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

Section 304 of the Sarbanes-Oxley Act of 2002, which covers clawbacks, is, on its face, a strict liability provision but the SEC has been exercising “prosecutorial discretion” when applying the statute.

The Dodd-Frank Act will expand the population of those potentially liable for clawbacks and the time period used to calculate the paybacks. The new law also drops the prerequisite under Sarbanes-Oxley that there has to be misconduct before paybacks are expected.

I covered this, and other provisions of Dodd-Frank that expand, retract, or revise Sarbanes-Oxley statutes, in a recent OpEd at Boston Review.

John White, a partner with law firm Cravath, Swaine & Moore LLP and a former Director of the SEC’s Division of Corporation Finance, believes the public and the media should focus on Dodd-Frank’s new Section 954 clawback provisions, not the SEC’s enforcement record under Sarbanes-Oxley:

“Dodd-Frank is much broader than SOX 304 and it’s mandatory. All listed companies will have to have clawback policies and enforce them. No misconduct is required — just an accounting error and a restatement. All present and former officers are covered. This could have a big impact and alter how incentive compensation is structured.”

As long as there’s a mismatch between what an executive should have earned under restated financial results and what they got based on errors or fraud, Dodd-Frank says they’re supposed to give back the excess to their companies. If not, the SEC can litigate to force them to return it. Although there is no private cause of action under Section 304 – only the SEC can bring a claim – under Dodd-Frank companies or shareholders could potentially sue a present or former officer to recoup compensation based on employment contracts that stipulate compliance with new mandatory company policies and procedures.

What both the Sarbanes-Oxley Act of 2002 and Dodd-Frank’s clawback provision do require is a restatement. The restatement of financial results to correct material errors – whether those errors occurred by default or by design – is a necessary condition for enforcing both the Sarbanes-Oxley Section 304 provision and the new Dodd-Frank law.

The Sarbanes-Oxley Section 304 law is very specific, according to attorney Stephen Quinlivan of Leonard Street and Deinard:

Morgenson uses the term “clawback” in a broad, non-technical sense to cover any recovery of compensation from a public company’s executives. As written, Sarbanes-Oxley includes only a narrow statutory disgorgement provision. It applies only to a CEO and CFO, and only where there has been “misconduct” that resulted in a “restatement.”

Morgenson doesn’t mention the impact of the Dodd-Frank law on clawbacks in her piece. Her point is: The bark of Sarbanes-Oxley’s clawback provision has been much worse than its bite.

But the Sarbanes-Oxley enforcement numbers are much worse than Morgenson cites. Morgenson supports her argument by citing unattributed statistics. She also incorrectly interprets the Sarbanes-Oxley Section 304 law. As a result, Morgenson credits three cases by name as Sarbanes-Oxley 304 enforcement that are not. She also neglects to mention a key one that is.

It appears Morgenson may have based her numbers on a review of the SEC initial complaints that included a Section 304 allegation, amongst many other allegations, when they started their enforcement journey. If Morgenson took the SEC’s word for what constituted a case and what did not, it’s not surprising that the regulator might have padded grim numbers with cases that are still pending or that, in the end, didn’t meet the strict Section 304 requirements.

That approach overstates the SEC’s efforts and certainly misstates their enforcement effectiveness.

It’s a long road, sometimes years, from complaint to settlement or adjudication. Only a few cases that the SEC filed with Section 304 amongst the litany of allegations have survived all the motions to dismiss and legal maneuvers from both sides. Along the way, the Section 304 allegation is often dropped.

Sometimes it’s pure expediency. The SEC wants to close the case, notch their gun and move on. A negotiated settlement is the fastest and easiest way to get some money back from the executives. Sometimes the facts don’t fit the law’s requirements. That happens when there’s no restatement, a necessary condition for taking credit for a Section 304  – or a Dodd-Frank – clawback enforcement.

Dorsey & Whitney’s Tom Gorman, who authors the blog, SEC Action, sympathizes with Morgenson. It’s not easy to verify the SEC’s record of enforcement of this statute.

The article does make a point. The SEC is inconsistent in how it applies the statute. It does not apply it in every case where it might. Nor does there seem to be any logic to how and when they apply it.

In those cases where the SEC chooses to apply the statute they seem to want the full measure of repayment as written by the statute.

For example, one key case Morgenson does not mention, SEC v. Jenkins, was the first “innocent executive” case brought under Section 304. The complaint admits the CEO was not involved in the wrongful conduct. The SEC sought recovery of bonuses and incentives from Jenkins, the CEO of CSK, but he was not the one who committed the misconduct that caused the restatement. However, the SEC’s Commissioners recently rejected a recommendation from SEC enforcement staff to settle for less than half the amount claimed in Jenkins complaint. The SEC enforcement staff was ready to settle for less than, presumably, the full Section 304 measure of repayment.

In other cases, the SEC realizes, after additional investigation and the passage of time, that the case doesn’t fit the strict requirements of Section 304. Maybe there’s no restatement or maybe misconduct can’t be easily proved. The result is a settlement and a negotiated recovery of some money from the CEO, CFO, maybe a controller, that may or may not be reimbursed to the company – it’s not always clear – and is no longer identified as a Section 304 enforcement.

Morgenson mentions the very first Section 304 case in 2007 but not by name. SEC v. McGuire was settled not litigated and the SEC considers it their first enforcement of the law.

One case that figures prominently in Morgenson’s piece is SEC v. Morrice. The original complaints filed against Morrice the CEO, the company’s CFO, and its controller included Section 304 allegations. Maybe it was hard to resist including this case in the story because it refers to the failure of New Century Financial, the second largest mortgage originator at the time. This failure was one from the “subprime crisis”, which led to the credit crisis in early 2008 and, finally, to the full blown financial crisis that was precipitated by the failure of Lehman Brothers in September of 2008.

