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SEC Splits Over CPA Bars For PCAOB Audit
August 15, 2016
In recent times, the lines of political demarcation have become trenches from which war is waged. Compromise has become a dirty word. We live in an age of ultimatum with brinkmanship resulting in an unending stream of bodies falling from the brink. Since its inception in the 1930s, the Securities and Exchange Commission had been a relatively collegial body, but, to its detractors, the federal regulator was also seen as a tad too much of a revolving door between the public and private sectors -- and a tad too deferential of Wall Street's big fish. Recent years, however, have the emergence of far more active SEC Commissioners for whom making a point is more important than getting along and going along. Sometimes the discord is bad; sometimes it's good. Consider the splits among the SEC's Chair and Commissioners in some recent cases imposing Bars upon respondents.
Case In Point
TierOne Corporation was a holding company for TierOne Bank, a federally-chartered savings bank. On June 4, 2010, TierOne Bank was closed by the United States Office of Thrift Supervision and went into receivership followed by Chapter 7 bankruptcy. The registration of TierOne's shares, which had traded under the Nasdaq symbol "TONE" and on the Pink Sheets, was revoked by consent on June 4, 2012.
KPMG Auditors
John J. Aesoph, CPA, a KPMG, LLP auditor since 2001 and partner since 2005, was the 2008 TierOne audit engagement partner (he had first worked on the company's audit in 2002). Darren M. Bennett, CPA, a KPMG auditor since 2001 had worked on the TierOne audit since 2003 (with the exception of one year) and was the senior manager for the 2008 TierOne audit.
SEC OIP
In January 2013, the Securities and Exchange Commission ("SEC") instituted proceedings (the "OIP") against both Aesoph and Bennett. In the Matter of John J. Aesoph, CPA and Darren M. Bennett, CPA, Respondents (OIP, '34 Act Rel. No. 68605; Acct. and Audt. Enf. Rel. No. 3436; Admin. Proc. File No. 3-15168 / January 9, 2013). As set forth in the "Summary" of the OIP (Ed: Footnotes omitted):
1. Aesoph and Bennett (collectively, "the auditors") repeatedly engaged in improper professional conduct during their year-end 2008 audit of TierOne Corporation, a holding company for TierOne Bank (collectively "TierOne"). They did so by failing to subject TierOne's loan loss estimates - one of the highest risk areas of the audit - to appropriate scrutiny. Aesoph served as the audit partner and Bennett served as the senior manager on the engagement; they each had significant responsibility for the audit decisions, the inadequately designed and implemented audit programs, the review of audit work papers, and the failures to follow audit standards that are the subject of this proceeding.2. TierOne's loan losses were a critical audit area that warranted heightened scrutiny. Up to and during 2008, as a result of the financial crisis and related real estate market crash, TierOne had been experiencing a dramatic increase in the number of its troubled real estate loans. TierOne estimated its loan losses for a key component of its troubled loan portfolio - large, unique loans accounted for under Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 114 ("FAS 114") - by using the value of the collateral underlying these loans. Rather than get updated appraisals to value the collateral of the loans that TierOne evaluated for impairment under FAS 114 (called here "the bank's FAS 114 loans"), TierOne frequently relied on stale, dated appraisals to which the bank's management sometimes applied a discount. TierOne's determination of the discount amounts, and its decisions not to apply a discount, were not documented, nor were they supported by reliable facts or evidence.3. Aesoph and Bennett violated numerous Public Company Accounting Oversight Board ("PCAOB") audit standards in both their audit of internal control over financial reporting and their audit of the financial statements. The auditors correctly identified TierOne's loan losses as presenting a fraud risk and a significant risk of material misstatement. The actual audit test work in this area, however, was inadequate considering the associated audit risk and materiality. For example, the internal controls identified and tested by the audit engagement team relating to the allowance for loan and lease losses ("ALLL") did not effectively address one of the most important and riskiest components of the bank's loan loss calculations: management's use of stale and inadequate appraisals to value the collateral underlying the bank's FAS 114 loans. Based on this test work, Aesoph and Bennett had no reasonable basis to conclude that TierOne maintained, in all material respects, effective internal control over financial reporting. Moreover, the auditors failed to adequately identify and evaluate defects in the design and operating effectiveness of controls over collateral valuation that would have been important to the auditors' conclusion about whether TierOne's controls sufficiently addressed the assessed risk of misstatement. The