General counsel were provided some important lessons about auditor impartiality following a Securities and Exchange Commission (SEC) investigation on Ernst & Young (EY) auditors and the firm’s response.
Under a recently announced settlement, while not admitting any wrongdoing, EY will pay $9.3 million after the SEC alleged two auditors at the firm “got too close to their clients on a personal level and violated rules that ensure firms maintain their objectivity and impartiality during audits.”
The cases are the first SEC enforcement actions related to auditor independence and close personal relationships between auditors and client personnel.
According to the SEC, Pamela Hartford got into a romantic relationship with financial executive Robert Brehl while she was on the team auditing his company. Moreover, Michael Kamienski, who supervised Hartford on the audit, was aware of the improper relationship but did not respond appropriately with the EY’s independence group, the SEC said.
In a different audit, Gregory Bednar and the CFO of a company, which was being audited by EY, stayed overnight at each other’s homes and traveled together with family members on overnight trips, the SEC said. They also exchanged hundreds of personal text messages, e-mails and voicemails during the auditing periods. Bednar also provided the CFO’s family tickets to sporting events and other gifts. EY partners became aware of the issues but took no action to confirm that Bednar was following independence obligations.
EY employees were asked if they had family, employment or financial relationships with audit clients that could raise independence concerns. But these procedures did not ask about non-family, close personal relationships that could impair the firm’s independence, according to the SEC. Also, EY misrepresented in audit reports issued with the companies’ financial statements that it maintained its independence throughout these audits, the SEC said.
Jeffrey Cohen, an accounting professor at Boston College, said that now – in addition to family relationships and economic relationships – “audit firms must have counsel develop a checklist on personal relationships.”
“Until now, social ties were not brought into question and obviously this will now need to be monitored very closely,” he advises.
When asked about the case’s lessons for general counsel, Robert Plaze, an attorney at Stroock & Stroock & Lavan and who formerly was deputy director of the SEC’s Division of Investment Management, said, “If you are aware [that] … one of your officers or employees has developed a personal relationship with your auditor, it’s important you find out exactly how personal it is. While friendly cooperative work is important for the success of an audit, a certain amount of professional distance needs to be maintained. In one of the cases the SEC brought, it suggests that a new auditor was brought in with the idea of developing relationships that could overcome professional difficulties. Close personal relationships between employees of a company and its auditors risk corrupting the auditing relationship.”
Moreover, based on the SEC’s actions general counsel may want to follow up with their own companies. “The general counsel and/or in-house attorneys should ensure that the audit committee/board of directors meet separately with members of top management and separately with the external auditors to discuss independence issues,” Steven Mintz, an emeritus accounting professor at California Polytechnic State University, said. “In-house attorneys must rigorously enforce rules and regulations that pertain to independence and the conduct of an audit in accordance with generally accepted auditing standards. Those standards require external auditors to be both independent in fact and appearance. EY staff violated both by compromising their objectivity and impartiality as a result of close personal relationships with the CFO and having a romantic relationship with the CAO. The firm should have detected these violations through a thorough internal check of independence requirements and not rely solely on self-reporting because the affected audit engagement professionals had a vested interest in keeping their relationships under wraps.”
Mintz explained that companies cannot rely on the accounting firms’ “due diligence efforts because they have a built in financial self-interest not to report independence violations and can be motivated by egoism rather than a commitment to serve the public interest. The public relies on the independence of external auditors to ensure the audits are conducted in accordance with accepted standards. In my opinion, the accounting profession has demonstrated over a relatively long period of time that it is incapable of regulating itself when it comes to independence issues and the audit committee/board of directors must play a more proactive role in making these determinations. There is an important role for the chief compliance officer as well in these matters.”
Furthermore, Plaze said that company personnel who interact with the auditors should be reminded of the rules. “GCs and audit committees should make inquiries of the public accounting firm, and make sure that the auditing firm prohibits close personal relationships with clients, and have surveillance procedures in place,” he said.
Overall, auditor independence has been a concern at the SEC for many years. “Independence issues have been a priority of the SEC ever since the Enron and other scandals that led to the enactment of the Sarbanes-Oxley Act,” Plaze said. “Failure of auditor independence was viewed as contributing [to] the securities frauds of that era.”
“All trust is lost in auditors/audit firms when a basic ethical standard such as independence is violated,” Mintz added. “Nothing is more sacrosanct than the independence requirement.”