But New Century Financial is not a Section 304 clawback case because there was never a restatement of financial results. New Century began to implode after the company announced the necessity of a restatement. But that restatement never happened. The company filed bankruptcy two months later.

Many of the early backdating cases that may be pumping up the statistics Morgenson cites are most likely the SEC’s attempt to “have their cake and eat it too”. The cases may have resulted in some type of financial recovery or disgorgement from CEOs and CFOs. But some, like SEC v. Mercury Interactive, were no longer Section 304 cases when they settled – CFO Abrams voluntarily repaid the stock option proceeds to the company.

Or the Section 304 claim was dismissed because there was no restatement, even if the SEC claimed there should have been one. That’s the point the defendant argued – and won – in SEC v. Shanahan. Or the cases are “administratively closed” pending resolution of criminal charges like SEC v. Brooks. By the time these cases get to the finish line, the SEC can drop the Section 304 claim or the entire civil case altogether.

SEC v Brooks raised another interesting issue that will become even more important under Dodd-Frank’s “clawback” provisions.

Brooks, CEO of DHB Industries, and Schlegal, the CFO, sought indemnification for any Section 304 claims from the company. In their settlement of a shareholder’s derivative suit brought as a result of the fraud, insider trading, and accounting violations at DHB Industries, the company agreed to pay any penalties imposed by the SEC on the CEO and CFO.

A judge told DHB Industries that Section 304 did not allow that.

The SEC’s decision to pursue Section 304 relief is not solely intended to reimburse a company; it also furthers important public purposes. The Section 304 remedy is an enforcement mechanism that ensures the integrity of the financial markets… In sum, companies themselves do not have the authority effectively to exempt persons from § 304 liability.

The new Dodd-Frank “clawback” provisions are “listing standards”. That means the SEC will write rules to comply with the new law but the rules will be enforced by exchanges who must write their own rules. The exchange rules will be used by companies to develop internal policies and procedures that will address reimbursement issues as they arise.

The SEC’s most recent published schedule for Dodd-Frank rule writing says that a proposal on Dodd-Frank Section 954 clawback rules is expected by the end of the year and a final rule to exchanges by the end of the second quarter of 2012. It’s going to be even longer before companies are ready to enforce these provisions. In the meantime, companies and their lawyers are raising significant objections to them.

Dorsey & Whitney’s Gorman would like to see Dodd-Frank Section 954 applied in a manner which encourages corporate executives to strictly adhere to their duty to monitor.

The point in applying the statute should be to encourage executives to prevent wrong doing in the first instance by carefully monitoring and having “best practices” systems.

Ideally, the new Dodd-Frank provisions, and Sarbanes-Oxley Section 304 in the meantime, can and should be enforced more often and more consistently.

My analysis of the Section 304 cases mentioned in Morgenson’s piece and others of note, as of September 15, 2011, is here.

Main page image from this site of Lady Gaga in Alexander McQueen’s lobster claw shoes.

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.

Making the non-obvious connections between the audit firms and their clients, between the clients and each other, and between the firms and each other is like shooting fish in a barrel. As each new story comes out, especially about the banks, the web of connections and the repeated attempts by desperate executives to move the same deck chairs around on the financial system Titanic are becoming easier to spot.

Sometimes I don’t even have to close my eyes to see the last story where the same guy or the same assets or the same scam is mentioned.

Yesterday it was news of the sale of servicing rights to a gazillion dollars of almost worthless mortgages by Bank of America to Fannie Mae.  Why Fannie Mae?  Because they are so good at using their marketing skills to “conduit” bad paper from the very needy to the less needy.  But is the next guy really a sucker or do they know something we don’t?  When was the last time Fannie Mae assisted the system in this way?  And how do we know it was rotten paper crossing from one bad actor to perhaps another on a government-sponsored bridge built of the taxpayers’ aching backs?

And who is standing on the sidelines watching it all with a wink, a nudge, and a “say no more”?

For the answers to these and other questions, you’ll have to read, “Fool Me Twice: Bank of America Plays Hide and Seek Using Fannie Mae.”

Here’s a teaser:

The last time Fannie Mae got involved in shape-shifting servicing rights to hide fraudulent activity was Taylor Bean Whitaker. That‘s the mortgage originator, audited by Deloitte, that used Fannie Mae’s silence and their influence, according to Bloomberg, to market servicing rights on bad loans to GMAC.

How do we know the most recent $73 billion portfolio might be full of loser loans made via potentially fraudulent means? Fannie Mae told us so when they sued Countrywide, the mortgage originator and source of significant woe Bank of America bought in 2008.

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.

I was previously quoted in American Banker on bank balance sheet window-dressing.

My quote focused on disclosures and transparency – for the loans and the reserves for losses. It’s a subject I’ve written about extensively.

Has transparency improved?

Financial Accounting Standards Board rule updates that went into effect last December did require banks to disaggregate their data and to be more specific in their disclosures.

However, the FASB rule updates still leave banks with a lot of discretion as to how they break out their data on receivables such as second-lien loans.

“In general, we are seeing definitely better disclosure and more detailed disclosure,” said Francene McKenna, president of the consultancy McKenna Partners LLC. “However, it looks like they are still to some extent being somewhat a little optimistic on what the future is going to hold,” she said. “There are still missing pieces; you really wish for some kind of consistent disclosure.”

I presented the luncheon keynote speech Friday, April 1st at the AAA mid-year meeting here in Chicago at the Hyatt Regency hotel.

My speech was entitled, “The Future of the Accounting Profession“. I also participated  in a panel discussion on Saturday afternoon, “Defining the Public Interest,” moderated by Professor Patrick Kelly of Providence College.

I’ve reprinted my speech below.

For the panel, I was asked to suggest research topics for accounting and audit academics who are interested in public policy and accounting and audit in the public interest. Get a grant and we can work together!

Here’s my Top X List. For more details get in touch or look around the site for more ideas and starting source material.

