Not That Satisfying: SEC Slams KPMG For Independence Violations
Jon Lovitz Appears as Tommy Flanagan* the Pathological Liar on “The Tonight Show Starring Johnny Carson” in 1985.
It’s been almost three years since I first broke the story of KPMG’s loaned tax staff arrangement with audit client GE. On January 24 the Securities and Exchange Commission (SEC) announced an $8.2 million settlement with KPMG over violations of auditor-independence rules. KPMG’s settlement includes pay back of some fees earned on the illegal services and some fines. The wheels of justice turn very slowly. Unfortunately, none of the companies involved were named and, as far as I can see, the GE case was not one of the three cited as a subject of the enforcement. What did KPMG do wrong in the cases the SEC did cite? It’s a dog’s breakfast of broken independence rules and not even the tougher ones:
According to the SEC’s order, KPMG provided various non-audit services – including restructuring, corporate finance, and expert services – to an affiliate of one company that was an audit client. KPMG provided such prohibited non-audit services as bookkeeping and payroll to affiliates of another audit client. In a separate instance, KPMG hired an individual who had recently retired from a senior position at an affiliate of an audit client. KPMG then loaned him back to that affiliate to do the same work he had done as an employee of that affiliate, which resulted in the professional acting as a manager, employee, and advocate for the audit client. These services were prohibited by Rule 2-01 of Regulation S-X of the Securities Exchange Act of 1934.
The SEC did do something unusually satisfying in this enforcement proceeding and that’s when I gained some level of gratification, and vindication, for my report on KPMG’s violations at GE. The SEC published the results of an investigation that did not end in an enforcement action. Some detractors might shout, “Hey FMcKenna, if it is GE they’re talking about, KPMG and GE must not have done anything wrong if the SEC left GE out of the enforcement action.”
Au contraire, mon lecteur! Let’s look at what the SEC said KPMG did do:
The Division’s investigation identified that, from at least 2007 through 2011, KPMG entered into loaned staff engagements with multiple SEC audit clients. These loaned staff engagements involved non-manager level KPMG professionals performing junior level tasks related to tax compliance. For example, a typical task performed by the loaned staff was inputting data into federal or state tax returns using an audit client-issued computer, while being supervised by a member of the client’s tax department. Among other things, KPMG loaned staff assigned to these engagements generally:1. were supervised by, took sole direction from, and had their performance evaluated by, the audit clients’ managers;2. performed the same work as employees of the audit clients;3. worked exclusively and continuously at the audit clients’ places of business during such engagements for extended periods of time, ranging up to six months; and4. used the audit clients’ resources, including physical work spaces, client-issued computers and email addresses, and internal networks, spreadsheets and shared folders,to perform their loaned staff work.KPMG paid the loaned staffers in accordance with its typical practices for compensating KPMG employees and continued to provide KPMG benefits to these individuals. Fees for loaned staff arrangements were billed to the audit clients in a manner similar to the manner in which KPMG bills its clients for other non-audit services.
In defiance of these provisions, KPMG – GE’s auditor – provides “loaned staff” or staff augmentation to GE’s tax department each year. These “temps” perform tasks that would be otherwise the responsibility of GE staff. Sources tell me KPMG employees working in GE tax have GE email addresses, are supervised by GE managers – there is no KPMG manager or partner on premises – and have access to GE employee facilities. They use GE computers because the software required for their tasks is GE proprietary software.
Rule 2-01 addresses the issue of acting as an employee of an audit client. First, Preliminary Note 2 to Rule 2-01 makes clear that, in applying the general standard in Rule 2-01(b), the Commission considers, among three other principles, whether a relationship or service “results in the accountant acting as management or an employee of the audit client.” Second, Rule 2-01(c)(4) identifies specific non-audit services that are deemed inconsistent with an auditor’s independence, including:
Management functions. Acting, temporarily or permanently, as a director, officer, or employee of an audit client, or performing any decision-making, supervisory, or ongoing monitoring function for the audit client.
Accordingly, under the guiding principles of the Preliminary Note and the specific prohibition in Rule 2-01(c)(4)(vi), an accountant cannot maintain its independence if it is acting as an employee of an audit client.”
