Four Years After Madoff, Audits and Auditors of Broker-Dealers Still Lousy

Last week I posted a column at Forbes: Already Behind The Eight-Ball: Auditors of Broker-Dealers Are A Disaster

The Public Company Accounting Oversight Board, the US audit industry regulator, issued its first report on the auditors of broker-dealers this week and it was ugly.

The PCAOB inspection team found serious auditing deficiencies in all 23 audits they reviewed. The PCAOB released the report on August 18, the first anniversary of the SEC’s approval of temporary rules that gave the regulator the authority, under the Dodd-Frank Reform Act, to require registration and, therefore, inspection of the auditors of broker-dealer firms, a majority of which do not audit any other SEC registered companies.

This was the first time most of these firms were scrutinized by anyone but their peers in the accounting industry.

According to the PCAOB’s first report, there are 800 registered public accounting firms that issued audit reports for financial statements of brokers-dealers for fiscal period 2011 that were filed with the SEC. Some of these firms audited as few as one broker-dealer, while others audited over 150 broker-dealers. Approximately 300 of the 800 firms also reported issuing audit reports for public company issuers. There were approximately 4,400 broker-dealers that filed audited annual financial statements for fiscal periods ended during 2011 with the SEC.

As of October 1, 2010, there were approximately 12,000 investment advisors registered with the SEC. There were 2,636 registered investment advisers that had an affiliated broker-dealer. Investment advisors are not required to have an independent audit of their financial statements. However,there is a new auditor attestation required for investment advisors. I talked about that in my column this week in American Banker regarding the relationship between private equity firm Bain Capital Partners and PwC.

As of March of 2010, investment advisors like Bain Capital Partners that have custody of customer funds and securities must hire an “independent” auditor to do a “surprise” examination. The auditor that performs the “surprise” examination must be registered with the PCAOB and subject to its inspections. The PCAOB, however, has no authority to review the “surprise” examination. And an investment advisor is not obligated to have a full audit by an independent auditor.

The broker-dealers that were inspected by the PCAOB were not judged by any new rules. The auditors operate, for now, under generally accepted auditing standards (“GAAS”) issued by the American Institute of Certified Public Accountants (“AICPA”). The new “surprise” examination of investment advisors who have custody of customer funds or securities is also performed under AICPA attestation standards.

Broker-dealer audit firms will soon have to start auditing those firms under PCAOB standards. One wonders how, given their poor performance under well-known AICPA standards, how most of them will ever be able to make the transition and stay in business. From my Forbes column:

The SEC has not yet finalized the rules – 17a5 – under Dodd-Frank that officially require broker-dealers to use a PCAOB-registered firm. Broker-dealer auditors are not yet officially required, therefore, to use PCAOB standards for conducting their audits. The inspections were performed under GAAS, the AICPA audit standards, since the broker-dealers whose audits that were reviewed are not public companies. Once the SEC’s rules are approved, all broker-dealers audits will be conducted under the PCAOB audit standards.

SEC spokesperson Judy Burns told me the agency has not publicly stated when it will adopt the broker-dealer auditor rules under Dodd-Frank.

One very difficult complication is that auditors of broker-dealers are required to be independent of their clients under SEC rules, not AICPA rules. AICPA independence rules are more lenient and do not prohibit auditors from also preparing the financial statements they audit and supporting firms with accounting software and IT expertise.

The PCAOB also said one firm failed to maintain its independence in accordance with SEC rules in two audits. SEC rules on auditor independence apply to auditors of brokers-dealers, not the AICPA rules that are more lenient regarding prohibited services.

Fortunately for PwC, investment advisors have no audit requirements so PwC can audit the funds of private equity firms like Bain under AICPA rules and still provide any service they like to Bain and its partners. PwC is not an “independent” audit firm for Bain according to SEC standards.