Going Concern warnings

• How soon after warning did a Chap 11 filing occur?
• How often do warnings occur outside of annual reporting period? What events precipitate them?
• How many companies survive a going concern warning one year, two years, five years?
• Re the banks – In UK and US, choose the top 20 banks that received bailouts, were nationalized for force acquired at brink of failure. None of them (except Bear Stearns, but it was a retro warning) received going concern warnings the annual reporting period prior to this event, i.e. 2007 and 2008 annual reporting periods. Review criteria for going concern and compare to balance sheets in four last quarterly reports. How many were insolvent or deserving of auditor going concern warnings based GAAS?

Audit firm litigation

• Settlements – examine trend of settlements twenty years (pre-post PSLRA) correlating to largest firms revenues reported, estimated margins. Are firms settling for more because claims are higher or because plaintiffs can squeeze more out of them as firms grew and prospered with lower settlements in lean year?
• Look at the few large cases that went to trial with a judgment against the Accounting firms (BDO-Bankest, PwC Ambassador Insurance). What are factors that cause a firm to go to trial rather than settle since it’s so rare?  Do they always lose at trial? Why?
• What is the magic number for a settlement that would be catastrophic to a Big 4 global firm?  Does it matter if it is in US or abroad – see EY’s legal troubles in Hong Kong  – Some have written it is $1 billion per firm or multiple smaller settlements for less than a billion that come too quickly.
• What is the litigation capacity of the largest four firms based on what we know about settlement patterns, revenues, margins and estimating source of funds and reserves. Look at trend in partner capital contributions, growth of partner numbers, aging population, other sources of capital…

Contingency disclosures and parallel assets – Review disclosures, valuations, reserves

• How often do two public companies in litigation have the same auditor?  Are litigation disclosures similar?  -  Using put-back or repurchase risk and reps and warranties issues as a starter – FHLB vs. BAC and JPM (PwC) , FRE vs JPM or BAC (PwC)
• Same assets on either side of an audit client – PwC and GS vs AIG re: super senior CDS, Repo 105 transaction between Lehman with UBS as counterparty (EY)

SEC sanctions against individual audit partners last ten years.

• Where are they now?  Do they stay at their firm? (DiFazio Delphi Deloitte) Move to another firm after sanction is lifted? (BDO partner) Do something else? Start a hedge fund?
• Are the sanctions issued so late after activity that some are already retired? (Bally’s EY)  What is deterrent effect? Track impact on audit quality of individual partner sanctions and look at a recidivism rate, if applicable.
• What would the impact of a “known and repeat offenders” list be on the profession? Would there be a deterrent effect?  Could easy access to the sanctioned and sued professionals and their location and status help investors?

And here’s the speech I gave on Friday April 1. There were some slides that were displayed at strategic spots.  They can be found here.

Good afternoon.

Thank you so much to Michael Kraten and the program committee for asking me to speak and allowing me the opportunity to participate in this conference. It’s enormously rewarding to me to be here amongst accounting educators with an interest in their public duty and the profession’s activities in the public interest.

My mother always thought I would be a teacher. That’s also a very noble profession. So it’s an honor to be here sharing my thoughts with a group of professional educators in my chosen field. Because as much as I am now a writer and speaker, I am still an accountant and I consider myself a professional.

I’ve worked a lot of different places over the years and I’m no different than you or your students in finding the world we live in a constant professional challenge.

I think your students will face more than one ethical dilemma during the first year of their career at a large public accounting firm or other work environment. In a public accounting firm, which is my focus, the landmines are everywhere.

They may have to decide whether to check a box for a test or review that wasn’t done. They may be asked to create or backdate a workpaper to complete a file before a quality review or PCAOB inspection. They may be pressured to falsify their timesheet to stay under budget for their part of the engagement.

Some will make the right decision and some will go along to get along. This is self-interest and career survival. These are the pressures that chip away, day after day, at their self-esteem as professionals and their ethical resolve.

I graduated in 1984 with a degree in Accounting from Purdue University.

1. My first nine post-graduate years were spent, first, as an internal auditor and financial analyst at the first “too big to fail” bank, Continental Illinois National Bank and Trust of Chicago. Then I worked as a financial reporting manager, G/L manager and Controller in two different B2B industrial distribution companies.

Some of my best “truth is stranger than fiction” stories are from those years and it was during this period that I passed the CPA exam.

2.  The next eight years I spent with KPMG Consulting, JP Morgan, and then returned to BearingPoint as a consultant. The last half of this period was spent 100% in Latin America.

3.  The post 9/11 years, until recently, were spent at two firms, Jefferson Wells, part of Manpower, as a Regional VP for the Midwest including Toronto, and at PwC, auditing the firm itself.

4.  I’ve been on my own now since October 2006, writing re: The Auditors, writing the column at Forbes and writing for others such as Accountancy Age in the UK.

I’ve now embraced another profession – journalism – that has its own list of ethical standards for writers that want to be taken seriously. But journalism is a profession with a voluntary set of standards and code of ethics, not the legally required ones we have to adhere to.

So, what are the standards accounting professionals must acknowledge and adhere to?

First, let’s differentiate between an “accounting professional” and the accounting or audit industry where many professionals practice.

Those of you who are CPAs and teach rather than work in industry can attest that I’m talking about two different things. Accounting professionals work in industry, government, politics, journalism, academia, and other vocations other than a public accounting firm.

What does it mean to be an “accounting professional”?

[Slide1]

That’s it.  If you work in client service, if you are a CPA, your first obligation as a professional is to your client – not your firm, your partners, or even your family. If your client is doing something illegal, then your obligation shifts to society and to law enforcement. That may seem harsh, but it’s the code that’s supposed to insure that lawyers and accountants, for example don’t cut corners out of their own self-interest and to the detriment of their client’s interests.

