement partner rotation every 5 years and key audit personnel rotation every 7 years and compulsory withdrawal from the audit should any non-audit services supplied not be viewed as consistent with the objectives of the audit itself.

However, despite these developments, fundamental questions over auditors’ ability to live up to the service ideal of professional integrity still remain and there is much controversy over what can be done to ‘minimise the possibility of an Enron or WorldCom situation occurring’ (Reeves, 2002:4). Whilst it appears that ‘no single solution is a panacea’ (Reeves, 2002:4) for UK auditor independence concerns, interested parties have yet to agree upon important issues such as whether non-audit service provision should be prohibited or whether a system of mandatory audit firm rotation should be introduced. It is clear that further consideration may be needed to prevent future losses of confidence in auditor independence.”

The arguments for combining the external audit and internal audit activities under one provider repeat, not surprisingly, a familiar refrain. But they conveniently and completely ignore the lessons of the past.  What’s different today is that journalists, corporate governance experts, and plaintiffs attorneys have longer memories:

From The Financial Times’ Jennifer Hughes:

Rentokil Initial has struck a cheaper, streamlined form of audit deal with KPMG that could be adopted by other companies but has raised eyebrows in the corporate governance world.  Rentokil has shaved £1m, or almost a third, off its annual payments to its external and internal auditors, it disclosed in its interim statement on Friday…

KPMG said there was no conflict in its deal with Rentokil and that it was conscious of the rule.

“Conceptually, doing internal audit isn’t a conflict in itself, only if you get involved in the wider aspects such as management – which we are not,” said Oliver Tant, head of audit for KPMG UK.

“Companies are aware today of the importance of good assurance yet at the same time, they’ve got to look at costs. There are ways you can do it more efficiently and effectively.”

KPMG’s pitch was helped by the history the audit team had in working previously with Alan Brown, Rentokil’s chief executive, when he was finance director at ICI.  It was Mr Brown who initiated the discussions that led to the new arrangement.

Given the pressures on costs and the longstanding ties some finance, audit, and accounting executives have with the accounting firms, it is not surprising that the weakening of the independence commitment may come from the companies themselves.  What’s the downside for them?  The potential for scrutiny by corporate governance experts and journalists?  You can’t argue with a recession.  And in the event of an accounting scandal or restatement, plaintiff’s lawyers will have an uphill battle to penetrate the impenetrable auditor liability shields and caps.

I would hate to think, as Dennis Howlett has suggested, that this could become another lame excuse for repealing SOx/general deregulation of audit firms under the threat  of companies decamping to more hospitable climates?

What’s lost in all of this discussion of efficiency and cost cutting?

Independence protects shareholder’s interests.

Fortunately, at least one important voice, the Institute of Internal Auditors (IIA) President and CEO Richard Chambers, has issued a strong statement “in response to recent suggestions that it may be time to revisit existing prohibitions on provision of internal audit services by the same firm responsible for the external audit in the U.S., as well as a recent high-profile instance of the practice in Europe.”

“Internal audit services should not be provided by the same accounting firm that audits the organization’s financial statements, as it would impair the independence of the external auditor. We have expressed this numerous times over the past two decades and we feel it’s important to re-emphasize this at a time in which the practice is potentially being reconsidered,” said IIA President and CEO Richard Chambers, CIA, CGAP, CCSA. “The SEC prohibits this practice by public companies listed in the U.S., but The IIA believes that even if allowed by law or statute, this practice – at a minimum – creates a perceived impairment of independence and erodes public trust.”

I could not have said it better myself.

In addition, KPMG and Rentokil must realize that KPMG’s internal audit practice and Rentokil’s internal audit function will no longer be able to say they comply with IIA standards.  May not seem like a big thing to you but, to internal auditors, it’s the heart and soul of being a “professional.”

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Not so long ago, Dennis Howlett and I went public with a bet:  

Which Big 4 audit firm is the next to fail?

This may seem like a dead pool – a quite depressing and morbid fascination with something that will add pain and misfortune to so many.  I have been accused of being so totally negative that I strain credibility.  After all, isn’t there anything good to say about any of the firms?  