Going Concern reported in September, based on a tip, that KPMG professionals had been ordered to preserve all correspondence and documentation related to the tax “loaned staff” assignment with long-time client GE. That meant someone – the SEC or PCAOB – was investigating my story.You may remember earlier this year when The New York Times broke a little story about General Electric’s tax savvy ways and the best tax law firm the universe had ever seen (aka the GE tax department)…Despite all the back and forth, everyone was pissed at GE. The company lost a Twitter joust with Henry Blodget and then a bogus press release went out claiming the company was returning the “refund” of $3.2 billion and the Associated Press ran it. Slightly awkward.Francine McKenna also did a write-up on KPMG’s role in this little soap opera, as the firm has been the auditor for GE since Bill Taft was maxing out the White House bathtub.The latest twist comes from a tip we received earlier about a “Preservation Notice” sent to all KPMG employees yesterday from the firm’s Office of General Counsel (“OGC”).
URGENT TARGETED PRESERVATION NOTICE: GENERAL ELECTRIC’S LOAN STAFF ARRANGEMENTS Please be advised that until further notice from KPMG LLP’s (KPMG or firm) Office of General Counsel (OGC), you are hereby directed to take all steps necessary to preserve and protect any and all documents created or received from January 1, 2008 through the date of this Notice relating or referring to the loaning, assignment or secondment of tax or other professionals to General Electric Company and its direct and indirect subsidiaries, affiliates and divisions (collectively “General Electric’s Loan Staff Arrangements”).
The preservation notice refers to tax and “other loaned staff arrangements” so there were probably more engagements like this at GE and other firms that have also been stopped. What’s truly amazing is how long KPMG got away with using the forbidden term – “loaned staff” – internally and with its audit client.
KPMG stopped an average $8-10 million dollar a year engagement at GE and probably others like it, in spite of, according to the SEC, having an internal policy that said such engagements were allowed. Keep in mind, the Sarbanes-Oxley Act was passed in 2002 and Rule 2-01, the rule that prevents an auditor from acting as an audit client’s employee, predates SOx.
KPMG’s Internal Guidance Permitting Tax Loaned Staff EngagementsIn March 2004, KPMG issued internal guidance prohibiting most loaned staff engagements with SEC audit clients, but permitting loaned staff engagements for certain tax services. Through testimony taken as part of this investigation, the Division learned that part of KPMG’s rationale for continuing to allow loaned staff engagements for tax services was that auditors are permitted to provide tax services to audit clients and that the services to be provided were ministerial.
The Sarbanes-Oxley Act of 2002 started out tough on tax. The rules regarding prohibited activities by the auditor, intended to preserve their independence, scared the living daylights out of the largest firms. It appeared initially that the SEC would prohibit the tax side of the firms from providing highly lucrative tax advice to their audit clients. Many of those professionals started planning an exit from their firms so they could continue working with long time clients. A compromise was reached. The result is one of the loosest and most generous exceptions to auditor independence rules on the books.
The Commission reiterates its long-standing position that an accounting firm can provide tax services to its audit clients without impairing the firm’s independence. Accordingly, accountants may continue to provide tax services such as tax compliance, tax planning, and tax advice to audit clients, subject to the normal audit committee pre-approval requirements under 2-01(c)(7).
The KPMG guidance specified that loaned staff were to be supervised by, and take direction from, the audit clients at the clients’ places of business–effectively transferring control over the loaned staff to the audit client. In August 2008 , KPMG issued internal guidance that further revised its loaned staff policy. The 2008 KPMG guidance further restricted the conditions under which loaned staff services could be provided, but continued to allow loaned staff engagements with SEC audit clients for certain tax services.Among other things, the 2008 KPMG guidance: (i) prohibited loaning managers to SEC audit clients; (ii) specified that engagement letters must be preapproved by the client’s audit committee and in KPMG’s automated monitoring system; and (iii) specified that the engagements must be approved by KPMG’s national office and could not exceed three months without pre-approval of the National Partner in Charge of Tax, Risk Management.The 2008 KPMG guidance further provided that loaned staff could not “perform management functions or act as an employee (even on a temporary basis),” but also provided that loaned staff “should report to a specified member of client management who will supervise the staff member, make all decisions affecting the staff member’s work, and accept responsibility for the staff member’s work.”
A person familiar with the SEC’s thinking on the matter confirmed to me that the investigation report is referring to the GE case. This person also pointed to the SEC’s earlier independence case against KPMG for violations in its Australia practice for clues as to why the agency did not issue an enforcement order here. I discussed the Australia case in my original reporting.