Many of you, as accounting educators, send a large number of your graduates, especially your best and brightest to work for public accounting firms.

In the United States, certified public accountants are the only authorized non-governmental type of external auditors who may perform audits of financial statements and provide reports of those audits for public review, submission to the SEC, and to comply with exchange listing standards. In the United States, the firms and their state-certified, licensed professionals are also required to be independent of the entities being audited.

Public accounting is an industry that employs many accounting professionals, as well as lawyers and other professionals. Each group has its own set of standards and a code of ethics. As a regulated industry, all employees of public accounting firms have an obligation to behave within laws and standards governing that industry that are intended to protect investors and serve the public’s interest.

Look at the four largest global public accounting firms. They officially operate as a loose confederation of separate private partnerships for legal reasons and to insure secrecy, but their size and complexity makes them look more like corporations to the outsider. They manage by consensus, but in reality a limited number of partners lead the firm and make decisions on behalf of thousands of “partners” who are more like highly paid executives.

The top four firms generate more than $100 billion in total revenues globally and employ more than 600 thousand people. As auditors and advisors, they work inside the banks, brokerage firms, auto manufacturers, mortgage brokers, and homebuilders. They’re “in the know” about every public company and most large private companies, earning millions of dollars in fees, for audit opinions that, in my opinion, have ultimately proved worthless when it comes to the big financial institutions. Auditors were right there standing by in the boardrooms when the US government took over Fannie Mae, Freddie Mac, Citigroup, and AIG.

They are still at standing executives’ right hands, and also earning more fees helping the US federal government under TARP to organize and control the taxpayers’ new investments in subprime loans, non-liquid assets, and exotic financial instruments. The public accounting firms make money whether companies thrive or whether they fail. The Big 4 firms are now charging billions to advise each other’s clients as those companies file for bankruptcy protection.

Once your students go to work for the firms, they’ll be forced by the reality of auditor litigation, risk, independence, and quality policies, and seeing their firm’s name in the paper more often to think about some serious industry issues:

• Should auditors be immune from liability or accountability for their malpractice and when they’re guilty of aiding and abetting fraud?
• Does the “too few to fail” argument have merit?
• Is it realistic for us to expect auditors to acknowledge a public duty?
• Do audit firms have a right to look after their partners and their profits before the public?
• Do accountants working in for-profit private audit firms feel like professionals?
• Can large audit firms maintain ethical standards, as a firm and as a group of individuals?
• Whose ethical standards should the firm and the individual uphold?
• Does an individual who would otherwise be ethical or at least true to his own values, become compromised once he works for a larger firm?

I believe that a very good discussion of this challenge (larger firms becoming immoral or amoral) is taught in the seminar, “Leading Professional Services Firms, ” in Harvard Business School’s Executive Education program.

[Slide 2]

You can agree or disagree whether these ideals work when serving multi-billion dollar multinationals to produce the current audit report product. When a professional services firm strays from these principles, it runs the risk of sacrificing values, culture, a code of ethics and the requirement to put the client’s interests above theirs that is inherent in being a firm made up of  “professionals”.

A corporate structure, for example, means a professional services firm has to focus on financial results and meeting shareholder expectations rather than meeting partner expectations within the constraints of the values, expertise and professional code of ethics that the firm agreed on when it came together.

Some interesting examples of corporate model professional services firms with varying levels of success are:

• BearingPoint, a spin-off of KPMG,
• Accenture, Huron Consulting, and Protiviti all have an Arthur Andersen pedigree, and
• Resources Global, a spinoff of Deloitte.

Growing too large or acquiring firms that have very different values or culture, even within the partnership model, can also stretch the limits of aligned behavior.

One case that will have a significant effect on how employees of the audit firms view themselves and how the firms view their contribution is the class action in California, Campbell v Pricewaterhouse, a lawsuit about overtime.

Several overtime lawsuits are pending against some of the major accounting firms doing business in California. These suits were filed by non-CPAs, non-licensed associates (entry level college graduates), who believe they were misclassified under California law as exempt professionals and are due overtime and other benefits due to non-exempt employees.

I have mixed feelings about these lawsuits. In twenty-five years of working as an accountant, consultant and internal auditor, I have never been paid time and a half. When you choose to work in a profession, you don’t expect it. My father belongs to three unions and has pensions and generous health benefits in retirement as a result. When I was growing up, as the oldest of six on the South Side of Chicago, his overtime pay as a fireman and bricklayer was what made extras like vacations and college possible. But it was the dream of an easier life for their kids – higher pay for less labor because they had worked long and hard to educate all of us – that drove my parents to give us the chance for a “professional” career.

Many college graduates, these days, don’t see the point in working eighty hours a week during the busy tax or audit season for a fixed salary. When they calculate their hourly rate, even given the fairly generous salaries, signing bonuses, and benefits the best and brightest get as new Audit Associates, many question the total cost of the sacrifices they’re making.

All they see are strained relationships with family and friends, excessive stressful travel, late nights spent performing mind-numbing “monkey work” on laptops, non-stop scanning and photocopying, fewer partners and opportunities for promotion, and very little use of the ambition and brains they thought they were hired for.

It’s no wonder that with the increase in layoffs and cutbacks at the audit firms during the general economic slowdown, when Sarbanes-Oxley work slowed and the financial crisis hit, accountants starting careers in the new millennium have to squint to see the light at the end of the tunnel.

A few states like California, Wisconsin, and Massachusetts – and Canada where similar suits were settled with very little notice here – have wage and hour laws that are perceived as more employee-friendly. Some believe the audit firms are breaking the law in many states by treating non-licensed, non-supervisory, staff as “exempt” from overtime.

The suits are all in various stages but Campbell v. PricewaterhouseCoopers is the fastest moving. On March 11, 2009 a lower court in California court granted plaintiffs’ motion for summary adjudication on the issue of exemption. The judge agreed that the audit associates at PwC in California are not exempt from overtime pay under the 2001 wage order.