auditors violated PCAOB standards, including specifically Auditing Standard No. 5 ("AS No. 5"), in their audit of internal control over financial reporting.4. Compounding these flaws in the audit of internal control over financial reporting were Aesoph and Bennett's failures to comply with PCAOB standards in their substantive audit procedures over the bank's FAS 114 loans. The relevant audit work on these loans consisted of checking management's basic math, confirming that appraisals (no matter how stale) existed, reviewing a sample of appraisals, and relying on management's uncorroborated representations concerning property-specific issues, including whether stale appraisals required adjustment. These procedures fell short of the requirements of a number of PCAOB standards, including specifically AU Sections 328 and 342, which address auditing fair value and accounting estimates, respectively. In short, the auditors failed to subject management's estimates to appropriate scrutiny.5. Aesoph and Bennett failed to obtain sufficient, competent evidential matter to provide assurances that management's estimates were reasonable. They further failed to act with due professional care or appropriate professional skepticism.6. These failures, along with others detailed below, demonstrate a single instance of highly unreasonable conduct that resulted in a violation of applicable professional standards in which Aesoph and Bennett knew, or should have known, heightened scrutiny was warranted; and repeated instances of unreasonable conduct, each resulting in a violation of applicable professional standards, that indicate a lack of competence to practice before the Commission
ALJ Initial Decision
Following 9 days of hearings, an SEC Administrative Law Judge ("ALJ") issued an Initial Decision, which found that Respondents conduct was negligent "improper professional conduct" under Commission Rule of Practice 102(e) and Section 4C of the Securities Exchange Act of 1934. Pointedly, the ALJ found:
- a single instance of highly unreasonable conduct that resulted in a violation of Public Company Accounting Oversight Board ("PCAOB") auditing standards in circumstances in which they knew, or should have known, that heightened scrutiny is warranted; and
- repeated instances of unreasonable conduct.
In determining appropriate sanctions, the Initial Decision offers this rationale under the heading "SANCTiONS" [Ed: Footnotes Omitted]:
The Division asks that Aesoph be denied the privilege of practicing or appearing beforethe Commission for three years, and Bennett, for two years. Respondents request that the proceeding be dismissed. For the reasons below, Aesoph will be denied the privilege of appearing or practicing before the Commission for one year, and Bennett, for six months.The purpose of Rule 102 sanctions is not to punish, but to protect the public from future reckless or negligent conduct by professionals who practice before the Commission and to encourage more rigorous compliance with auditing standards in future audits. McCurdy v. SEC, 396 F.3d 1258, 1264-65 (D.C. Cir. 2005). The Commission determines sanctions in a Rule 102(e) proceeding according to the so-called Steadman factors,39 and it also considers deterrence. See Steven Altman, Esq., Exchange Act Release No. 63306 (Nov. 10, 2010), 99 SEC Docket 34405, 34435, petition denied, 666 F.3d 1322 (D.C. Cir. 2011). Respondents' auditing lapses, which were negligent, occurred in a single audit. Each continues to audit U.S. public companies as an auditor with KPMG, so the occupation of each will present opportunities for future violations. Consistent with a vigorous defense of the charges, neither has recognized the unreasonable nature of his conduct. Concerning egregiousness, Respondents' conduct fell short of professional standards in their failure to evaluate management's FAS 114 estimates in accordance with professional standards in the face of the need for heightened scrutiny and the corresponding failure to identify a material weakness in TierOne's internal control over financial reporting. Their conduct involved a lack of due care and failure to obtain sufficient evidence to support their audit judgments.Respondents note that they are highly regarded at their firm and have significant experience, recognized risks associated with the ALLL, worked longer hours on the 2008 audit than on the previous audit, and adequately conducted other areas of the audit. These factors are praiseworthy, but do not obviate the need for a sanction. None of the previous auditing engagements on which either Respondent worked has been the subject of any regulatory complaint; however, a lack of a disciplinary record is not an impediment to imposing sanctions for a respondent's first adjudicated disciplinary violation. See Wendy McNeely, CPA, 105 SEC Docket at 61708; Robert Bruce Lohmann, 56 S.E.C. 573, 582-83 (2003); Martin R. Kaiden, 54 S.E.C. 194, 209-10 (1999). A one-year suspension for Aesoph and six-month suspension for Bennett are appropriate sanctions and consistent with Commission precedent and take account of Aesoph's more responsible role in the engagement.