The fund documents may lead you to believe PwC also audits Bain Capital Partners and the rest of the Bain investment advisors. PwC does prepare the personal tax returns of all Bain partners, according to Dan Primack of Fortune. But PwC is not an “independent” auditor for the investment advisors. Non-audit services such as M&A advisory, systems development and personal tax return preparation for partners with financial reporting responsibility would be prohibited, per SEC and PCAOB rules, if PwC was the “independent” auditor.

PwC audits the Bain funds in line with private company American Institute of Certified Public Accountants standards. AICPA independence rules prohibit auditors from having a financial relationship with clients but are more generous than are the SEC independence rules about the kinds of services an auditor can provide. PwC stays away from the audit activities that would require SEC level independence because PwC probably prefers to be Bain’s full-service provider.

Services provided to private private equity firms (as opposed to public private equity firms like Blackstone or Carlyle or KKR) and their portfolio companies, pre-IPO venture capital backed companies, and hedge funds are huge business for the Big Four auditors and “off the radar” from the public awareness and accountability perspective.

Just like the audits of broker-dealers used to be.

Having your private company or fund audit performed by a Big Four audit firm is no guarantee of quality. As a matter of fact, I would argue that the quality may often be less than what you might get at a medium-size, regional firm that concentrates solely on that niche. A Big Four audit is definitely more expensive.

To see how bad it can get, just look at the failures of MF Global, audited by PwC, and Refco, audited by Grant Thornton who inherited the audit and its team from Arthur Andersen.

The ten futures commission merchants, or FCMs, with the most customer segregated assets under their control, almost $117 billion, as of June 30, 2012 according to reports filed with the CFTC, are audited in four cases by PwC. The rest are audited by one of the other Big Four audit firms. (A Big Four auditor obviously didn’t help safeguard customer funds any better at MF Global where the auditor is also PwC.)

  • Goldman Sachs (PwC)
  • JP Morgan (PwC)
  • Newedge (EY)
  • Deutsche (KPMG)
  • UBS (EY)
  • Citigroup (KPMG)
  • Merrill Lynch (PwC)
  • Morgan Stanley (Deloitte)
  • Barclays (PwC)

Large banks have been sanctioned recently for commingling their broker-dealer customers’ funds with their own. JP Morgan, and its auditor PwC, and Barclays were fined in the UK for not safeguarding the funds of brokerage customers.

JP Morgan was MF Global’s primary banker.

More serious scrutiny by the PCAOB and SEC of the large audit firms who cover the largest FCMs is also required. PwC audits four of the top ten FCMs. Why has there been no scrutiny of PwC lapses at MF Global and at JP Morgan and Barclays where PwC not only allowed the banks to commingle but stood by while JPM exploited control weaknesses related to the “whale trades” and Barclays manipulated Libor?

There are some great business opportunities here for independent service providers, visionary audit firm leaders, and independent consultants. I’ve been talking about this since 2010.

  • Training to broker dealers on compliance and audit requirements per Dodd-Frank rule changes.
  • Training to investment advisors on custody “surprise” examination requirement.
  • Support to broker-dealers and investment advisors on remediation of audit/examination findings.
  • Audit firm training on AICPA and PCAOB audit standards and independence standards.
  • Interim staffing to broker-dealers to support financial statement prep, accounting software support and remediation, controls enhancement, policy and procedure development, internal audit staffing.
  • Interim staffing to investment advisors to support policy and procedure development and internal controls enhancement to meet “surprise” examination requirements.
  • Experienced broker-dealer auditors who can act as QA partners for multiple firms on a staffing or contract basis.

The inspections of the ten broker-dealer audit firms and 23 audits performed by those firms took place between October 2011 and February 2012. The firms to be inspected were chosen before the bankruptcy of MF Global and the inspections were performed before the news of the failure of PFGBest. While we were waiting for this report, almost $2 billion of customer funds that are legally required to be segregated from the broker-dealers’ accounts went missing. They are still missing.

We’ve seen that customers or broker dealers and private firms can not count on the self-regulatory regime to cover these industries.

According to the SEC’s 2011 annual report, the SEC and Self-Regulatory Organizations (SROs) like the National Futures Association have been doing fewer and fewer exams of broker-dealers during the last five years.