Isn’t some audit failure natural? Isn’t some error and omission in the audit process the result of a rational cost/benefit formula at work – one that determines how much more testing, sampling, investigation, questioning, and verification work should be done to reduce risk of material misstatement to an “acceptable” level?

Isn’t everyone cutting staff in this recession? Why can’t the audit firms run a business like any other capitalist and make a profit? Why are auditors any more responsible for the public interest than lawyers?

Aren’t plaintiffs’ lawyers too aggressive and going after audit firms only because they have “deep pockets” ? Aren’t auditors responsible only for certifying based on what management tells them? Can anyone hold them responsible if they were “duped” by bad guys? 

The litany of crybaby defenses goes on and on.

Frankly, it’s getting a little tedious.

Let’s face facts. Dennis may be right.  It may be EY that’s next.  

Even before the conviction this week of four current and former partners of Ernst & Young for criminal tax fraud involving tax shelters, EY had a bundle of other trouble.  They were the auditors of Lehman Brothers and are being sued for their role in that failure. They have Madoff exposure.  They are also co-auditors for Societe Generale and auditor for UBS – two problem children, for sure. There is speculation about EY in other quarters, and although I don’t agree with their reasoning, the conclusion is the same.

Dennis believes that I’m betting on PwC as next to fail.  I don’t honestly remember committing to that, but I’m willing to go with it for the sake of argument.  This is in spite of the fact that the other Big 4 have plenty to worry about and the next tier firms are in no way ready for prime time.  Wishful thinking that BDO can somehow win their appeal in the Banco Espiritu Santo case, that Grant Thornton won’t get hurt by Refco, or that McGladrey is innocent in the Sentinel case is trumped by the fact all have additional exposure to Madoff.

KPMG, of course, has New Century, Anglo Irish Bank, Citi, Siemens, and others.

Deloitte, well, too many to count. And the Parmalat case is a potential model changer. And a very embarrassing insider trading scandal. Then there’s the loser consulting gigs and a declining demand for consulting, all of which makes for never ending cuts and a not so rosy outlook.

And yet, for my money, PwC is still the closest to the precipice, if only now because of Satyam.

Think about it.  It’s their third strike (at least that we know of) internationally after Japan and Moscow.  Two of their Indian partners, for God’s sake, are still in jail – thrown to the prosecutorial sharks by the Indian Central Bureau of Investigations. The Chairman (soon to be retired ) of Pricewaterhouse International Limited, Sam DiPiazza, has pulled out all stops in investigating what occurred in India, sending US and other professionals to “assist” colleagues in India with comprehensive audit quality reviews, and personally meeting with Indian government officials and others worldwide to try to repair the “lost trust.”

And then there’s PwC’s Madoff exposure.  

And the lawsuit for wage and hour violations in California that they’ve already lost on the facts but are vigorously appealing. They completely flubbed the administrative responsibility test in this case and will lose the licensing argument.  Why?  Because the fear mongering they’re trying to stir up through proxies (there have been friend of the court briefs filed by business organizations sympathetic to PwC) are just that. Empty threats. The law firms have nothing to be afraid of if audit firms are required to pay overtime to not-yet-licensed associates. The law firms exposure is minimal.  After all, you pass the bar and are a licensed attorney in most states by late fall of the year you graduate.  Most law firms don’t tolerate a delay or a failure to pass the bar the first try, especially for top graduates. Contrast this to the audit firms. You can work for five to seven years, eighty hours a week during busy season, before making Manager level, the typical cutoff for future promotions without a CPA.  

And there are still questions lingering over their role in Northern Rock. And their forays into gambling audit have not been so successful all the while they’re advising the US to open up online gambling in order to reap the tax revenues.

The rumbling has also started in the comments on this blog over PwC’s stealth “reductions in force” and their broken promises over start dates and starting salaries to graduates. It’s fully expected that additional staff cuts will come soon and be of such a volume that it will be hard to hide behind the “didn’t fit with our performance culture” excuse.  

Finally, there’s the strategically disastrous purchase of BearingPoint’s Commercial Services practice.  Sources tell me due diligence has been non-existent, it’s solely an ego-trip for current leadership, and there’s a shell game going on in public statements regarding their interest in full blown systems integration services. The probability that  integration of the operations, financials, staff and infrastructure will be smooth and trouble-free is in the low single digits.