SEC Corrected Opinion
The Respondents appealed the "Initial Decision" to the full SEC. In The Matter Of John J. Aesoph, CPA and Darren M. Bennett, CPA (Corrected Opinion of the Commission; '34 Act Rel. No. 78490; Admin. Proc. File No. 3-15168 / August 5, 2016) [Ed: Footnotes omitted]: As set forth in pertinent part of the "Introduction" section of Opinion:
This case concerns TierOne's loss estimates for impaired commercial real estate loans recorded in its allowance for loan and lease losses ("ALLL") balance sheet reserve account. Those impairment losses drastically increased for TierOne in 2008 because of the sharp deterioration of the real estate market. The ALJ found that Respondents knew or should have known that their audit of the ALLL warranted heightened scrutiny because, among other things, the Office of Thrift Supervision ("OTS") had increased TierOne's capital requirements after finding, during a mid-2008 examination, that TierOne was in "deteriorating financial condition" because of its impaired loan losses. The ALJ found that Respondents knew that TierOne's management had an incentive to intentionally misstate the ALLL to meet the increased capital requirements and prevent potential OTS enforcement action.The ALJ found that Respondents violated PCAOB auditing standards in three aspects oftheir audit of the ALLL: (1) the effectiveness of internal control over financial reporting;(2) substantive audit test work; and (3) post-audit procedures. On appeal, Respondents ask that we dismiss the charges against them and set aside the sanctions imposed-a one-year suspension on Aesoph and a six-month suspension on Bennett from appearing or practicing before us as accountants. The Division of Enforcement ("Division") cross-appeals the sanctions imposed, contending that Aesoph should have received a three-year suspension and Bennett a two-year suspension.Based on our independent review of the record, we find that Respondents engaged in"improper professional conduct" as defined by Rule 102(e)'s negligence-based standards, and that it is in the public interest to deny Respondents the privilege of appearing or practicing before us with a right for Aesoph to apply for reinstatement after three years and for Bennett to apply for reinstatement after two years.
Commissioner Piwowar Dissents
Reminding us of the maverick tendencies of former SEC Commissioner Daniel Gallagher, Commissioner Piwowar authored a separate Concurrence/Dissent apart from Chair White and Commissioner Stein:
I concur with the opinion's findings that the Respondents Aesoph and Bennett engaged in "improper professional conduct" as defined by Rule 102(e)'s negligence-based standards. However, I dissent from the imposition of a permanent denial of the privilege of appearing or practicing before the Commission as an accountant.As recognized by the U.S. Court of Appeals for the D.C. Circuit, "[t]he Commission may impose sanctions for a remedial purpose, but not for punishment" under Rule 102(e).In her initial decision, the administrative law judge determined that Aesoph should be denied the privilege of appearing or practicing before the Commission for one year and Bennett should be denied for six months. In reaching her decision, she considered the Steadman factors and the need for deterrence. She noted as "praiseworthy factors" that the Respondents were highly regarded at their firm, recognized risks associated with the allowance for loan and lease losses, worked longer on the 2008 audit than on the previous audit, and adequately conducted other areas of the audit. Nonetheless, she concluded that these factors did not obviate the need for sanctions and she considered numerous other Commission precedents in reaching her decision.The Division of Enforcement ("Division") requested that Aesoph be denied the privilege for three years and that Bennett be denied for two years. At oral argument, I specifically asked counsel for the Division to clarify whether the Division was seeking a three-year and two year suspension for Aesoph and Bennett, respectively, or whether he was seeking a bar with the right to apply for reinstatement after three years and two years. Counsel for the Division responded the former.By imposing a permanent bar with the right to apply for