But the court noted that the determination regarding exemption is one involving a controlling question of law, that there is substantial ground for difference of opinion, and that an immediate appeal from the order will materially advance the ultimate termination of the litigation. Therefore, Judge Karlton certified the matter for interlocutory appeal pursuant to 28 U.S.C. § 1292.

What all this legalese means is that the plaintiffs and their law firm are winning so far. The Ninth Circuit Court of Appeals accepted the appeal and Campbell will finally be argued today before the 9th Circuit Court of Appeals. The oral arguments will produce a ruling either affirming or reversing the lower court decision. That means either the audit associates will finally win or the issue will go to trial.

The judge, when concluding that “unlicensed accounting assistants do not fall under the learned professional exemption”, made this observation:

The court would be less than frank not to recognize the difficulties this interpretation tenders for some of the employees identified in PwC’s brief. They are not before this court and thus no opinion concerning them need be reached. I note in passing, without intending to suggest resolution of other issues, that at least arguably the work engaged in by the class members is more like the work of paralegals than law clerks.

Does the requirement of a Masters in Accountancy in order to reach the 150-hour CPA licensing requirement in some states negate my assumption of a graduate degree as a sufficient, if not a necessary, condition to be considered a “professional” without a license?

Will universities that provide their states’ CPA hour requirements without the necessity of a graduate degree doom their graduates to status as “para-accountants” until licensing?

There’s an economic argument at play here: In this environment more work produced for less pay is both tolerated by labor and a business model that rewards firms with higher profitability. But there’s also a practical regulatory issue at stake: Can the regulators allow audit firms – who play a role as critical regulatory cogs in the financial system wheel – to delegate more judgment and decision making over financial reporting and disclosure to the lowest level of staff because they are the per-hour cheapest?

If you’ve watched any medical-themed TV show, you know what lack of sleep, overwork, crappy food, and low pay means for emergency room health care delivery. You may also be able to afford the sweatshop approach to media. But can your 401k afford “slave labor” when the product of using the lowest cost labor input is fraud and failure?

Individual assimilation and success in a Big 4 public accounting firm starts with selection based on university credentials, referrals from professors, family background, and business ties, as well as having political beliefs and economic philosophies that are aligned with firm values. This process now starts in some universities in freshman year, with some students having two or three internships before they graduate.  For some students it starts even earlier.  One or both parents work for the audit firms and the career is one that has always been considered a safe choice. That’s especially true if the apple doesn’t fall far from the tree in talents and personality.

Auditors often marry other auditors or accountants because in school or in their early career they have no time to date anyone else! How many of you married an accountant?

Internal operations of the public accounting firms, especially the largest ones, are conducted in a secretive manner. Financial results and common business metrics are minimally disclosed to the outside and on a “need to know” basis even internally. Once initiated into firm culture, survival requires adoption of an informal oath of allegiance that makes it shameful to betray even one’s deadliest enemy, your competitors, to legal and regulatory authorities. It’s a Big 4 type of omertà, the extreme form of loyalty and solidarity in the face of authority usually attributed to the Mafia.

Examples of an extreme sense of loyalty to even those who’ve disgraced the profession can be found when partners that have been sanctioned by the SEC, forbidden to audit public companies, are later reinstated. Deloitte, for example, kept the partners responsible for Delphi and Navistar on their payroll during their SEC suspension and they survived the sanction to audit more public companies.

Only in cases of potential criminal indictment, such as insider trading or the tax shelter scandals are individuals thrown under the bus by their firms. That’s because the financial and reputational risk to the firms of not cooperating with a Department of Justice criminal indictment is more significant than the cost of defending and typically settling private securities litigation.

Private parties have significant difficulty getting suits against audit firms past the complaint stage to discovery and a trial given the higher requirements for pleading particularity based on the Private Securities Litigation Reform Act of 1995. Particularity means that investors basically have to present, at the pleading stage, hard evidence such as whistleblowers or leaked documents proving complicity in a fraud or deliberate fraudulent behavior on the part of auditors, not just implied auditor fraudulent behavior. Third-party aiding and abetting allegations are not allowed to be made by anyone but the SEC.

In addition, the federal authorities are fiercely reluctant to be the instrument of destruction of another firm a la Arthur Anderson via a criminal indictment or a significant SEC civil complaint. That means the auditors have as much moral hazard now under the “too few to fail” doctrine as the banks have under “too big to fail”.

However, that doesn’t mean the audit firms aren’t faced with an enormous amount of litigation they spend significant time and money fighting.

[Slide 3]

And we haven’t even gotten started with holding them accountable for their role in the financial crisis.

[Slide 4]

[Slide 5]

It’s not easy for an individual external auditor to step up and do the right thing. The model of providing audits, a critical public service meant to protect shareholders via a profit making private partnership, often encourages “behavior that must be regulated”.

The Sarbanes-Oxley Act of 2002 established the PCAOB to replace industry self-regulation after Enron because the public perceived that peer review and self-regulation for auditors of public companies had failed.

Many accounting professionals who work for the audit firms write me in earnest for advice.  One of the more common sources of confusion is about their “true client.” They do not know who their real client is. They have either never been taught this concept or had it beaten out of them by the reality of which behavior is rewarded at their firms.

The client for audited financial statements is the shareholder, not the company management. The Audit Committee of the Board of Directors, who hires and is supposed to manage the external auditor, represents that shareholder client but has a legal duty to the corporation not the shareholder. Other stakeholders include bondholders, lenders, employees, vendors/customers who depend on the continued viability of the company, and regulators (whose role is to protect investors and overall capitalist system.)

When professionals forget or suppress acknowledgement of their true client, an auditor loses the ability to properly structure decisions with moral and ethical implications, let alone those with serious legal and regulatory ones.  In the face of potential legal implications of a decision, they seek advice from their own counsel in order to avoid liability.  In the face of a moral or ethical dilemma, they look at costs/benefits of looking out for the shareholder versus looking out for their own financial self-interest, at an individual and at a firm level.