Yep.  Of the Big 4, my bet is with PwC US to fail in the next twenty-four months.

Photo Source

“KPMG is being sued for $1bn by the liquidators of New Century, the collapsed subprime lender, in the first big case against an auditor arising from the current financial crisis.

In a court filing on Wednesday, lawyers for New Century’s liquidators claimed that KPMG “assisted in the misstatements and certified the materially misleading financial statements” filed by the lender. They claim KPMG was responsible for its collapse because it allowed the lender to use inappropriate accounting that led it to underestimate the provisions it needed to cover bad loans. This made its position look better and gave it access to more funds…”

And Donna Kardos in the WSJ:

The lawsuits filed Wednesday said that specialists at KPMG tried to point out errors in New Century’s financial statements but were silenced by the KPMG partner in charge of the audits “to protect KPMG’s business relationship with, and fees from, New Century.”

The claims are among the first to attempt to blame auditors for the subprime-mortgage crisis, which spread beyond lenders such as New Century and engulfed the global financial system.

If the New Century trustee is successful, ”it may embolden others to look more closely at the possibility of bringing [accounting] firms to some level of culpability for the things that happened,” that led to the credit crisis, Francine McKenna, president of McKenna Partners LLC, a corporate-governance consultancy, said in an interview.

KPMG had a tough day all around as yesterday also saw stiff sentences handed down to two former KPMG’ers related to their tax shelter case.

If you’ve been reading this blog, you’re very familiar with the New Century case.  I wrote about New Century for the first time back in March of 2007!

New Century Financial, the US subprime lender scrambling to avoid bankruptcy, hit further troubles on Tuesday as it revealed that it was facing a preliminary investigation by the Securities and Exchange Commission and that it had received a grand jury subpoena from the Department of Justice…The US Attorney is examining trading in New Century’s securities and accounting errors in how much it set aside for loan losses. …The halt, ordered by the New York Stock Exchange, came after New Century said its banks had either cut off credit or signalled their intention to do so, increasing the likelihood of an imminent bankruptcy filing or asset liquidation….

There are 17 pages of discussion of general and REIT specific risk associated with this company, but no mention of the specific risk of the potential for their banks to accelerate the repurchase of mortgage loans financed under their significant number of lending arrangements….it does not seem that reserves or capital/liquidity requirements were sufficient to cover the possibility that one of or more lenders could for some reason decide to call the loans. Did the ratios drop? Were they delivering their monthly compliance certificates to all the lenders? Were those accurate and truthful? Did the lenders have the right to call the loans unilaterally? It does say that if one called the loans it is likely that all would. Didn’t someone think that this would be a very big number (US 8.4 billion) if that happened?… I find it very curious that no matter how much auditing and disclosing goes on, we continue to see “rapid, unexpected declines” in once high-flying companies that suddenly teeter on the edge of bankruptcy, even though the best and the brightest are supposedly “Keeping Watch” for us as their auditors.

New Century declared bankruptcy in April of 2007. KPMG resigned as New Century auditor in May 2007, shortly afterward. (Unfortunately they were still auditor for Countrywide, the other big ugly mortgage lender, until it was bought by Bank of America.) It was a tough couple of weeks for KPMG, although they were not alone in their pain. All of the Big 4 were experiencing similar pain or the anticipation that they may be tarnished by the same subprime brush.

The litigation-like activities began and the bankruptcy trustee said KPMG was still part of the problem, delaying his investigation. 

And then the bankruptcy examiner’s report pointed the smoking gun at KPMG, almost a year ago to the day.  

The lawsuits filed yesterday are interesting from several perspectives.  I’m going to point to several areas now and expand them in later posts.

1) There’s both a California filing against KPMG LLP, the US firm, and a filing in New York against KPMG International, the umbrella firm for the KPMG “global network” of firms.  Interestingly, and not too surprising to me, the attorney for these cases against KPMG, Steven Thomas, is the same attorney who won the large judgment under appeal in the Banco Espiritu Santo case against BDO Seidman and the one who is going to trial in the same issue against BDO International, their umbrella firm.  

