SEC Says Independence Compromised By Auditor And Client Friendship

September 23, 2016

When does a relationship between an auditor and the audit client become too close so as to cross over the line from merely a "close personal relationship" and wind up in the land of "compromising?" A recent Securities and Exchange Commission settlement shows how the federal regulator grapples with that edgy issue.  More ominously, what may have passed as harmless T&E for generations may no longer pass the sniff test.  

SEC Actions Doubled

The Securities and Exchange Commission's ("SEC's") Director of Enforcement Andrew Ceresney ominously noted in a recent speech [Ed: Footnotes omitted]: 

While the numbers only tell part of the story, from fiscal year 2013 through the end of last fiscal year, excluding follow-on proceedings, the Commission has more than doubled its actions in the issuer reporting and disclosure area, which includes actions against auditors and audit firms - from 53 in fiscal year 2013 to 114 in fiscal year 2015. We have made similar strides in the number of parties we have charged for such violations: in the past two fiscal years, excluding follow-ons, we have charged 128 and 191 parties, respectively, with issuer reporting and disclosure violations, a significant increase over the prior years. The number of accountant proceedings under Rule 102(e) has also been increasing, from 37 respondents in fiscal year 2013 to 76 respondents in fiscal year 2015, which included actions against 57 individual accountants and 19 firms. And, we continue to see similar trends in the number of proceedings against accountants under Rule 102(e) in the current fiscal year.

"The SEC Enforcement Division's Focus on Auditors and AuditingAndrew Ceresney, Director, Division of Enforcement / Keynote Address; American Law Institute Conference on Accountants' Liability 2016: Confronting Enforcement and Litigation Risks; Washington, D.C. / Sept. 22, 2016. 

Auditors and their issuer clients would be wise to heed Ceresney's comments. Note his observation that the SEC sees "similar trends" in the current year.

Case In Point

In anticipation of the institution of these proceedings by the Securities and Exchange Commission ("SEC") but without admitting or denying the findings, Robert A. Waegelein, CPA, submitted an Offer of Settlement (an "Offer"), which the federal regulator accepted. In the Matter of Robert A. Waegelein, CPA, Respndent (Order Instituting Cease And-Desist Proceedings, Making Findings, and Imposing A Cease-And-Desist Order, SEC, '34 Act Rel. No. 78897; Acct. and Audit. Enf. Rel. No. 3805; Admin. Proc. File No. 3-17562 / September 21, 2016). The SEC's Order Instituting Proceedings ("OIP") found that Waegelein had caused an issuer (an unnamed NYSE publicly-traded company) to violate Section 13(a) of the Securities Exchange Act of 1934 and Rule 13a-1 thereunder. In settling the matter, Waegelein agreed to a cease-and-desist order and to pay a civil penalty of $25,000.

 As set forth in the OIP's "Summary":

This matter arises from a close personal relationship between Respondent, the former chief financial officer of a New York-based public issuer ("Issuer"), and a former partner of the public accounting firm retained to provide an independent audit of the Issuer's financial statements (respectively, the "Audit Partner" and the "Audit Firm"). Section 13(a) of the Exchange Act and Rule 13a-1 thereunder require public companies like the Issuer to file annual reports with the Commission that have been audited by an independent accountant. The close personal relationship between Respondent and the Audit Partner caused the Audit Firm to lack independence during the 2012, 2013, and 2014 audit and professional engagement periods. Nonetheless, Respondent continued to certify Issuer's annual reports and allowed them to be publicly filed. By so doing, Respondent caused the Issuer to violate Section 13(a) and Rule 13a-1 thereunder.

"Troubled" Account

As noted in the "Summary," this settlement attempts to address the nature of a "close personal relationship" between an accounting firm Partner in the role of an auditor and Respondent, the former chief financial officer of a client public issuer, The SEC's concern was whether that relationship got too close and compromised the "independence" of the audits. As detailed in the OIP, the issuer client was deemed a "Troubled Account" by the audit firm and a replacement audit team  headed by a partner who was told to mend the relationship, which had previously soured:

Background of the Audit Firm's Relationship with the Issuer

5. The Audit Firm served as the Issuer's auditor from 1995 until August 2015, when the Issuer terminated the Audit Firm. Between 1995 and 2010, the Issuer, including Respondent, expressed dissatisfaction with certain aspects of the Audit Firm's performance. As a result, in 2010, the Issuer informed the Audit Firm that it was considering changing audit firms.