This is not just my polyanna-ish opinion.

New PCAOB board member Lew Ferguson spoke at an open meeting of the PCAOB last week and explained the disconnect:

[Slide 6]

What’s also remained the same over forty years is the auditor’s attitude towards investors. Except for a brief period of mutual antagonism after the passage of the Sarbanes-Oxley Act in 2002, auditors behave more than ever as if company management – typically the CFO – is the client with the Audit Committee, rather than investors, now a priority in their “relationship management” activities.

Major investors told the PCAOB that they feel they’ve been left out.

It’s clear to me that auditors demonstrated a profound lack of professional skepticism and professionalism during the crisis. They ignored the possible motives and motivations of their audit subjects.

Rather that assuming management, and possibly the Board of Directors, is self-centered and human, they accorded them the highest form of deference. In the interest of maintaining financial and social relationships, the auditors did not sufficiently challenge and expose survival instincts and financial incentives on behalf of shareholders and the public.

[Slide 7]

Human beings, however noble, virtuous, and full of integrity in words often fall short in action. We only have to look at the cases of whistleblowers I’ve written about to see how hard it is to step up.

Whistleblowers and those that push unpopular ideas or try to report on wrongdoing often lose their jobs, are vilified by the former employers and sometimes their former colleagues, are often disbelieved and laughed at, attributed with bad attributes and intentions such as revenge, anger, payback, whining, mercenary goals, bitterness, spite, Don Quixote-like tilting at windmills, unreasonable idealism, and impractical expectations.

Whistleblowers are often very right, but often end up being right all alone.

How many times has an external or internal auditor been told when raising concerns or questions about lack of segregation of duties, improper expense reports, lack of proper authorizations for stock options or shady compensation decisions:

“He’s a man of integrity.  He lives this company. He is a pillar of the community.  He donates to charity. He is an elder statesman of the industry. He has unquestionable, unassailable ethics and cares about this company.”

And maybe they are also told, “How dare you suggest that he would ever do anything to harm his employees, shareholders, business partners…”

Faced with the challenge of questioning someone who everyone else thinks is an icon and may not be, most people back down, question themselves, wonder if they’ve read, seen, or heard what they thought they had. Pressured by the cost of moving forward with potentially imperfect evidence, or with an accusation that shakes the foundations of belief and trust, most “professionals” trust their boss, the lawyers, the advisors, and drop it.

And then there’s the money. Raising difficult issues potentially threatens lucrative business relationships, big deals, or an important promotion. Speaking up can be a career- limiting move, threatening your own livelihood in addition to the success of your office, your practice, and your firm.

But auditors, who are inevitably almost always CPAs, have a higher responsibility. Making the type-two error of being right in your suspicions of illegal activity and potentially enormous harm or loss and not acting on them is completely unacceptable.

Don’t let anyone ever tell you again, after Madoff and the rest of the cases of hubris we have seen during this ignominious year, that any man or woman is above suspicion.

When you’re told, “He’s an icon,” as a professional you should look even harder, be professionally skeptical, trust your own instincts and judgment as long as they have been educated and are competent and objective.

Please teach your students the principle of professional skepticism.

[Slide 8]

[Slide 9]

PCAOB Chairman Jim Doty explained this principle at that same open board meeting last Wednesday:

[Slide 10]

When public accounting firms behave unprofessionally – break laws and compromise standards – the audit industry damages the accounting profession.

The future of the accounting profession is, for better or worse, in the hands of the audit industry.

Mark O’Connor, CEO of Monadnock Research, put together a research note for his subscribers that gives us the details of the accusations. He also provides new insight into why a guy like Gupta may have committed these alleged crimes.

Gupta is alleged to have tipped Galleon’s Rajaratnam, a friend and business associate, providing him with confidential information learned during board calls and in other aspects of his duties on the Goldman and P&G boards. Gupta reportedly made calls to Rajaratnam “within seconds” of leaving board sessions where market-moving information was discussed.

The complaint alleges that Rajaratnam then either used the inside information on Goldman and P&G to execute trades on behalf of some of Galleon’s hedge funds, or shared it with others at Galleon, who then traded on it ahead of public disclosure. The SEC claims the insider trading scheme generated more than $18 million in a combination of illicit profits and loss avoidance.

The SEC also says that Gupta was, at the time of the alleged disclosures of confidential non-public information, a direct or indirect investor in at least some of Galleon’s hedge funds, and had other business interests with Rajaratnam.

Gupta, as a McKinsey veteran, embodied the “trusted advisor” consulting ethos and personified the McKinsey “advisor to CEOs” business strategy and brand. The firm’s value to its clients and its effectiveness as an advisor requires knowing their secrets and holding them close to the vest.

Gupta was McKinsey & Company’s worldwide Managing Director for 9 years from 1994 through 2003…Gupta, now 62, stepped down as a McKinsey partner in 2007, and has since served as Managing Director Emeritus, according to his profile at the Indian School of Business (ISB). Gupta was instrumental in co-founding ISB in 2001, and continues to serve as its current Governing Board Chairman and Executive Board Chairman. He is also a current or former board member (or trustee) of AMR Corp., the parent of American Airlines; the Rockefeller Foundation; the University of Chicago; Harman International Industries; Genpact India; the World Economic Forum; the International Chamber of Commerce, World Business Organization; New Silk Route and New Silk Route Private Equity; and the Emergency Management and Research Institute. Galleon’s Rajaratnam was also associated with the New Silk Route ventures, where Gupta continues as Chairman. Rajaratnam is no longer associated with those entities.

Several media commentators have openly wondered whether the accusations against Gupta, and earlier accusations in the same scandal against McKinsey senior partner and Gupta protégé Anil Kumar, strike a deadly blow to McKinsey.

