Please read article and write 2 page article summary: Accounting- Francine

It’s never been easy to bring lousy auditors to justice, but in the last 35 years, it’s become

harder than ever.

T he law was supposed to restore

confidence in the integrity and

independence of the auditing

profession, and reduce the number and

severity of corporate and accounting

frauds like the ones at Enron and World-

Com. And for a time it appeared that

the auditing profession may have found

religion. But, ultimately, Sarbanes-Oxley

failed to make corporate accounting and

disclosure frauds a thing of the past.

Indeed, frauds have exploded in recent

years, making it clear that the accounting

industry is failing the markets.

Auditors of public companies are sup-

posed to perform a public duty. The audi-

tor’s true clients, according to statute, are

shareholders, not company executives.

There is an inherent conflict in the way

we pay for an audit, however. Similar to

the conflict that ratings agencies have,

shareholders have very little say in how

the relationship between the company

and its audit firm is managed because

their proxy votes are only advisory. The

company, through the Audit Committee

of the Board of Directors, hires, pays, and

evaluates an “independent” audit firm and

its work. Auditors risk losing clients when

they object to deliberate accounting manip-

ulation or possible illegal acts favored by

client management. Perversely, auditors

more often keep their jobs even when

shareholders sue them repeatedly for

lapses that allowed fraud and failure to

occur.

Legislators with short memories also

conveniently forgot how Arthur Andersen

lost its independence and objectivity at

Enron because of the hundreds of millions

it earned from consulting to its audit

client. Unfortunately, company execu-

tives, and the audit committees that serve

FOR INSTITUTIONAL INVESTORS

22 Bernstein Litowitz Berger & Grossmann LLP www.blbglaw.com

Redeem Accounting

Profession?

Can Private Litigation

The

By Francine McKenna

Continued on next page.

23

Sarbanes-Oxley was supposed to restore confidence in

the integrity and independence of the auditing

profession, and for a time it appeared that they may

have found religion. But ultimately Sarbanes-Oxley

failed to make corporate accounting and disclosure

frauds a thing of the past. Indeed, frauds have

exploded in recent years, making it clear that the

accounting industry is failing the markets.

Legislators with short memories conveniently

forgot how Arthur Andersen lost its inde-

pendence and objectivity at Enron because of the

hundreds of millions it earned from consulting

to its audit client.

them, have regained the upper hand in

the auditor-company relationship.

At the same time, the Supreme Court has

made it harder and harder for private

investors to hold auditors accountable.

Notwithstanding these obstacles, today

the Big Four audit firms — Deloitte, KPMG,

Ernst & Young, and Pricewaterhouse-

Coopers — are under intense scrutiny by

regulators and institutional investors for

consulting practices that have again

grown so large that they again have

threatened audit quality. In fact, it is the

institutional investor community that may

hold the key to redeeming the accounting

profession.

The Challenges to Accounting Accountability

It has never been easy to bring lousy

auditors to justice, but in the last thirty-

five years it has become harder than ever.

In 1975, the U.S. Supreme Court decided

in Ernst & Ernst v. Hochfelder that secu-

rities litigation requires an allegation of

“‘scienter’— an intent to deceive, manip-

ulate, or defraud.” The “scienter” require-

ment is notoriously difficult to meet in an

auditor liability case without a whistle-

blower or a “smoking gun.” Because Con-

gress’s 1995 Private Securities Litigation

Reform Act (“PSLRA”) prohibited investors

from discovery without getting past a

motion to dismiss, many cases against

auditors are, therefore, dismissed before

the first witness can be deposed or the

first document requested. In addition, in

a series of decisions that culminated in

the 2008 opinion in Stoneridge Invest-

ment Partners v. Scientific-Atlanta, the

Supreme Court sharply curtailed the

ability of investors to bring cases against

auditors for “aiding and abetting” secu-

rities fraud even where there is definitive

proof that an auditor actively conspired

with a company to commit fraud.

