What Possesses an Audit Partner to Trade on Insider Information?

KPMG is embroiled in an insider trading scandal that concerns me because a pattern of such improprieties may be developing. In 2010, Deloitte and Touche was investigated by the SEC for repeated insider trading by Thomas P. Flanagan, a former management advisory partner and a Vice Chairman at Deloitte. Flanagan traded in the securities of multiple Deloitte clients on the basis of inside information that he learned through his duties at the firm. The inside information concerned market moving events such as earnings results, revisions to earnings guidance, sales figures and cost cutting, and an acquisition. Flanagan’s illegal trading resulted in profits of more than $430,000. In the SEC action, Flanagan was sentenced to 21 months in prison after he pleaded guilty to securities fraud. Flanagan also tipped his son, Patrick, to certain of this material non-public information. Patrick then traded based on that information. His illegal trading resulted in profits of more than $57,000.

The KPMG case is a particularly egregious one because it involves insider trading by an auditor of client stock. Scott London, the partner in charge of audits of Herbalife Ltd. and Skechers USA Inc., traded on inside information for personal gain.  KPMG resigned as the auditor of both companies after learning that London provided non-public information about the companies to a third party, who then used the information in stock trades. The firm fired London.  

In resigning the two audit accounts, KPMG said it was withdrawing its blessing on the financial statements of Herbalife for the past three years and of Skechers for the past two. KPMG stressed, however, that it had no reason to believe there were any errors in the companies' books. Both companies said they are moving to find new auditors.

In a statement that should raise red flags for all CPA firms that audit public companies, KPMG stated it had concluded it was not independent because of alleged insider trading. Independence is the foundation of the accounting profession and the cornerstone of an audit conducted in accordance with generally accepted auditing standards. The public (i.e., shareholders and creditors) relies on auditors’ independence, objectivity, and integrity to ensure that the audit has been conducted in accordance with such standards and that the financial statements are free of material misstatements.

I’m having a hard time understanding the stupidity and moral blindness of London in this case. Surely he knew of his ethical obligations. All audit firms supposedly have been carefully assessing independence in the aftermath of financial frauds in the late 1990s and early 2000s (i.e., Enron and WorldCom). Firms generally have quality controls in place to prevent compromises to audit independence.

Trading on insider information for cash and gifts is bad enough, and when done by an audit partner it is unforgiveable. Even more baffling to me is that the quid pro quo for passing along stock tips about clients to a friend for London was to receive cash and gifts in return. According to London, he received a discount on a watch, and the friend bought him dinners from time to time and on a couple of occasions gave him $1,000 to $2,000 in cash. A cynic might say he sold himself cheap.

So, what happens next? Both Herbalife and Skechers will need to have their financial statements re-audited, not an inexpensive proposition. Even though the companies were not at fault, the public may misunderstand and think the companies were complicit in the matter.

For KPMG, the insider trading investigation is a setback. The accounting firm has worked hard to rehabilitate its reputation after coming under scrutiny last decade in a wave of corporate accounting scandals and the firm’s role in the marketing of fraudulent tax shelters. KPMG paid large nine-figure settlements to resolve lawsuits related to accounting scandals at the drugstore chain Rite-Aid and Oxford Health Plans. In 2005, the firm paid a $456 million penalty to the government related to tax fraud.

I have to wonder whether insider trading by partners at Deloitte and KPMG portends a larger scandal on the horizon. It seems every ten years or so the accounting profession finds itself in a “pickle” and hauled before Congress to explain its actions. It is about that time following financial frauds at Enron, WorldCom and a host of other companies. I don’t know how to get the message across to those in the profession that every time such incidents occur, and now insider trading, the public loses patience with the profession and doubts begin to surface about whether the profession truly acts to protect the public interest.

Blog Posted by Steven Mintz, aka Ethics Sage, on April 12, 2013