reinstatement after three years and two years, the majority of the Commission has imposed a punitive sanction that goes far beyond what the Division requested. There is a significant difference between a three-year and two-year suspension as compared to a bar with the right to apply for reinstatement after three years and two years. Under a suspension, the Respondents would be free to resume practicing or appearing before the Commission when the suspension ends. Under a bar with the right to apply for reinstatement, once the requisite time period has passed, Respondents will only be no longer prohibited from seeking reinstatement from the Commission. They must still file a petition with the Commission even to be considered for reinstatement.Petitions for accountant reinstatements are first evaluated by our Office of the Chief Accountant and, if satisfactory, are then recommended to the Commission for approval. There are no deadlines for the Commission or its staff to complete this process. Pursuant to Rule 102(e)(5) of our Rules of Practice, the Commission may, but is not obligated, to reinstate a person "for good cause shown." Based on my experience as Commissioner, the reinstatement process, even if successful, can take years to complete after the requisite time period has expired.Moreover, since there is no assurance that a petition for reinstatement will be granted by the Commission, the right to apply for reinstatement can be illusory.Given the record in this matter, I find no compelling reason for going beyond theDivision's request and imposing a permanent bar with a right to apply for reinstatement on the Respondents. The majority's sole justification for this punitive sanction and resulting destruction of the Respondents' professional careers is that it "follow[s] our usual practice." This is not a sufficient justification under our rules and legal precedents.
Bill Singer's Comment
No Gilding This Lily
Under no circumstances should we gloss over the facts that are at issue in this case. Two KPMG auditors respondents were charged with failing to properly audit TierOne, which appeared to have attempted to hide millions of dollars in loan losses in an apparently futile effort to stave off bankruptcy. The cited auditing failures took place at a time when the real estate market was in turmoil and banks with loan portfolios dependent upon that sector were in dire straits. All of which combined into the mortgage market meltdown and the deadly storm of the Great Recession.
As part of the Respondents's alleged shortcomings was a failure to make adequate inquiry of the so-called Allowance for Loan and Lease Losses ("ALLL"). Respondents allegedly failed to question management's fair-value estimates of the collateral underpinning troubled loans. As a consequence, the red flags waved but were never seen and the Respondents's issued unqualified opinions on TierOne's 2008 financial statements. When the times called for rigorous doubt, the Respondents's efforts took on the appearance of a rubber stamp.
Notwithstanding the compelling case against Respondents, we are compelled to ask whether the sanctions fit the misconduct. The Division sought the denial of the right to practice/appear before the SEC for three years for Aesoph and two years for Bennet. Such a request is not taken lightly by any respondent or legal counsel and is typically the fulcrum upon which decisions to settle or not to settle balance. Notably, the Initial Decision called for lesser sanctions than sought by the Division in the form one year for Aesoph and only six-months for Bennett. All of which was merely preamble when the SEC imposed to what amounts to a Bar from appearance/practice subject to a "right" to apply for reinstatement after three years for Aesoph and after two years for Bennet.
Appellate Unease
In the Initial Decision, the ALJ had imposed only a one-year suspension for Aesoph and a six-month suspension for Bennett. On appeal, the SEC's Division of Enforcement argued that those suspension were too light and should be raised to 3 years for Aesoph and 2 years for Bennett. The full SEC barred both respondents from appearing/practicing before the SEC but granted Aesoph the right to apply for reinstatement after three years and Bennett after two years.