6. In response, the Audit Firm presented the Issuer with a replacement audit team led by the Audit Partner, who would serve as coordinating partner. "Coordinating partner" was the term used by the Audit Firm to describe the lead partner on this audit engagement. The Issuer's audit committee decided to continue to retain the Audit Firm as its auditor.

7. Based on internal discussions at the Audit Firm, the Audit Partner understood that the Issuer was a "troubled account" and that his responsibilities as coordinating partner would include "developing" and "mending" the Audit Firm's relationship with the Issuer. The Audit Partner, along with several other engagement partners assigned to the Issuer's audit, assumed their roles on the Issuer's engagement team in or around May 2010. Respondent, as the chief financial officer ("CFO") of the Issuer, had regular communications with the Audit Firm engagement team about significant accounting issues and other issues relevant to the Issuer's audit. 

Damage Control or Friendship?

In fleshing out the nature of the allegedly inappropriate professional relationship between the Audit Partner/Audit Firm and Respondent/Issuer, the OIP offers these examples:

12. For example, in January 2012, the Audit Partner gifted tickets to two successive regular season professional football games to Respondent for Respondent and his family to attend. Neither the Audit Partner nor any other the Audit Firm employee attended these games with Respondent and his family.

13. The following week, the Audit Partner and his wife took a trip to Green Bay, Wisconsin with Respondent and Respondent's son to attend a professional football playoff game. The Audit Partner purchased the tickets for the group, and they stayed overnight at the same hotel near Green Bay.

14. Two months later, in March 2012, the Audit Partner, who was in South Carolina for a separate golf outing, visited Respondent at Respondent's brother-in-law's vacation home in Hilton Head. The Audit Partner stayed overnight in that vacation home, where Respondent was also staying.

15. In October 2012, Respondent stayed overnight at the Audit Partner's apartment while on a business trip to Chicago. The Audit Partner and Respondent then planned a joint overnight trip to Nashville, Tennessee the following month to, among other things, play golf and attend a professional football game. While Respondent ultimately cancelled the trip, the Audit Partner and his wife travelled to Nashville and attended the football game with the Audit Partner's brother and Respondent's son, both of whom lived in Nashville.

16. In April 2013, the Audit Partner, Respondent, and members of their respective families again traveled to Nashville to celebrate the Audit Partner's birthday and attend a professional hockey game together. Upon learning that the Respondent and his son were attending a golf tournament in Augusta, Georgia later that same month, the Audit Partner and his wife traveled to Augusta, Georgia to attend the Masters golf tournament. Another Audit Firm partner also attended this trip. The Audit Partner and his wife, the other Audit Firm partner, Respondent, and Respondent's son stayed in the same hotel during this trip.

17. In October 2013, Respondent and his son traveled to Chicago for the purpose of visiting the Audit Partner and his wife, and attending a professional football game and a golf outing with them. Respondent and his son stayed overnight in the guest apartment in the Audit Partner's building during this trip.

18. In April 2014, the Audit Partner and his wife traveled to South Carolina for the purpose of spending leisure time and attending a golf tournament with Respondent and his family over Easter weekend, staying three nights as guests at Respondent's vacation home. After the trip, the Audit Partner thanked Respondent and his family for "treating us to such a wonderful time"; Respondent responded, "I can see many more of these ahead in the coming years . . . we appreciate how generous you are with us as well."

19. In December 2014, the Audit Partner, Respondent, and their respective wives flew to Nashville to attend a professional hockey game with Respondent's son, among others. In an email to Respondent and members of Respondent's family after the trip, the Audit Partner described the trip as a "Great 24 Hour Extravaganza," writing "We had a blast (as usual) being with all of you."  

20. In or around February 2015, the Audit Partner began planning a second overnight trip to the Masters golf tournament in April 2015 with Respondent, Respondent's son, and another Audit Firm partner, among others. The Audit Partner planned to treat the trip in part as a retirement party for Respondent. Respondent and the other Audit Firm partner did not attend this trip, after the Audit Firm received a regulatory inquiry in March 2015 regarding the Audit Partner's relationship with Respondent.

