It’s becoming clear that the Securities and Exchange Commission is very serious about policing corporate internal controls.
Last week, the SEC okayed a final rule requiring corporations to make sure their controls over finance were up to snuff and fully reported on. But even before that, the commission was reportedly taking legal action against the one of the Big Four audit firms — and its apparent lack of good internal controls.
The SEC, in fact, has asked an administrative law judge to ban Ernst & Young from accepting new clients for six months because of alleged lapses in the firm’s internal controls, according to The Washington Post.
The commission is reportedly charging E&Y with failing to report on its business relationships with audit clients, particularly PeopleSoft. The SEC also alleges that the firm has failed to supply a clear way for employees to speak out internally about partnerships between E&Y and its audit clients.
In court documents cited by the newspaper, commission lawyers called E&Y’s control “woefully inadequate, internally inconsistent, and under-publicized within the firm.” The firm was apparently cited for lacking centralized records that could be regularly looked by regulators wanting to trace E&Y’s client joint ventures.
In a 128-page court brief, the commission reportedly charged E&Y auditors with “widespread independence cluelessness.” For example, the firm’s lead partner for its PeopleSoft account, “remained totally unaware” of a joint software venture until 1999, the SEC alleges. That was “four years into his tenure as PeopleSoft’s auditor certifying E&Y’s independence.”
The reported suit appears to undercut some of the marketing bumf found on the E&Y corporate website. In describing the firm’s quality control policies, the site proclaims that “Ernst & Young’s independence standards are among the strictest in the profession and always have been, and extend beyond those required by the U.S. SEC and professional standards.”
Toward that, E&Y executives reportedly defended their work with PeopleSoft. “Our people know how to raise the issues, and they did,” Beth Brooke, an E&Y vice chairperson, told the Post. E&Y’s audits of PeopleSoft have never been questioned, she said, noting that the firm has sold its consulting practice.
But lawyers at the SEC appear to believe the firm maintained an improper relationship with PeopleSoft while the accountancy served as the software maker’s external auditor, according to the newspaper. From 1994 through 2000, E&Y and PeopleSoft jointly developed and marketed a software product called “EY/GEMS for PeopleSoft,” which incorporated components of PeopleSoft’s proprietary source code into software previously developed and marketed by E&Y’s tax department, according to the SEC.
The SEC sued Ernst & Young last year, charging the firm with violating commission auditor independence rules and generally accepted auditing standards. According to those allegations, E&Y was serving as PeopleSoft’s auditor while simultaneously incorporating the software maker’s source code into its product.
E&Y also allegedly agreed to pay PeopleSoft royalties ranging from 15 percent to 30 percent from each sale of the resulting product, with a guaranteed minimum royalty of $300,000.
The SEC further charged that during the period, E&Y earned hundreds of millions of dollars in consulting revenues from implementing PeopleSoft software for third parties.
Citing government sources, the Post reported that while a ban on obtaining new clients is a serious sanction, it may have little lasting impact on firms seeking an auditor. That’s because companies tend to review their choice of auditor only once a year.
SEC officials had thought about asking for a longer suspension than six months, according to The Wall Street Journal. But they were worried that it would put too great a limit on the choice of auditors available to public companies.
The SEC staff has also recently warned auditors against potential conflicts of interests when marketing software to help clients track and evaluate their internal controls. In a separate story by The Post, the paper noted that Scott A. Taub, the SEC’s deputy chief accountant, said that such moves could raise questions about auditor independence if accounting firms are helping to set up the systems they later evaluate. “Companies and their auditors need to be mindful” of those problems, Taub said.
Among its advisory services, Ernst & Young helps corporate clients determine if their internal controls meet requirements mandated by the Sarbanes-Oxley Act.
The Price of Terrorism: No Insurance
Remember the fuss the insurance industry made about the need for a federal backup for terrorism risk insurance?
It turns out that the Terrorism Risk Insurance Act that insurers managed to wrangle from the government last year hasn’t been much help in making coverage more available or reasonably priced for corporate insureds.
