United States: A CD Or Not A CD, That Is The Question… That The Auditors Should Have Answered

A headline-grabbing SEC enforcement action last week against BDO USA and several of its national partners may lead audit firms to insist on more audit committee-led investigations when questionable transactions are identified. On September 9, the SEC announced an enforcement action against national audit firm BDO USA and five of its partners, including charges against the national director of accounting and national SEC practice director. To settle the matter, BDO was forced to admit wrongdoing, and agreed to pay over $2 million and institute remedial undertakings. Four BDO partners agreed to be barred from practicing before the SEC for various lengths of time, ranging from one to three years, and each agreed to pay monetary penalties. A fifth partner agreed to pay a penalty and cease and deist from various violations, but was not barred from practice.

Underlying the SEC's allegations is a tabloid-ready tale of a conspiracy, led by former convicted felon Wilber Huff, to secretly control General Employment Services, Inc. ("GEE"), the company audited by BDO.  Huff allegedly found the perfect front person to be CEO–Stephen Pence, who was both a U.S. Attorney when Huff pled guilty to fraud several years earlier and the former lieutenant governor of Kentucky. In a separate complaint against Pence, the SEC claims that in exchange for acting as the front man for the business, Pence was paid $500,000 and given a Cadillac Escalade worth about $50,000. The SEC claims that to conceal embezzlement by Huff and other co-conspirators from GEE, the company recorded a bank CD on its books. The SEC's detailed Orders against BDO and its five partners allege that after encountering red flags about whether the $2.3 million bank CD existed, as well as other indications of fraudulent related party transactions, BDO demanded the GEE audit committee hire counsel to conduct an independent investigation before BDO would issue a clean audit opinion. Instead of undertaking an investigation, GEE replaced Pence with a new CEO, and admitted to BDO that "inappropriate actions [had been] taken," but promised that such actions would stop. Although internal BDO emails acknowledged that the auditors still had not received adequate explanations for the red flags, BDO withdrew its demand for an investigation and issued its audit opinion. Several months after BDO issued its unqualified opinion, one of Huff's co-conspirators in the scheme was indicted, becoming the first of two individuals charged criminally in connection with the matter.

SEC enforcement actions against senior leadership of audit firms are quite unusual, and the case also marks the first time that an audit firm has had to admit wrongdoing as part of an SEC settlement. Already, the BDO case is reverberating among the top leadership of national audit firms, as it is being read as further evidence of the SEC's increasingly tough line against gatekeepers such as auditors. In a conference call with reporters when the case was filed, SEC enforcement chief Andrew Ceresney said that "the message of this case [is] that audit firms need, when they see red flags, to ensure that they receive reasonable and coherent answers.... before they sign off" on the audit.

The Bottom Line: Once outside auditors raise serious questions about a transaction or about management's integrity, they may require an independent investigation to answer those questions and provide reassurance that the issue is not more widespread. In such situations, companies facing skeptical auditors may well decide to proactively initiate an independent investigation before the auditors force them to do so.

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