A Matter of Independence

In considering the above cited entertainment/travel events and other matters, we must wonder as to where lines should be drawn in the future. Are the trips too many in number or was the problem the involvement of family? Do the travel and entertainment expenses reflect a developing personal relationship that overwhelmed the professional one, or were the issues here limited to the parties and would not necessarily have the same impact if other individuals were involved? As the OIP explains in pertinent part:

31. The circumstances in which an auditor will-and will not-be deemed independent are set forth in Rule 2-01 of Regulation S-X. Rule 2-01(c) provides a non-exclusive list of specific relationships that render an accountant non-independent. Rule 2-01(b) provides the "general standard" for auditor independence, which all auditors must meet even if their conduct does not fall within one of the specific prohibitions in Rule 2-01(c). Under the general standard,

[t]he Commission will not recognize an accountant as independent, with respect to an audit client, if the accountant is not, or a reasonable investor with knowledge of all relevant facts and circumstances would conclude that the accountant is not, capable of exercising objective and impartial judgment on all issues encompassed within the accountant's engagement. In determining whether an accountant is independent, the Commission will consider all relevant circumstances, including all relationships between the accountant and the audit client and not just those relating to reports filed with the Commission.

17 C.F.R. § 210.2-01(b) (emphasis added). This standard applies with equal force to individual accountants and the audit firms in which they practice. See 17 C.F.R. § 210.2-01(f)(1).

Bill Singer's Comment

Compliments to the SEC on drafting a compelling OIP, which sets forth the underlying facts and rationale in a comprehensive fashion. Readers may disagree with the conclusions but there should be no doubt as to the SEC's concerns or perceptions, both of which are clearly presented.

From my perspective, once the Audit Firm deemed the Issuer a "Troubled Account," heightened policies should have been implemented to ensure that the new Audit Partner and team were not engaging in damage control designed to placate an unhappy client rather than continuing to ensure that audits were conducted in a rigorous fashion in accordance with applicable audit rules and regulations. One has to wonder how much harm the Audit Firm caused itself when internal discussions prompted the Audit Partner to believe that his role with the Issuer included "developing" and "mending" the Audit Firm's relationship with the Issuer." On the other hand, what service business does not view its mission as developing client relationships and mending those that have gone astray? After all, it's still a business and we're not shooting an episode of "Friends."

How should protocols be designed and implemented to permit an audit firm to monitor its staff's T&E activities -- and, more critically, when do we reach that territory when a given expense is "too much" or the number or kind of trips/entertainment becomes inappropriate? Frankly, that's pretty much a rhetorical question; but it is, perhaps, the most important such query that needs to be asked within any regulated industry. What are the lines that should not be crossed? Who properly designates "No Man's Land": an outside regulator or industry participants? How can proscribed and prescribed conduct be monitored, who should be tasked with such oversight, what prerogatives do the supervisors have in terms of discipline, and, finally, who is watching the watchers?  Again, more rhetoric.

For those who argue that we live in an over-regulated society, cases such as Waegelein become the best example of regulatory excess; on the other hand, for those who argue for more regulation, Waegelein is a powerful example of what's wrong and what needs fixing. It is that very dynamic and tension between trusting an industry to utilize in-house compliance versus imposing an outside governmental regulator that continues to bedevil us in so many aspects of business. I have no definitive answers. My role at this point is merely one of agent provocateur.


In the Matter of Robert A. Waegelein, CPA, Respndent (Order Instituting Cease And-Desist Proceedings, Making Findings, and Imposing A Cease-And-Desist Order, SEC, '34 Act Rel. No. 78897; Acct. and Audit. Enf. Rel. No. 3805; Admin. Proc. File No. 3-17562 / September 21, 2016)

"The SEC Enforcement Division's Focus on Auditors and AuditingAndrew Ceresney, Director, Division of Enforcement / Keynote Address; American Law Institute Conference on Accountants' Liability 2016: Confronting Enforcement and Litigation Risks; Washington, D.C. / Sept. 22, 2016