Will Rajat Gupta Destroy McKinsey? John Carney, NetNet, March 2, 2011

McKinsey’s clients are attracted by its reputation for excellence and discretion—and its stellar network of alumni. Its consultants often refuse to even disclose who their clients are.

If the charges against Gupta prove true, it could be a mortal threat to the firm. Even if there’s no evidence that confidentiality was breached while Gupta was at the firm, being led by a man who would later leak insider information would be devastating. If Gupta is shown to have engaged in similar actions while he was at McKinsey, that could be the end for the Firm.

“At that point, I think we go the way of Arthur Andersen,” another former McKinsey consultant said, referring to the once-prestigious accounting company brought down by its connections to Enron.

Loose Lips, Reuters BreakingViews, Robert Cyran and Rob Cox, March 3, 2011

McKinsey’s reputation rests on its ability to keep secrets. Consultancies, unlike investment banks, don’t provide access to financial markets.  All they offer is counsel, which relies partly on confidences revealed by their clients. According to McKinsey, “Our clients should never doubt that we will treat any information they give us with absolute discretion.” The allegations against Gupta make it hard for clients not to wonder.

It’s understandable that, in the heat of this moment, some might naïvely compare the consequences of the criminal indictment of an audit firm with civil charges against an individual, albeit one who trades on – pun intended – his association with a prestigious professional services firm.

It’s not the same thing.

Extrapolating Gupta’s behavior to McKinsey as a whole is a stretch. I’m no McKinsey apologist but one man, even a former Global Managing Director, does not make this firm.

On the contrary. The firm made him and he’s the one whose currency is now worth less.

Let’s look at a few similar examples from the world of the Big 4 audit firms. The accounting firms are actually regulated and they’re still around in spite of inside traders inside of them, trading on their client confidences more than once.

A Deloitte active-duty Vice Chairman, Thomas Flanagan, was accused and settled with the SEC this past summer over insider trading charges related to several Fortune 500 companies. Auditors have a public duty to shareholders and a legal obligation under federal securities laws to maintain engagement confidentiality, in addition to their contractual obligation to do so.  Directors have a duty only to the corporation. And yet, the Flanagan story captured only momentary media attention and no one claimed Deloitte was going down as a result. In fact, the SEC never even charged Deloitte. It was somehow acceptable to the regulator when the firm said they had been duped by their own senior leader.

Closer to the kind of work McKinsey’s Gupta did for clients, we have another senior Deloitte partner accused of insider trading, Arnold McClellan. He advised private equity firms about the tax implications of proposed acquisitions. The level of trust  – and consequences of a betrayal of that trust  – in M&A advisory is akin to the level of trust expected of a company director. Interestingly, the two cases have a company in common – Kronos.

The McClellan case is pending but, in spite of being the second one for Deloitte in such a short time and with allegations of tipping others for profit that covered the same time period as the Flanagan case, Deloitte is still kicking consulting ass and taking names, including for the federal government.

And finally, but certainly not meant to complete an all inclusive list of auditors accused of betraying client confidences in service to insider trading, we have the poor Ernst and Young Tax partner James Gansman. He was lured by the bad, bad internets into a debauched life of inside trading and an illicit love triangle.

In the fall of 2004, a forty-something investment banker named Donna Murdoch logged into Ashley Madison, the discreet dating website married people visit “when divorce is not an option,” and introduced herself to James Gansman, a partner at Ernst & Young in New York. The two struck up a relationship, meeting occasionally in hotels in Philly, New York, and California, and talking on the phone about their lives: James told Donna about how he was kicking ass at work, Donna told James about how she was struggling with her subprime mortgage.

Eventually the two settled into a comfortable day-to-day routine in their respective offices in New York and Philadelphia, staring at the same Yahoo Finance screen.

{…}

Eventually, their conversations about business grew more specific.

Mr. Gansman led Ms. Murdoch in a guessing game about which deals he was working on, she said. “The game was that I wouldn’t be looking and he would give me hints: The market cap of two billion or market cap of 400 billion, and here’s what they do, and he’d read it to me, and ultimately make sure I guessed,” Ms. Murdoch testified. Before long, the guessing game fell away. Mr. Gansman told her more directly about upcoming deals of Ernst clients, she said.

She made $400, 000 off the deal, and the SEC noticed. He made nothing, and now he’s going to jail. The end.

Ernst & Young survived the embarrassment of one of their partners being an inside trader. Even worse, the firm was mentioned in the same news stories as swinger cheater site AshleyMadison.com. Ernst & Young is still working for the federal government and several Fortune 500 clients as an auditor in spite of also being accused of complicity in the failure of Lehman Brothers.

You may wonder why Gupta, a rich and successful businessman, would risk everything to pass inside information to friends. He didn’t need the money. We have not seen any evidence he profited personally from the trades, unless Galleon’s Rajaratnam sent profits to him indirectly through other business interests in India, for example. Monadnock Research’s O’Connor gives us a clue into the gargantuan ego and pure pathology which might help someone like Gupta rationalize the behavior of which he is accused.

Just after starting his third term as McKinsey’s Managing Director in May 2001, Gupta did an interview with Wharton Professor Jitendra Singh for the Academy of Management Executive. [i] The interview was wide-ranging and retrospective on the subject of Gupta’s contributions to McKinsey since his appointment as its leader in 1994, with a special emphasis on his contributions toward policies, processes and systems to support enterprise knowledge innovation at McKinsey.

Monadnock Research co-founder, Mark O’Connor, interviewed Brook Manville, McKinsey’s Chief Knowledge Officer, four years into Gupta’s terms and featured many of the firm’s innovative efforts in his Yankee Group report, Knowledge Management: People and the Process.

Gupta closed the 2001 interview with the following quote, when addressing the question of what advice he would give to young men and women just starting their business and public service careers.