All hope to bring auditors to justice for

securities fraud is not lost, however. The-

oretically, where auditors issue public

statements themselves (like certifying a

company’s public financial statements),

plaintiffs can attempt to satisfy the

requirement of auditor scienter. To do so,

the auditor must be “reckless.” The

“reckless” standard established by the

Supreme Court’s 1975 Ernst decision re-

quires more than just a misapplication of

accounting or auditing principles. Plain-

tiffs must prove that the auditing was so

deficient that the audit amounted to “no

audit at all” or “an egregious refusal to

see the obvious, or to investigate the

doubtful,” or that the accounting judg-

ments which were made were such that

no reasonable auditor would have made

the same decisions if confronted with the

same facts.

Proving that an audit amounted to “no

audit at all” is increasingly difficult these

days, because companies are refusing

to restate their past audited financials.

Instead, when companies misstate finan-

cial information, intentionally or not, they

are using a “revision” approach more and

more to fix it without filing a Form 8-K

with the SEC or formally restating and

refiling prior financials. Fewer formal

restatements means it is harder for share-

holders to bring any case, let alone one

against a third-party such as auditors,

because without a formal restatement it’s

difficult to quantify the harm to investors

prior to discovery. When a case can be

filed, auditors, and their lobbyists, have

FOR INSTITUTIONAL INVESTORS

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FOR INSTITUTIONAL INVESTORS

Spring 2013 The Advocate for Institutional Investors 2 5

made it very difficult to prevail. As a

result, auditors are left off the list of

class action defendants or dropped once

judges signal acceptance of the common,

but professionally embarrassing, auditor

defense: “We were duped, too.”

Making matters worse, if audit firms paid

for failure at all, it was typically a fraction

of what other defendants paid. There’s a

rule of thumb heard repeatedly in settle-

ment discussions: Big Four firms won’t

pay more than 10% of what the company

paid.

Meaningful Prosecutions on the Rise

Auditors have only sparingly been

named as defendants in securities cases,

including in the recent financial crisis law-

suits. But that is beginning to change. In

March of 2010, the Lehman Bankruptcy

Examiner used the word “fraud” in his re-

port and implied that Ernst & Young,

Lehman’s auditor, was complicit in

Lehman’s misconduct.

While securities cases have recently been

brought against auditors, such cases are

rarely, if ever, going to trial. Especially

since Andersen’s high-profile demise, the

Big Four global audit firms settle securi-

ties litigation before trial both because

they fear a judgment large enough to

threaten their solvency and because they

don’t want their mistakes aired in public.

Indeed, if there is substance to a claim, or

negligence or complicity by an audit part-

ner and his firm, the case usually settles

before any facts are made public.

For example, New Century Financial was

a subprime mortgage originator that

failed early in the crisis. The bankruptcy

trustee and private investors in a class

action suit both sued auditor KPMG

successfully. The cases settled in spite of

— or perhaps because of — very specific

examples of reckless auditor behavior

documented by the New Century bank-

ruptcy examiner. Thus, the allegations

against KPMG will never be heard in

open court.

Similarly, in 2011, Price Waterhouse India,

Price Waterhouse International Ltd. and

PwC U.S. settled for $25.5 million for the

massive Satyam accounting fraud, a $1

billion scam that involved falsified bank

confirmations. Shareholders alleged the

auditor was “reckless” in carrying out its

duties. Price Waterhouse India also paid

$7.5 million in fines to the Public Com-

pany Accounting Oversight Board, the

audit regulator, and the SEC who alleged

Price Waterhouse India had aided and

abetted the Satyam fraud and there had

been “no audit at all.” In 2012, Deloitte

agreed to pay $19.9 million to settle

claims for its work at JPMorgan Chase &

Co. (JPM)’s Bear Stearns unit after plain-

tiffs successfully argued “no audit at all”

allegations.

If a Big Four audit firm ever does go to

trial again for a major fraud, we may

finally close the “expectations gap,” the

infamous gulf between what investors

think auditors do and what auditors actu-

ally do, and say they do. There are a few

cases where this remains a possibility:

■ There’s a trial scheduled to start in June

2013 against Deloitte as auditor for Taylor,

Bean & Whitaker (TBW), another financial

crisis era mortgage originator fraud

where plaintiffs allege there was “no

audit at all.”

