First SEC enforcement actions for violations of auditor independence rules resulting from personal relationships

by Cydney Posner

In two orders made public today, the SEC announced settled charges against EY and individual EY auditors (and officers involved at the subject companies) with regard to alleged violations of the auditor independence rules as a result of “close personal relationships” with officers at audit clients.  According to the press release,  these “are the first SEC enforcement actions for auditor independence failures due to close personal relationships between auditors and client personnel.” EY and the other auditors charged consented to the SEC’s order without admitting or denying the findings and paid penalties, as did the officers involved at the audit clients. EY was also censured, and the individual auditors (as well as the CAO of one of the issuers) were suspended from practice before the SEC.  These cases are of interest to issuers as well as auditors because the auditors’ (and the officers’) violations caused the companies involved to violate Section 13(a) of the Exchange Act and Rule 13a-1, which require public companies to file Forms 10-K with financial statements that have been audited by independent accountants.

Rule 2-01(c) provides a non-exclusive list of specific relationships that cause an accountant to lose his or her independence. Rule 2-01(b), however, provides a more “general standard” for auditor independence, which applies to all auditors even if their conduct does not fall within one of the specific prohibitions in Rule 2-01(c). Under the general standard, an accountant is not “independent” with respect to an audit client “if the accountant is not, or a reasonable investor with knowledge of all relevant facts and circumstances would conclude that the accountant is not, capable of exercising objective and impartial judgment on all issues encompassed within the accountant’s engagement. In determining whether an accountant is independent, the Commission will consider all relevant circumstances, including all relationships between the accountant and the audit client and not just those relating to reports filed with the Commission.” (Emphasis added in the order.)

The SEC’s Director of Enforcement charged that EY “did not do enough to detect or prevent these partners from getting too close to their clients and compromising their roles as independent auditors.” For example, while the independence certifications required of members of the engagement team “specifically asked about possible employment relationships that could impair EY’s independence, they did not specifically ask about possible close personal relationships between that Engagement Team member and any employees at the Issuer who were in accounting or financial reporting oversight roles.” The absence of independence in these cases of individual audit partners could be attributed to EY.

One of the cases involved a romantic relationship between the company’s chief accounting officer and an audit partner on the engagement team. The original coordinating partner was “aware of facts suggesting a possible romantic relationship [and] should have identified those facts as red flags but did not. He failed to perform a reasonable inquiry regarding the extent of the relationship… or to raise concerns internally to EY’s U.S. Independence group.”  Meanwhile, EY continued to represent that it was independent in audit reports. The relationship was finally uncovered when a VP of the company made an internal whistleblower complaint regarding a possible inappropriate relationship. The SEC concluded that a “reasonable investor with knowledge of all relevant facts and circumstances concerning [the EY partner’s] personal relationship with [the CAO] would conclude that [the EY partner] was not capable of exercising objective and impartial judgment with respect to the audits of the Issuer. The Commission has made clear that auditor independence is always an area requiring heightened scrutiny.”

Although less sensational, the more interesting order  — from a legal standpoint anyway  — also involves a “close personal relationship,” but one that appears to be a bit more woolly because, with some exceptions, the conduct at issue was problematic largely because of the scale of it. Although it’s surely not uncommon for partners at audit firms to engage in some of the activities  described — providing tickets to sporting events, for example — the difficult and somewhat subjective issue here is determining in the future at what point the line has been crossed.

According to the order, the CFO of the issuer had previously expressed dissatisfaction with certain aspects of EY’s performance and had threatened to change audit firms. As a result, the audit partner who is a subject of this order was enlisted by EY to serve as the coordinating partner on a replacement audit team for a “troubled account”; he understood that “his responsibilities as coordinating partner would include ‘developing’ and ‘mending’ EY’s relationship with the Issuer.”

The order goes into substantial detail, but in summary, the allegations in the order suggest that the coordinating partner may have taken his remedial “responsibilities” too far: the SEC alleges that the coordinating partner repeatedly violated EY policies “by developing and maintaining a close personal relationship with the CFO and members of the CFO’s family that was inappropriate for an independent auditor. [He] spent extensive leisure time, including frequent overnight, out-of-town trips, with the CFO and his family. In all, [he] and the CFO took at least seven out-of-town trips together during the relevant period, all of which were social in nature and did not have a valid business purpose, as that phrase was defined in EY’s independence and hospitality and gifts policies. In addition to these trips, [he] and the CFO attended sporting events and socialized near the Issuer’s headquarters in the greater New York City area to an excessive degree. [He] also gifted tickets to sporting events and other things of value to the CFO.” He also had a “close personal friendship” with the CFO, who shared with the coordinating partner “personal information, including sensitive health information and other information not typically shared with a solely professional colleague….”  According to the order, the coordinating partner incurred approximately $109,000 in entertainment-related expenses in connection with the audits of three fiscal years of the issuer. Again, the SEC concluded that a “reasonable investor with knowledge of all relevant facts and circumstances” regarding the relationship between the issuer’s CFO and the coordinating partner would conclude that the partner “was not capable of exercising objective and impartial judgment with respect to the audits of the Issuer.”

During the period, EY’s internal policies “required all activities with clients to have a ‘valid business purpose requiring an expectation that meaningful business discussions or activity will take place.’ The policies forbade certain EY employees [and partners] from giving gifts or ‘hospitality’ to audit clients, or receiving gifts or ‘hospitality’ from clients, ‘that are not commensurate with the normal courtesies of business and social life.’”  In addition, EY policies “acknowledged that close personal relationships between engagement team members and audit client employees in an accounting or financial reporting oversight role could create ‘independence issues from an appearance perspective.’ EY’s policies also prohibited partners from taking vacations with audit client employees, and warned that the amount of leisure time spent by a partner with an audit client employee in a financial reporting oversight role should be limited.”

Although various EY senior or managing partners became aware that the coordinating partner’s expenses were “by far the highest in the practice” and made inquiry about those expenses, according to the SEC, they did not inquire “into whether these levels of expenditures could suggest a violation of EY’s policies or the existence of an inappropriate personal relationship with any of [the coordinating partner’s] audit clients,” nor were there any systems that would alert EY when a “partner’s entertainment expenses reached aberrational levels or were improperly charged to a billable client account.” According to the order, EY’s procedures to assess independence asked whether the individuals “had familial, employment, or financial relationships with audit clients that could raise independence concerns.  But these procedures did not specifically inquire about non-familial close personal relationships that could impair the firm’s independence.” The order indicates that EY has taken steps to improve its policies, training and systems.

Leave a comment

Filed under Accounting and Auditing, Litigation, Securities

Comments are closed.