KPMG should know better. KPMG was recently sanctioned by the SEC for a similar transgression involving their Australian office.
KPMG Australia and at least one other KPMG member firm outside Australia seconded non-tax professional staff to work at each client’s premises, under the supervision and direction of each client, doing the same types of work that each client’s own employees or managers ordinarily would perform, in violation of the prohibition under Rule 201(c)(4)(vi) against “[a]cting, temporarily or permanently, as a director, officer, or employee of an audit client, or performing any decision-making, supervisory, or ongoing monitoring function for the audit client.”
Note the citation of a “secondment” problem for non-tax professionals only. Did KPMG Australia also “second” tax professionals but the SEC neglected to cite it? Did the SEC neglect to take the Australian violations as an opportunity to look at KPMG US policies about similar engagements? The investigation report is instead just a “warning” and enough information about the agency’s position to, hopefully, clear up any earlier “misunderstandings” about what is or isn’t allowed, especially with regard to tax services.
But is a warning enough? KPMG’s violations of these independence provisions, encouraged by internal policies that flouted laws that have been on the books for years, were globally systemic. Under the circumstances, with no prior enforcement of the provisions in the US and none regarding tax services, and given the tendency noted by a recent SEC judge’s decision of the Big Four firms to “flout” US regulations and regulators from China, you have to wonder if the other Big Four firms are doing it, too.
Jonathan Weil over at Bloomberg had no trouble putting two and two together in his column and seeing that the SEC’s investigation referred to my KPMG GE stories. He was also not afraid to print that in his column, calling the SEC out for going soft on GE, in particular. He reminds us that former SEC Chairman Mary Shapiro is now a GE board member.
The second part of today’s settlement offers more intrigue. The SEC issued a separate report about an investigation into KPMG’s practice of lending tax professionals from its own staff to certain audit clients. Once again, the SEC didn’t name any of the companies. But it’s a safe bet that one of them was GE. Francine McKenna, who writes about accounting and auditing for her website re: The Auditors, broke the story in March 2011 that KPMG was doing this at GE. Some of the KPMG employees working at GE even were given GE e-mail addresses, she reported.
(No other reporters were willing to make the connection between my KPMG GE stories and the subject of the SEC investigation, probably because the SEC, KPMG, and GE would not confirm it on the record.)
So why do I think the SEC should have hit harder at KPMG and, especially, GE here? Because of the long and very lucrative engagement at GE and no excuse for anyone “misinterpreting” the law. (If I can figure it out, why can’t KPMG’s lawyers and GE’s audit committee?)
Instead of disgorging $8 million in total, the SEC could have gotten at least an additional $8 million a year for the GE engagement for at least the four years mentioned in the investigation, if not more. By highlighting systemic “flouting” and willful disregard for the regulations by KPMG and, perhaps, the industry as a whole, the agency may have had a case to force some firms like KPMG to resign longstanding audit engagements like its 100 year old one at GE. These egregious violations are the result of complacency and coziness borne of long symbiotic relationships, rather than independent, skeptical, objective ones.
And why not go after the Audit Committees too? They are violating the law when they allow auditors to provide prohibited services or to otherwise violate independence rules. Yeah, that’s the ticket… Clearly I’m now just dreaming impossible dreams.
Nota bene: The SEC has now crossed my GE story off the list. Now maybe it can cite PwC for its tax software business relationship with audit client Thomson Reuters in the US, UK and China. (A similar violation by EY regarding PeopleSoft from the pre-SOX era cost the firm a six month auditing ban in the US.) Or maybe the SEC can cite the illegal advocacy apparent in $2 million of “testifying” support EY provided to audit client HP when they both appeared before a Senate investigative committee. EY was also caught by Reuters tax lobbying for audit clients. The person familiar with the SEC’s thinking told me all of the above are still under investigation. My SEC “Broken Gate” to-do list is here.
*Tom Flanagan is the name of a Deloitte Vice Chairman in jail for insider trading on several Fortune 500 audit and advisory clients.
The Australian violations resulted in the client firing them. That was the loss of a $20m annual audit. In the seven years since they were fired, they have made just twice that in advisory services. That’s a $100m penalty net. Enough already.