HP, Hurd, Deloitte and Tone at the Top

What do HP, Boeing and Navistar have in common?  All three companies, over the years, have fought SEC investigations, internal investigations, and shareholder lawsuits.

HP and Boeing saw their CEOs, Mark Hurd this week and Harry Stonecipher in 2005, resign in disgrace because of “lapses in personal judgment” of the female dalliance kind.

Navistar’s CEO Dan Ustian has managed to hang on to his job through all kinds of SEC troubles including firing Deloitte after 99 years as their auditor and a delisting. But Ustian, and his former CFO Bob Lannert, were recently the targets of an up until now very rare type of SEC enforcement action – use of the Sarbanes-Oxley Section 304 clawback provision to force the return of millions of incentive compensation received as a result of accounting manipulation.

Because, after all, “boardroom Puritanism covers sex, but not greed. Where, oh where are the corporate ethics policies prohibiting chummy boards from approving eye-popping pay packages for C.E.O.’s whether or not they are doing a good job? Where are the solemn mission statements promising a workplace free of executive pillaging? Whom would you prefer: a C.E.O. who writes the occasional indelicate e-mail message? Or someone like [Bob] Nardelli, who treats shareholders with callous indifference? And which of the two executives really has worse judgment?” New York Times June, 25, 2006

Ustian is last man standing at Navistar. It’s an organization that had the rare experience of having to actually admit a “tone at the top” –type material weakness in their internal controls.

Navistar’s restated 2005 financials issued December 2007:

Material Weakness Description                         Remediation Actions

1.  Control Environment:  As of October 31, 2005, management was unsuccessful in establishing an adequately strong consciousness regarding the consistent application of ethics across all areas of the company and the importance of internal controls over financial reporting, including adherence to GAAP. This weakness in the overall control environment likely contributed to many of the other material weaknesses disclosed herein. As identified by the Board of Directors’ independent investigation, certain members of management and other employees, in place at that time, were involved in instances of intentional misconduct that resulted in some of the company’s smaller, but material, restatement adjustments. With respect to these instances, most of these individuals are no longer employed by the company. In other instances, the Investigatory Oversight Special Committee of our Board of Directors has implemented appropriate remediation plans.

Ernst & Young is HP’s Auditor. Although Deloitte is Boeing’s auditor and was Navistar’s auditor until all of their problems, HP’s auditor until 2001 was PwC. The relationship was terminated when HP made a bid for PwC’s Consulting practice and there were concerns about PwC’s independence.

Deloitte and HP do have a very significant relationship on the consulting side. Deloitte was recently named HP’s Software and Solutions US Partner of the Year at the Hewlett Packard Software Universe 2010 User Conference.

The award, which is based on license revenue, revenue growth, breadth of services and ease of doing business, recognizes Deloitte’s ability to assist customers in resolving their business challenges utilizing solutions including HP software.

“The award is due, in great part, to the synergies created through Deloitte and HP’s distinctive alliance model,” said Frank Strelau, principal, Deloitte Consulting LLP and HP global alliance lead.

Deloitte was also in the news last week. The SEC settled their civil and administrative claim against former Deloitte Vice Chairman Thomas Flanagan and his son for insider trading.

Thomas P. Flanagan of Chicago traded in the securities of Deloitte clients, often while serving as a liaison between those companies’ management teams and Deloitte’s audit engagement teams. In this role, Flanagan had access to advance earnings results and other nonpublic information from Deloitte’s audit engagements with Best Buy, Sears, and Walgreens as well as the firm’s consulting engagement with Motorola. Flanagan made trades in the securities of these and other companies while in possession of the confidential information, and also tipped his son Patrick T. Flanagan who then traded on the basis of the nonpublic information.

The Flanagans agreed to pay more than $1.1 million to settle the SEC’s charges.

“Flanagan’s insider trading violated one of the most fundamental rules of public accounting,” said Robert Khuzami, Director of the SEC’s Division of Enforcement. “All audit firms should learn from this unfortunate episode and employ vigorous controls designed to ensure compliance with the SEC’s auditor independence rules.”

Unfortunately, I don’t think Deloitte or any other accounting firm will learn anything from the Flanagan case other than how to get out of similar ones free and easy. The SEC, it seems, does not plan on bringing any charges against Deloitte in the Flanagan case.

HP and Boeing called upon Hurd and Stonecipher, respectively, to clean up their predecessors’ messes.  Hurd replaced Carly “The Conversation” Fiorina.

LA Times February 10, 2005: Hewlett-Packard Co.’s board of directors has ousted Carly Fiorina, the high-gloss chief executive who hobnobbed with Hollywood stars and graced dozens of magazine covers but who ultimately was unable to meet Wall Street’s expectations for the technology behemoth.

In September of 2006, Bloomberg reported that HP faced indictment by California’s attorney general who had enough evidence to pursue charges in a scandal of the computer maker’s probe of its own board of directors.

The probe began as an effort to track down the source of leaked information about company strategy and board deliberations leading up to the ouster of former Chief Executive Officer Carly Fiorina in February 2005. The private investigators used “pretexting,” in those efforts, Hewlett-Packard said, which typically involves impersonating individuals to gain personal information.

In January 2004, Stonecipher was called in from retirement by the board to replace Phil Condit after Boeing was rocked by scandals. In July 2003, the Air Force found Boeing had stolen documents from Lockheed Martin as the companies competed for a rocket launch program. In November of 2003, Boeing’s chief financial officer was fired after an internal inquiry found that he had met with an Air Force executive who supervised Boeing contracts and discussed hiring her. CFO Sears was eventually sentenced to four months in prison.