Gupta: “Oftentimes many of us get tied up in what is good for our careers, how to get ahead, what’s the best career to pick. More important is, I think, to develop as a professional, to have a learning mindset, to always learn from every experience and to become a richer human being. If you concentrate on that, then career success automatically follows. If you make career success an over-arching objective, you’ll not become a full human being, a rich human being, a great professional, or a great leader.

The second piece of advice I’d give is that I think it is vitally important to make other people successful. If you have a mindset of always trying to make other people successful, they will in turn make you more successful that you ever dreamed-of. So, I really believe that it’s not about getting ahead at the expense of others, it is getting ahead because lots and lots of people are helping you achieve it.

Singh: “Perhaps together with others.”

Gupta: “Yes. The last thing I’d say is that you have to have a set of values and principles that you really believe in that is your moral compass. Avoid the temptations of doing the politically right things, because the person you have to live with the most in your life is yourself. You have to always be true to your own set of values and principles, even though there may be temporary costs to that.”

McKinsey had that interview posted on its Web site at the time of this writing. Certainly there are many interpretations of Gupta’s words in this passage. The irony of it in support of the SEC’s allegations will almost certainly not be lost on government prosecutors.

What hangs in the balance, beyond the obvious allegations, is what Gupta truly meant philosophically with his advice to our next generation of business and government leaders. The best and worst examples of ethics are evident in his words. Clearly no reader of this interview would have had any question of its meaning in 2001. But there is a clear foundation for questioning it today.

Statement of Gary Naftalis, Counsel for Rajat Gupta

These allegations first made by the SEC are totally baseless. Mr. Gupta’s 40-year record of ethical conduct, integrity, and commitment to guarding his clients’ confidences is beyond reproach. Mr. Gupta has done nothing wrong and is confident that these unfounded allegations will be rejected by any fair and impartial fact finder.  There is no allegation that Mr. Gupta traded in any of these securities or shared in any profits as part of any quid pro quo. In fact, Mr. Gupta had lost his entire $10 million investment in the GB Voyager Fund managed by Rajaratnam at the time of these events, negating any motive to deviate from a lifetime of honesty and integrity.

Main page art is from Damien Hirst’s Sotheby’s sale, “Beautiful Inside My Mind Forever” described here.

This article was originally published at GoingConcern.com on March 3, 2010.

Most don’t wear stilettos, although Cynthia Cooper is fairly attractive for a blond. Harry Markopolos, the Madoff “hero” whose new book is out is being called a whistleblower. I do not see him really warming up to that label or really warming up at all. He did admit that, early on, he was partially motivated in his quest to get the SEC to listen to his theories about Madoff’s fraud by the potential for whistleblower rewards.

From The Boston Globe in January 2009: Markopolos allows that at times he was motivated partly by the opportunity to receive a bounty that the government pays to whistleblowers in successful prosecutions, if the fraud falls within certain categories – the front running issue, for example… Over time, Markopolos concluded that he wasn’t likely to get a whistleblower payment, but he continued nonetheless, spurred on by the pure intellectual challenge of cracking a Wall Street legend…

Now Markopolos works to seek out other whistleblowers and shares in the bounty if they successfully file claims.

From a recent Fortune interview:

You were a whistleblower and you work with them now. What is the profile of the whistleblower’s personality? If you don’t have a strong belief system, you’re not going to be a whistleblower. You have to be crazy-brave. The risks are all weighted to the downside.

Crazy-brave? Yes. You cannot have self-doubt. You just have to go forward and say I believe in this country. I believe in these core values. I know if I get outed and get caught, I’ve committed economic suicide for myself and my family. I’m going to be on the industry blacklist.

Markopolos reminds me of many internal auditors I have known over the years. Many are introverted, not comfortable with the spotlight, anal-retentive but with a pit-bull, black-and-white, judgmental sense of right and wrong. It’s what it takes to do the job.

One of the biggest challenges for the internal audit profession after Sarbanes-Oxley was passed was to live up to the enormous expectations. Internal audit functions were mandated. Controls were front and center. I expected Internal Audit to gain more prominence as Chief Audit Executives began reporting directly to the Audit Committee and started making their own Board presentations instead of hiding behind the CFO.

Unfortunately, as my friend Chuck Eldridge from Korn Ferry told me back in 2003, very few internal auditors at the time were prepared to be “outside guys” instead of inside guys. In fact, it should be suspect if the internal auditor is too cozy with senior executives. We’ve seen internal audit come back again full circle to having to justify their existence via consulting and cost-savings initiatives.

It is hard out there for the internal auditors, external auditors, and accounting professionals, who want to expose fraud and illegalities and still live to work another day. Markopolos said he feared for his life. I know I’ve been more wary about my own safety since November. Cynthia Cooper of WorldCom fame received death threats.

“For me, this has been the most difficult thing I have gone through in my lifetime…There were times when I was scared to death,” Cooper told the audience, adding that she had to dig down to find her courage and push forward.

Few are prepared for the consequences or realize fully how bad they can be. Ideally you are either independently wealthy or so poor that you have nothing to lose. Sticks and stones can’t hurt you.

I know one real-life whistleblower personally. He’s actually a former Chief Audit Executive who is more of an outside guy than usual. He was always active in professional associations like the IIA, was comfortable presenting to outside counsel and the Board of Directors and has the chops to deal with tough issues. When asked to look the other way in a job that was supposed to be a repair and renewal assignment rather than all CYA, he balked. He’s currently working as the CFO of a startup while pursuing his claims.

Section 404 was adopted with little controversy in 2002, and for good reason. It simply mandated that public companies report on the effectiveness of their internal financial controls, and that auditors render an opinion on them.

Since the law already required companies to maintain effective controls — and had done so since 1977 — it seemed unlikely that would increase costs much for any company that was already in compliance. And it was crystal clear that controls either did not exist, or were evaded, at WorldCom and Enron.