The SEC admits it will never happen for investment advisors:

The anticipated decline in the number of registered investment advisers following the effective date of Title IV of the Dodd-Frank Act — the Private Fund Investment Advisers Registration Act (“Title IV”)12 — could result in a greater percentage of registered investment advisers being examined. The amount of any potential increase in examination frequency, however, may be offset by the need to divert examination resources to fulfill new examination obligations that the Commission was given by the Dodd-Frank Act. Moreover, the Staff expects the number of registered investment advisers to grow in subsequent years. While the Commission’s resources and the number of OCIE staff may increase in the next several years, the number of OCIE staff is unlikely to keep pace with the growth of registered investment advisers.

As a result, the Staff believes that the Commission likely will not have sufficient capacity in the near or long term to conduct effective examinations of registered investment advisers with adequate frequency. The Commission’s examination program requires a source of funding that is adequate to permit the Commission to meet the new challenges it faces and sufficiently stable to prevent adviser examination resources from periodically being outstripped by growth in the number of registered investment advisers (i.e., it requires resources that are scalable to any future increase ― or, for that matter, decrease ― in the number of registered investment advisers).

How many more billions do customers have to lose before someone steps up?

Call me if you have any questions…

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8 replies
  1. Hans J. Gscheidmeyer
    Hans J. Gscheidmeyer says:

    Dear Fran,
    (I just read your invitation to call you this way and take the liberty to do so!) 🙂

    as you probably are aware, we here in Europe will have changes from 2014 onwards, that will put companies into the obligation to write annual CSR-reports.
    Thats in a way good news, especially when it boils down to Integrated Reporting.
    The bad news are, that the usual suspects -nobody knows the list better than you do!-are already sitting in the starting blocks, because they smell even more money. Are they qualified in this area of ethics, I wonder? If you already can lie with figures…
    Do you have any remarks on that issue from your view angle and from your level of competence? And most welcome: Any recommendations, how to deal with that scenario in near future?

    Warm regards

  2. Carl Olson
    Carl Olson says:

    The PCAOB is the only federal agency which is functioning for the investing public from the Sarbanes-Oxley legislation. Whatever we can do to promote and fund the PCAOB is absolutely vital.

    Notably absent from SarBox is the promise of big fines and jail time for executives who sign false financial statements. How about Fannie Mae, Freddie Mac, AIG, and the legion of others? So far, no prosecutions. We need to get Atty Gen Eric Holder actively prosecuting.

  3. Francine
    Francine says:

    @Carl Olson

    “The PCAOB is the only federal agency which is functioning for the investing public from the Sarbanes-Oxley legislation.”

    You make a good point. I’m going to use that.


Trackbacks & Pingbacks

  1. […] One year ago, in Forbes on August 22, 2012, I published Already Behind The Eight-Ball: Auditors of Broker-Dealers Are A Disaster. That was followed up with a post on this blog on August 30, Four Years After Madoff, Audits and Auditors of Broker-Dealers Still Lousy. […]

  2. […] Yesterday the U.S. House of Representatives voted 321-62 for the H.R. 1564, the Audit Integrity and Job Protection Act. I’ve got news for the Congressmen and Congresswomen:  The integrity of the audit industry is already shot to hell. Again. The only jobs you’re protecting belong to the audit industry, in business by virtue of the laws Congress enacted and the SEC enforces, albeit less strenuously lately, that require an audit be performed by a PCAOB registered public accounting firm for every public company and broker-dealer. […]

  3. […] Capital, although not quite an inactive, zombie shell corporation, is audited by PricewaterhouseCoopers. PricewaterhouseCoopers must have missed the software migration to […]

  4. […] be the auditor’s defense when, and if, they are ever called to answer questions from the SEC, PCAOB, or a Senate/Congressional investigative committee. More likely the audit firm has been working […]

  5. […] will be the auditors defense when and if they are ever called to answer questions from the SEC, PCAOB, or a Senate/Congressional investigative committee. More likely the firm has been working behind […]

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