Deloitte  – to win against Flanagan in their suit against him, to save their client relationships and to avoid SEC sanctions  – had to publicly reveal hundreds of embarrassing lapses in their own tone at the top but at the same time prove they had, at least on paper, the policies, procedures and systems to insure it.

What is tone at the top?

Compliance Week September 2006: John Gill, research director at the Association of Certified Fraud Examiners, minces no words: “Senior management doesn’t have a connection between internal controls and tone at the top necessarily. Probably most companies are more concerned about just meeting the compliance requirements,” he says…He cites the recent turmoil at Hewlett-Packard as a high-profile example of a company that had all the right elements in place, but didn’t maintain good behavior at the top echelon of management…

“You can’t just send policies out to employees and expect them to abide by them,” Gill says. “You have to act that way as well, and employees have to see that in you. You have to walk the walk as well as talk the talk.”

Officers of public companies are hired hands first, bound to deliver job performance for money under the supervision of the board.  The board stands in the shoes of the shareholders and investors and other stakeholders of the corporation and has a duty of care, good faith and a fiduciary duty to ensure the employees – management – carry out plans and strategies and deliver performance that is in the best interest of shareholders.

Notice I did not say management delivers performance, “that optimizes shareholder value.” Leaders of public companies, like policemen or firemen that do a job for money, also sign up for a public duty.  As stewards of a public company, the job of CEO and CFO is not a reward for years of service, an entitlement after achieving career objectives but a responsibility and honor that should be earned every day by setting an example for all those who work under them.

The auditors serve the role of independent watchdog, guardian of shareholders’ interests in the capital markets.  Their relationship to management should be adversarial – not friendly, cozy and comfortable. They are hired and fired by the Board, also supposedly independent. Given the way auditors are compensated, directly by the companies they judge, they have a very difficult job. Regulators are there to guard the guardians and are supposed to make sure they’re doing that job.

So how does an audit firm Vice Chairman, one of those guardians, “dupe” his fellow partners and professional colleagues more than three hundred times, as Deloitte’s lawsuit against Flanagan alleged?

Deloitte has a culture of non-compliance.

In spite of the SEC’s desire to give Deloitte credit for software, manuals and controls that may have been designed effectively, those controls surely did not, in the Flanagan case and the hundreds of other examples of non-compliance cited by the PCAOB, operate effectively.  Deloitte did not discover Flanagan’s sins.  FINRA discovered the abnormalities in activity via normal market monitoring activities during Walgreen’s acquisition of Option Care.

Financial Times August 4, 2010: The share and options purchases came to light through routine supervision by industry regulator Finra of trading around deals and earnings announcements.

The auditing firm is not facing charges in the matter. The SEC said Mr Flanagan lied to Deloitte and circumvented its controls. Many of his share and options purchases were made in accounts in the names of relatives and a family trust.

According to Deloitte’s civil lawsuit, Mr. Flanagan would enter his stock purchases in Deloitte’s tracking system and then “correct” the entries before warnings to compliance were triggered.

Deloitte’s audit clients – Walgreens, Best Buy, Sears Holdings and others – got calls from the SEC and then the SEC and the clients called Deloitte.   Deloitte had no choice but to force Flanagan to “retire” and then sue him to assuage their clients.  Deloitte’s claim against Flanagan cited potential costs in reimbursing clients for their investigations.

Deloitte did reimburse some clients: $456 thousand to Sears, $79 thousand to Best Buy, for example. Deloitte’s audit clients, of course, made the quick, universal decision that their auditor was still independent.  Those companies would have otherwise experienced the ignominy of admitting that prior-filed financial statements were audited by a firm that was not independent. They would have been vulnerable to lawsuits, may have had to pay for a new audit for the affected years and would have had to change auditors in a hurry – a messy and expensive proposition for a large public company. There are disclosures in almost all the proxies.  They look like they were all written by the same lawyer.

Following these investigations, D&T and our management advised the Audit Committee that no evidence was discovered that indicated that the former advisory partner had any substantive responsibility for or role in the conduct of the audit. D&T delivered a letter to the audit committee stating that, despite the trades in our securities by their former advisory partner and the resulting violation of the SEC’s independence rules, the former advisory partner had not exercised any influence over the conduct of the audit or its conclusions with respect to the audit or accounting consultations, that the objectivity of the persons responsible for the actual conduct of the audit had not been affected by the former advisory partner’s actions, and that D&T’s independence was not impaired. Based on the foregoing and the Audit Committee’s understanding of the application of the relevant SEC rules, the Audit Committee accepted D&T’s conclusion and letter regarding its independence and unanimously concluded that, based on all of the facts and circumstances known to the Audit Committee, D&T’s independence was not impaired with respect to any of our financial statements covering periods during which the former advisory partner was a member of D&T’s audit engagement team, including fiscal 2009.

I would expect some will now change firms quietly.

Deloitte is same firm that has the former Delphi engagement partner, who is still under SEC sanctions, leading its IFRS initiative.

Do you really expect a firm that looks the other way at their own partners’ self-dealing and that protects partners who have been found complicit in scandals to insist on strong ethical and fiduciary standards in companies such as HP, Boeing and Navistar?

It’s all about the relationships.

Disclosure:  I worked as a consultant to Navistar’s Internal Audit Department in 2007 and early 2008 supporting their Sarbanes-Oxley effort.  My former client is now suing the company in a Sarbanes-Oxley whistleblower suit.

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