The international cases looks similar and I believe this is a trend.  We’ve already seen Stuart Grant make his case successfully regarding Deloitte’s International firm’s potential culpability in the the Parmalat case.  A similar one will be filed against PwC in the Satyam case, I can assure you. 

2) One potential weak spot in the filings I see is their overemphasis on the “independence” issue.  It seems they are claiming “independence” issues and, therefore, invalid audits and audit related work. This is based on accusations that KPMG rolled over and acquiesced to New Century management even when they knew numbers, assumptions, calculations were wrong.  Not sure the attorneys understand the fine distinction between KPMG neglecting responsibility to their true client, the shareholders and other users of the financial statements, a statutory expectation of due professional care and adherence to standards, versus an actual “independence” conflict.

Did New Century pay KPMG’s bill? How much were the fees?  Were there other prohibited relationships or transactions that compromised the KPMG partners’ and professionals’ true independence and objectivity such as mortgage loans from New Century or personal relationships of the romantic kind?  Had they been planting KPMG professionals in the client over the years?  Those are true independence issues from an accounting and auditing professional standards perspective.  Rolling over and playing dead for the sake of the business is not an “independence” violation, I’m sorry to say.

3) There are a few phrases in the filing that allude to a potential claim theory of “deepening insolvency.”  

From the complaint against KPMG International: “…Had KPMG LLP done its job and upheld its public duty, the problems that caused New Century to fail – or at least to spectacularly increase the enormity of its failure – could have been stopped before they started and materially misstated financial statements would not have been issued in the public marketplace.  Moreover, had its financial statements been fairly presented in accordance with GAAP, New Century could not and would not have incurred billions in liabilities to repurchase mortgages or direct liabilities to lenders.”   

As much as I like the “deepening insolvency” theory on an intellectual level, it’s not been successful.  No less than Judge Posner has smacked it down, for what I believe are very naive and too limiting ideas about the auditor’s role. Maybe those are the limits of the law, unfortunately. Don’t go there.  This one seems clear cut enough on the negligence and professional malpractice points alone.

4) I wrote a few days ago about former PCAOB Chief Auditor and Director of Professional Standards Tom Ray returning to his home firm, KPMG, after several years at the PCAOB.  I lamented the fact that Ray could roll back into his old firm and rejoin as a partner in their Professional Standards group.  I was assured by the PCAOB spokesperson that:

The Sarbanes -Oxley Act of 2002 directed the PCAOB to establish ethics rules for its Board members and staff.  In accordance with these provisions, the PCAOB adopted an Ethics Code that governs the conduct of all Board members and staff.  The PCAOB’s Ethics Code includes "post employment" restrictions (Section EC12(b)) that prohibit Board members and professional staff  from:

 

• practicing before the Board  (or the SEC with respect to Board related matters) for one year after leaving the PCAOB; and 
• practicing before the Board  (or the SEC with respect to Board related matters) on particular matters involving specific parties in which the Board or staff member participated personally and substantially while at the PCAOB.  

 

The PCAOB has not yet taken any disciplinary action against KPMG or the KPMG partner for New Century named in the lawsuits.  I guess Mr. Ray is free to help KPMG defend itself against this one.  I’m sure it won’t come up before the PCAOB or SEC for at least a year. How convenient.

5) I’m sure the attorneys took most of the information about specific conversations and evidence that KPMG looked the other way from the bankruptcy examiner Missal’s report.  Did they think to subpoena the 2005 inspection reports on KPMG from the PCAOB?  It’s highly likely that New Century was one of the clients sampled for inspection during this period by PCAOB. Although the clients cited as exceptions in their inspections reports are not named and are kept a closely guarded secret to the detriment of investors and plaintiff’s lawyers, it may be interesting to see if these lawyers could test that theory.  If there are specific instances where KPMG did not uphold the actual auditing standards, per the regulators’ judgment,  it will be all there (including KPMG’s response to any exceptions noted) in those reports. In addition, the non- published Part Two of the reports, which talks about the actual quality and risk management processes at KPMG, would also be interesting for this purpose.