When a case is argued in full with witnesses and evidence before a given trier-of-fact, who then renders a considered decision replete with rationale, there is something fundamentally disturbing when the initial trier-of-fact's findings and sanctions are overturned by a reviewing body (particularly when most appellate bodies do not conduct a plenary hearing). In Aesoph, we confront that disturbing and unsettling process head on. The SEC's facile rationale for enhancing the practice and appearance bars is purportedly based upon "the public interest," but that comes off as not much more than a conclusory because we say so.
For those readers incapable of discerning nuance, let me try to preempt your misunderstanding of my point. Unquestionably, the trade-off for virtually all administrative and judicial appeals is that the appellants argue before an appellate panel without calling witnesses or introducing evidence. It is, after all, an appellate hearing and not a trial. That being said, any appellate system needs to have sufficient integrity so that the precursor trials do not take on the cast of being superfluous.
Pointedly, I am not disagreeing with the factual findings as amply set forth in both the Preliminary Decision and Corrected Opinion. Nor, I would add, am I necessarily disagreeing with the ultimate sanctions of Bars imposed via the Corrected Opinion. I am simply noting that there should always be some unease when an ALJ imposes lesser sanctions, which are thereafter enhanced by Commissioners who have not heard any live testimony during any plenary hearings.
Commissioner Piwowar Stakes Out A Position
In the Matter of the Application of Thomas C. Gonnella (Opinion, '33 Act Rel. No. 10119; '34 Act Rel. No. 78532; Invest. Adv. Act Rel. No. 4476; Invest. Co. Act Rel. No. 32210; Admin. Proc. File No. 3-15737 / August 10, 2016), we are presented with a case where the ALJ;s Initial Decision suspended Respondent Gonnella from the securities industry and from participation in penny stock offerings for twelve months, entered a cease-and-desist order, and assessed a civil money penalty of $82,500. The Division appealed the suspension, and Gonnella cross-appealed the findings of violations and sanctions imposed.
The SEC's Opinion's preamble offers this synopsis:
Respondent, who was associated with a dually registered broker-dealer and investmentadviser, committed fraud when he prearranged to sell and then quickly repurchase aged bonds in his trading book to convey a false appearance of compliance with his firm's aged inventory policy and avoid nonrefundable charges to his trading profits he would have incurred had he held onto the aged bonds. Respondent also aided, abetted, and caused his firm's recordkeeping violations. Held, it is in the public interest to impose an industry bar, including a penny stock bar and bar from serving or acting in certain capacities with respect to an investment company, with a right to reapply after five years; to enter a cease-and-desist order; and to assess a civil money penalty of $82,500.
In an interesting and articulate Concurrence/Dissent, SEC Commissioner Piwowar offer this intriguing commentary in Gonnella:
I concur with the opinion's findings that Respondent Gonnella willfully violated Section17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934, and Exchange Act Rule 10b-5, and that he willfully aided, abetted, and caused Barclays's failure to keep accurate books and records, in violation of Exchange Act Section 17(a) and Exchange Act Rule 17a-3(a)(2). I also concur that it is in the public interest to impose certain sanctions, including a cease-and-desist order and civil money penalties. However, I dissent from Section III.A. of the opinion, in which the majority of the Commission, among other things, imposed a permanent investment company bar, with a right to reapply after five years.As acknowledged in the opinion at footnote 53, the Division of Enforcement ("Division")did not request a bar from serving or acting in certain capacities with respect to an investment company, and the administrative law judge did not impose one. Nonetheless, the majority of the Commission finds that it is in the public interest to impose such a sanction. I have serious concerns, on due process and other grounds, about the Commission imposing sanctions that are neither requested by the Division nor found by the administrative law judge to be appropriate.1 Given the record in this matter, I find no compelling reason for going beyond the Division's request and imposing a permanent bar from serving or acting in certain capacities with respect to an investment company, with a right to reapply after five years.=====
Footnote 1: 1 See, e.g., In the Matter of John J. Aesoph, CPA and Darren M. Bennett, CPA, Exchange Act Rel. No. 78490 (Aug. 5, 2016), available at https://www.sec.gov/litigation/opinions/2016/34-78490.pdf#page=32 (separate opinion, concurring in part and dissenting in part).