Or at least, that’s the take-away from a new survey of U.S. commercial-line insurers done by Moody’s Investors Service. According to the survey, as of April, few carriers were covering domestic acts of terrorism or selling stand-alone terrorism policies.
Further, no insurer is offering broad coverage for nuclear, biological, or chemical acts of terrorism, notes the report.
Pricing on the scant amount of coverage has cooled somewhat compared to what it was following September 11, 2001.
But terrorism coverage is still extremely dear. “Overall, the act does not yet seem to have increased the availability of terrorism insurance coverage at prices that most buyers would view as reasonable,” says James Bartie, a vice president/senior analyst with Moody’s property & casualty and reinsurance group in New York.
Why has the cost of coverage remained so high? It’s a self-protective device for insurers, according to Moody’s. Insurers are charging extremely high prices “to discourage policyholders from buying terrorism coverage in cities considered highly vulnerable to future attacks,” Bartie says.
Panel Offers IPO Ideas
Whether the moribund market for initial public offerings will soon revive is a highly debatable matter. The five IPOs issued so far this year have raised $593 million, according to Bloomberg News. Last week, Citadel Broadcasting executives said the company planned to raise $306 million in an IPO.
But whatever the state of the market, regulators are making stabs at cleaning up discredited IPO practices. In the most recent effort, an IPO advisory committee formed by the New York Stock Exchange and NASD (at the SEC’s request) has coughed up its recommendations for cleaning up the market.
A big source of IPO abuse arising during the late 1990s bubble were whopping aftermarket premiums, the committee said in its report. Those huge first-day price boosts created a pool of instant profits that underwriters sometimes swapped for promises of future business.
Staffed by such bigs as NYSE director and former Clinton Administration Chief of Staff Leon Panetta and former Merrill Lynch chairman Daniel Tully, the committee cited four harmful IPO practices that could use fixing:
- “Spinning.” In return for investment-banking business, some underwriters doled out “hot” IPO shares to executives and directors of potential clients.
- Plumping up aftermarket prices. Some underwriters used unfair or illegal ploys to keep prices high and boost demand after IPOS were issued. Among the tactics: dishing out shares based on an investor’s commitment to buy more of them in the aftermarket at preset prices.
- Illegal quid pro quos. Underwriters unlawfully allocated IPO shares based on an investor’s agreement to pay overly steep commissions on trades of other securities.
- Biased analyst advice. Some research analysts apparently agreed to stick with “buy” recommendations on certain stocks in the face of prices that jumped exponentially in the aftermarket.
The panel delivered a slew of recommendations aimed at stopping IPO chicanery. They include: requiring boards to set up IPO pricing committees; preventing “laddering” (luring investors to buy shares in the aftermarket at specified prices in exchange for IPO allocations); and barring IPO share allocation to corporate officers and directors of companies who have investment banking relationships with an underwriter.
While the SEC hasn’t set a deadline for adopting IPO rules, it will hold a comment period in the next few months, according to The New York Times. During that time, NYSE and NASD committees will mull over the advisory committee’s recommendations. The rule proposals that emerge from those talks would then be sent to the SEC for final approval.
Schering-Plough Probe Widens
In a widening criminal investigation of Schering-Plough, the U.S. District Attorney for Massachusetts told the company that it’s being investigated by a federal grand jury.
The pharmaceutical company had previously disclosed that the U.S. Attorney’s Office was investigating its sales, marketing, and clinical trial practices. Now Schering-Plough executives say they understand that the government has enough evidence to support an indictment.
The grand jury is looking into possible document destruction and obstruction-of-justice charges. It’s also probing the possibility of payoffs to managed care organizations and doctors to get them to buy Schering products paid for through federal health care programs.
Other possible charges include the sale of misbranded or unapproved drugs and the submitting of false pharmaceutical pricing information to the government.
Schering-Plough executives said the company is cooperating with the U.S. Attorney’s office on the investigation.