Auditors have only sparingly been named as defendants in securities cases, including in the recent financial crisis lawsuits. But that is beginning to change. In March of 2010, the Lehman Bankruptcy Examiner used the word “fraud” in his report and implied that Ernst & Young, Lehman’s auditor, was complicit.

While securities cases have recently been

brought against auditors, such cases are rarely

if ever going to trial. Especially since Andersen’s

high-profile demise, the Big Four global audit

firms settle securities litigation before trial both

because they fear a judgment large enough

to threaten their solvency and because they don’t

want their mistakes aired in public.

■ PwC is the last defendant standing in a

class action for the Colonial Bank failure,

pending a decision soon on a motion to

dismiss.

■ In the class action case related to the

Lehman failure, Ernst & Young is one of

two remaining defendants. Barring a last

minute settlement, we may finally see

some of the facts of that case given a

public airing.

This willingness to hold auditors liable for

their role in the crisis, and in several of

the non-crisis related corporate frauds

that have occurred since, did not come

soon enough to change the law or

judges’ minds. Attempts to restore pri-

vate plaintiffs’ right to allege aiding and

abetting by auditors, specifically an

amendment introduced by Senator Arlen

Specter in 2010 during the Dodd-Frank

financial reform bill debates, failed.

Shareholders Can Reform the Accounting Industry

Investor action can be a powerful tool to

effect change in boardrooms and at the

Big Four accounting firms. What can in-

vestors do when auditors behave more

like lapdogs of management than watch-

dogs?

1 Pay attention to the proxy. Supportcorporate governance initiatives such as “tender or explain” for long-term rela-

tionships between auditors and compa-

nies. When auditors serve the same client

for decades there’s bound to be a negative

impact on independence and objectivity.

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© Copyright 2002 Mike Lane – All Rights Reserved.

FOR INSTITUTIONAL INVESTORS

Spring 2013 The Advocate for Institutional Investors 2 7

2 Vote your proxy. When auditors aresued or suspected of negligence or complicity in frauds or accounting manip-

ulation, don’t allow your broker to reelect

them. Attend the annual meeting and

voice your concerns.

3 Support activist investor and corpo-rate governance initiatives to actively monitor companies that spend more with

their auditors on tax and consulting serv-

ices than the audit. Put pressure on the

SEC and PCAOB to discipline auditors for

breaking the rules on prohibited services

by an auditor.

4 Board directors, and especially AuditCommittee members, should moni- tor the work of the audit firm closely.

Don’t take the auditor’s word that it’s in-

dependent. Don’t allow the CFO to make

all decisions or be the only one to debate

accounting issues. Ask your auditor

about PCAOB inspection results and push

back on excuses for poor quality.

5 When frauds occur, pursue validclaims against the audit firms all the way to trial if necessary. Hire a great

lawyer who will fight as hard as the audi-

tors do to successfully overcome the

traditional obstacles to auditor litigation.

If you stay the course, you’ll likely recover

your losses.

When investors force auditors to play

their statutory role in the regulatory infra-

structure — and stop being handmaidens

to management — frauds can be stopped

earlier and losses mitigated. Shareholders

pay the accounting industry billions of

dollars to keep their portfolio companies

honest and open. They deserve more

bang for their auditing buck. ◆

About the Author Ms. McKenna is a freelance writer and

C.P.A. with more than twenty-five years

of experience in consulting and profes-

sional services, including tenure at two

Big Four auditing firms in the U.S. and

abroad. She is a columnist for both

Forbes (“Accounting Watchdog”) and

American Banker (“Accountable”), and

prior to that was a weekly columnist at

GoingConcern.com. Her other writing

credits include Financial Times, Account-

ancy Age, Accountancy Magazine, The

Columbia Journalism Review, Boston

Review, the FEI Blog, and various other

financial, media, and technology blogs.

When investors force auditors to play their statutory role in the regulatory infrastructure — and stop being hand- maidens to management — frauds can be stopped earlier and losses mitigated. Shareholders pay the accounting industry billions of dollars to keep their portfolio companies honest and open. They deserve more bang for their auditing buck.