In a related case, I can’t wait to see what the report by the PCAOB of their inspection trip to India last year at this time holds as clues to the PwC/Satyam debacle.  Did you know the PwC Satyam partners are still in jail in India, two months later? No, the PCAOB’s report is still not issued!

6) With BDO International case, the Deloitte International/Parmalat case, an inevitable PwC/Satyam case,and now this suit against KPMG International, the audit industry is extremely vulnerable on the “global network” issue.  

7) Can KPMG claim they were “duped” as they have in their counter suit against Fannie Mae? Will cases against New Century directors and officers go to trial first and guilty pleas/convictions of New Century executives for fraud diminish the case against auditor like they did in Refco?

KPMG were also the auditors of Countrywide. ( I think there was a “models” problem there, too.)  They are still auditors of Citigroup.  Who’s next?  Many claiming this is first subprime related case against auditors but NJ recently sued Lehman and their auditor EY.  And Deloitte is being sued over Bear Stearns and over WAMU. 

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It’s very gratifying.

There is at least one person who doesn’t have to worry about having a good job, at KPMG no less.   Thomas Ray was the Chief Auditor and Director of Professional Standards for the PCAOB.

According to WebCPA:

Ray is joining KPMG as a partner in the firm’s department of professional practice in New York. 

According to the PCAOB official press release:

The principal responsibility of the Office of the Chief Auditor is to advise the PCAOB Board members on the establishment of auditing and related professional practice standards. As such, Mr. Ray was actively involved in and oversaw the development of all of the auditing standards developed, proposed and adopted by the Board.

Mr. Ray was instrumental in designing the Board’s auditing standards to implement Section 404 of the Sarbanes-Oxley Act of 2002…the development of the suite of seven proposed new standards related to the auditor’s assessment of and response to risk in an audit… [and] was actively involved in the development of the Board’s Ethics and Independence Rules…

Prior to joining the PCAOB staff, Mr. Ray was a partner with KPMG LLP in their department of professional practice in New York. Prior to joining KPMG, he was director of auditing standards at the American Institute of Certified Public Accountants. He began his public accounting career with Grant Thornton LLP. 

I got a nice personally signed letter from Tom, once upon a time.  

I will treasure it always.

I met Mr. Ray last June at the Compliance Week Annual Conference.  

At the Compliance Week Conference earlier this month, I asked Tom Ray about the push on the part of some “activist accountants” – an oxymoron if there ever was one –  to change the rules about who signs audit opinions.  Some (including me) think that the individual responsible partner should be signing the report.  This recommendation (not proposal, in carefully worded language by ACAP) was made recently by the Treasury’s Advisory Committee on the Auditing Profession. 

I mentioned to Mr. Ray that, in contrast to lawyers, it’s very difficult to get information about individual partners and their clients from the audit firms.  Unless someone is a frequent public speaker or a frequent author of whitepapers, (in other words an anointed spokesperson for the firm,) you’d be hard pressed to find an email address or proof of employment, let alone a resume or photo.

Photo is not actually Tom Ray. Could not find one that did his preppy, good-boy looks ample justice.  It’s Hank Paulson circa 1973, courtesy of Fortune, via Dealbreaker.com

I wrote him a letter to comment on it. It’s reprinted below.

October 30, 2005
Dear Mr. Sanghera,

Thank you very much for maintaining a cynical tone during your feature on Mr. Welch and the new Mrs. Welch. In my mind, and it is a very personal opinion, Mr. Welch personifies everything that is wrong with US business.

1) While espousing a performance culture, GE instills instead a fear culture. Here in Chicago, you don’t have to throw a stick far in a crowd before you hit a former GE employee with it. There have been so many cuts and so many restructurings, that it seems that almost everyone has worked at one time for a GE sub. I can’t believe all of them were at the bottom 10% of the barrel. I hear more about fear and the forced tracking of employees into performance categories in order to meet the quotas of performance expectations than I do about what a great experience or great company it was to work for.

2) So here’s a guy who starts an affair with a journalist, cheating on his second wife. Not only do they both breach journalistic ethics, but they act proud of it, as if this is a recommended way to find true love. They deserve each other. I am not prude about age differences, but there is a Svengali air about all of it that is sickening.

