Commentary: The Big Five's Credibility Gap Is Getting WiderLouis Lavelle
For nearly 70 years, the nation's accountants have insisted their profession should regulate itself. They won the argument in 1933, persuading Congress to limit the government's role to setting broad standards for company audits. Today, federal regulators investigate about 40 cases of accounting failure a year, and frequently bar accountants from conducting audits. But discipline is largely meted out by the profession itself, and the monitoring of firms large and small is handled by peer review.
But revelations from a New Jersey courtroom suggest just how imperfect that self-regulation can be. Indeed, the portrait of the industry emerging from testimony suggests a coterie of powerful firms rife with incestuous professional relationships that undermine the industry's ability to make rules and investigate transgressions. The testimony also highlights basic structural conflicts, pointing out that Big Five participation in a common insurance pool conceivably could result in one firm paying a steep price for criticizing another.
The case, which went to trial on Oct. 12 in Superior Court in Camden, is being closely watched by the Securities & Exchange Commission. The SEC, intent on eradicating what it views as widespread ethical conflicts, is engaged in a pitched battle with the industry over a proposed rule that would prohibit the Big Five from providing consulting services to audit clients. While it doesn't involve the kind of conflicts the SEC wants outlawed, the New Jersey case suggests that leaving the industry to police itself in matters of ethics is at best a monumental gamble.
At the heart of the case is a fraud. The events, outlined in hundreds of pages of court documents, are undisputed. In 1991, Eugene Unger, a vice-president of Westmont (N.J.)-based Fidelity Mutual Savings & Loan Association, was sentenced to four years in prison for embezzling $6 million over an astonishing 16-year period. His M.O.: writing fake certificates of deposit for customers, using the bank's unnumbered forms, and simply pocketing the depositors' money himself. His fraud went undetected for so long partly because Unger never took a day off, ensuring that no one else ever looked at the fake CDs. When the embezzlement came to light, Fidelity hired KPMG Peat Marwick to determine if its auditor, Deloitte & Touche LLP, was at fault for failing to detect it. The probe, conducted by KPMG partner Roger C. Ham, uncovered massive blunders. Until the fraud was discovered, Deloitte's audits never identified any of the internal control weaknesses--such as unnumbered CDs and the lack of a mandatory vacation policy--that allowed Unger to pull it off.
MISSING WORDS. Ham prepared a scathing report on Deloitte, using the words "failed" or "failure" 10 times. But it never made it to the bank. On Feb. 27, 1991, the general counsel at Deloitte, Howard Krongard, called his close friend Leonard P. Novello, the general counsel at KPMG, to discuss the case, and the report was subsequently rewritten. The new report, authored by KPMG associate general counsel John Shutkin, noted some of the same problems Ham's probe turned up. But the words "failed" and "failure" do not appear. Whether the report was rewritten as a result of the phone call is the central dispute in the lawsuit.
Ham was fired in 1992. KPMG says he was terminated because of chronic alcoholism and low productivity, but Ham claims it was a result of Krongard's call to Novello. Having already arbitrated his grievance with KPMG--the results are confidential--he's now suing Deloitte and Krongard, seeking up to $2.5 million in lost earnings. Neither Krongard nor Novello could be reached for comment.
In his lawsuit, Ham calls the rewrite of his report a "whitewash." And the bank agreed. "When we hired KPMG...we wanted an objective evaluation," said Stephen R. Selverian, the former Fidelity president, in an interview. "And what better way than to go to a Big Five firm to do that?" But Fidelity says it didn't get what it paid for. "Even things an experienced layman would view as less than prudent practices by an auditor were ignored," said Michael D. Varbalow, a lawyer who represented Fidelity. In 1993, the company that acquired Fidelity, First Home Savings Bank, filed suit against Deloitte for failing to detect the internal control problems, and KPMG for failing to challenge Deloitte. First Home said only that it recovered $880,000 in an otherwise confidential 1994 settlement.
GROSS VIOLATION? The evidence for a whitewash is circumstantial, hinging largely on a memo Novello wrote to Shutkin, suggesting that Krongard called to complain about Ham. The memo states that Ham was perceived by "some" at Deloitte as the reason the bank had replaced Deloitte with KPMG just a few days earlier. Both KPMG and Deloitte dispute the whitewash theory. KPMG spokesman Alec Houston said Ham's report was not discussed during the Krongard-Novello call, and the rewrite was to "bring it into conformity with professional standards." Novello is no longer with KPMG and could not be reached for this story. Shutkin, now general counsel for KPMG International, declined comment through a spokesman. Krongard has left the firm and could not be located, and the attorney representing him and Deloitte, Joseph H. Kenney, did not return calls. Deloitte and Krongard, in their court filings, said they never sought Ham's termination or to influence the outcome of his investigation. The phone call, they said, was "innocuous," and Ham's conspiracy theory "preposterous."
In his lawsuit, Ham contends that the Krongard-Novello call was a gross ethical violation. John F. Malloy, a CPA testifying on Ham's behalf, says the call "blatantly and outrageously" violated ethical standards demanded by the American Institute of Certified Public Accountants and the SEC. Ham also says the call violated American Bar Assn. rules. The AICPA, SEC, and ABA would not comment on those assertions and other expert opinion was mixed. Stephen Gillers, a professor of legal ethics at New York University, said that Krongard had an affirmative duty to advance Deloitte's interest. Others weren't so sure. "It raises a question of influence, especially in the context of a later showing that the report was watered down," said Deborah L. Rhode, a law professor and director of the Keck Center on Legal Ethics at Stanford University. "It has the appearance of impropriety."
But the importance of the suit goes well beyond a single phone call and these two firms. The suit alleges that KPMG and Deloitte belong to the same liability insurance pool, so if Ham's report resulted in a damage award against Deloitte, KPMG could suffer higher rates. In fact, all of the Big Five are in the same pool, making an unbiased peer review impossible, according to Dean McMann, chief executive of The Ransford Group, a Big Five consultant. The suit also alleges--and industry sources confirm--that the general counsels of the Big Five firms meet for lunch in New York about every six weeks to discuss matters of common interest, including litigation.
Other testimony points to the possibility of even cozier relationships among the Big Five. Ham's former lawyer said in court documents that Shutkin told him--four times--that it was "business as usual" for Big Five firms to urge one another to avoid jobs that might entail leveling harsh criticism against their accounting brethren. What's more, the lawyer said Shutkin also told him that KPMG had an unwritten policy of not testifying against other national firms. In fact, Douglas R. Carmichael, a Baruch College accounting professor and former vice-president at the AICPA, says such policies are widespread among the Big Five. The fear, he said, is that such criticism will create an impossible standard for them all. "It's like shooting yourself in the foot," he says.
Ham questions whether an industry that can't investigate its own failings is capable of self-regulation. "If you're not willing to investigate your peers, then you don't have the ability to self-regulate," Ham said in an interview. For Ham's lawyer, Robert G. Holston, it all spells trouble: "If you have a system which immunizes the five most dominant players from peer challenge, then what are the implications for the collective quality of accounting work?"
It's a troubling question--for the industry, its clients, and the millions of investors who depend on Big Five audits for peace of mind. And it's one that urgently demands an answer.