3) From a business perspective, let me ask the question… Which Fortune 500 company, the biggest proponent of the Six Sigma quality movement, was the least likely company you would have expected to receive an adverse opinion on its internal controls from its external auditors at the end of 2004?

That’s right, GE had such a serious problem in its accounting and finance function, specifically with regard to its accounting for derivative contracts, that it received an adverse opinion on its internal controls and had to restate its earnings for several years.

Is this really a well run company or a well hyped-company? They’ve cut so many times and so deeply that it’s a wonder there’s anyone to do the non-sexy work like administration, HR, accounting, treasury, finance and internal audit.

4) Finally, we’re supposed to feel badly for Mr. Welch because he chose the lifestyle benefits over the cash when preparing for his retirement. After the disclosure of these lifestyle benefits during his messy divorce, he had to give them up and it was too late to go back for the cash. Cry me a river…

“A friend recalled this scene from decades ago: The president of a small Orthodox synagogue in New York had apparently absconded with about $2 million from the congregation, a huge sum in those days. But since he had not yet been formally charged or arrested, he was free to attend Shabbat services. Which he did.

Seeing the alleged scoundrel, another man — a Holocaust survivor — rose and faced his fellow congregants, banged on the bimah table and demanded a judgment from the rabbi before the Torah portion was chanted. “In America, if you are willing to work hard, you can earn a living,” the man said angrily. “You don’t have to steal!”

…there is a gnawing temptation to subject Bernard Madoff to such a ceremony, to publicly point the finger on behalf of the family members, friends, rabbis, business partners, communal leaders and untold numbers of ordinary folk whose lives and good causes have been permanently disrupted by his audacious, unfathomable deceit and say: You didn’t have to steal! You didn’t have to steal from us, your people!…”

What’s worse is that those who should be the guardians of the public trust and watchdogs for those who can not watch for themselves were, in the words of one source today, “…either complicit, incompetent or duped.” None of these conclusions is very appetizing.

From the Jewish Daily Forward again:

“…Any doubt that the proper regulatory function of the federal government was stripped bare and impotent during the Bush administration should now be laid to rest. Even the chairman of the Securities Exchange Commission had to acknowledge that his agency was shamefully asleep at the wheel. Congress, too, must work swiftly to undo the mess it helped create on its sprint to deregulate too many sectors of the economy that clearly cannot be left to guard their own hen houses.”

Within the last forty eight hours or so, at least four lawsuits have been brought against audit firms by clients of so called “feeder funds” that invested in Madoff funds.

From The Financial Times:

Top accounting firms were hoodwinked by Bernard Madoff’s alleged $50bn fraud as well as several leading banks and some of the world’s biggest hedge fund investors, according to lists of service providers to Madoff-linked funds.

PwC, KPMG and Ernst & Young, three of the “big four” accountants, and an arm of BDO International, the fifth largest, were all auditors of the feeder funds which channelled money into accounts at Mr Madoff’s New York brokerage.

The New York Law School became the first Madoff victim to target an accountant this week when it named BDO Seidman in a lawsuit alongside Ezra Merkin and his Ascot Partners fund, which invested almost all its money with Madoff and was audited by BDO.

PwC was auditor of Fairfield Sentry, the $7.3bn feeder fund run by New York-based Fairfield Greenwich; of Kingate Global, a $2.75bn feeder fund run by London’s FIM Advisors; and of Gibraltar-based Reliance Management’s $488m Defender fund.

KPMG audited two of Tremont Group’s Rye Select funds, which had $2.37bn invested with Mr Madoff. Other Tremont funds also invested with Mr Madoff, giving clients of the the New York-based manager a total exposure of $3.3bn, according to people familiar with the situation.

Ernst & Young audited at least four feeder funds. Two of them with $2.5bn are from Herald Asset Management, linked to Vienna’s Bank Medici, which is part-owned by Unicredit of Italy. The other two funds with $870m are managed by Pioneer Alternative Investments, a Unicredit subsidiary.

Fairfield itself is now considering suing PwC…”