Audit Partner Violates Independence Rule In Way He Probably Never Expected

I’ve been thinking about these auditor independence cases since the administrative orders were issued a few weeks ago.  They’re very interesting to me for a couple of reasons, but let’s start with the rules:

The Rules

Rule 2-02(b)(1) of Reg. S-X requires each auditor’s report on a public issuer’s financial statements to say “whether the audit was made in accordance with generally accepted auditing standards” (“GAAS”), including auditing standards set forth in SEC and PCAOB rules.  GAAS, in turn, requires auditors to be independent from their clients in both fact and appearance. PCAOB Rule 3520; PCAOB Auditing Standards, Independence, AU § 220.03.  And, facts and appearance are “equally important” in this area.  In re Ernst & Young LLP, Exchange Act Rel. No. 46,821, at *30 (Apr. 16, 2004); see also United States v. Arthur Young & Co., 465 U.S. 805, 819 n.15 (1984) (“It is therefore not enough that financial statements be accurate; the public must also perceive them as being accurate.”).

Rule 2-01(b) provides the “general standard” for auditor independence.  Rule 2-01(c) provides a non-exclusive list of specific relationships that render an accountant non-independent.  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.

Rule 2-01(b).  Under Rule 2-01(f)(1), this standard applies to individual accountants and their firms.

The Allegations

Engagement Partner

The SEC alleges that between March 2012 and June 2014, Engagement Partner and Robert Brehl, then the Chief Accounting Officer at audit client Ventas, maintained a close personal and romantic relationship while Engagement Partner was the engagement partner – and later the coordinating partner – on the team that performed audit and review services for Ventas.

As a result, the SEC says, the auditing firm violated Rule 2-02(b)(1) by falsely certifying that its reports for the 2012 and 2013 financial statement audits were conducted in accordance with PCAOB standards, when in fact the firm lacked independence during those periods.  Engagement Partner caused the firm’s violations of Rule 2-02(b)(1).  Engagement Partner and the firm also caused Ventas to violate Section 13(a) of the Exchange Act and Rule 13a-1 in 2012 and 2013. Those provisions require public issuers to file annual reports with the Commission that have been audited by an independent accountant. Engagement Partner and the firm caused Ventas’s violations of those provisions because they each knew or should have known that Engagement Partner’s relationship with Brehl deprived Ventas of an independent auditor.

Coordinating Partner

But that was not all.  Oh, no, that was not all.  Because this engagement also featured a Coordinating Partner, who was allegedly aware of facts that should have caused him to ask about a possible romantic relationship between Brehl and Engagement Partner. From early 2013 through June 2014, Coordinating Partner periodically told colleagues that Brehl was interested in a romantic relationship with Engagement Partner and that he thought she obtained responsibilities on the Engagement Team for that reason.

Coordinating Partner made these comments to Engagement Partner, a few members of the Engagement Team, and even employees at another audit client. Engagement Partner responded to Coordinating Partner’s comments by denying that Brehl maintained a romantic interest in her or by walking away. Despite her denials, Coordinating Partner continued to repeat these sorts of comments, including in January 2014 when he told a member of the Engagement Team that he thought Brehl’s romantic interest in Engagement Partner was the reason she had been selected as the coordinating partner on the Engagement Team.

On Feb. 11, 2014, Vice Presidents A and B informally met with Coordinating Partner and another audit firm partner at a restaurant after work. A and B expressed concern that Brehl and Engagement Partner were engaged in an inappropriate relationship. In response, Coordinating Partner and the other audit firm partner described their observations of other potentially inappropriate interactions between Brehl and Engagement Partner. Without inquiring further, Coordinating Partner authorized the release of the firm’s Report of Independent Registered Public Accounting Firm, which Ventas filed on Feb. 18, 2014.

Despite Coordinating Partner’s observation and the comments of A and B, Coordinating Partner never inquired of Engagement Partner about the extent of her relationship with Brehl or provided her with guidance. Nor did he raise any concerns about Brehl’s and Engagement Partner’s relationship with the audit firm’s U.S. Independence group. Coordinating Partner’s failure in this regard violated the audit firm’s independence policies. Those policies provide that coordinating partners bear ultimate responsibility for independence issues on their engagements and in that regard they must identify threats to the audit firm’s independence, and upon such identification, consult with the audit firm’s U.S. Independence group. Coordinating Partner did none of these things.

For all of this, the SEC found that Coordinating Partner engaged in improper professional conduct and denied him the privilege of appearing or practicing before the Commission as an accountant, for three years.

What to Do (if you’re Coodinating Partner)

I am most interested in Coordinating Partner here.  As described in the SEC’s allegations, he had a lot of data suggesting an inappropriate relationship between Engagement Partner and Brehl.  But how sure do you have to be?  And if you’re in that position, what do you have to do?  The allegations section suggests that he should have confronted Engagement Partner about it directly.  Would you want to do that?  I wouldn’t.  The allegations section also says he didn’t raise any concerns about Brehl’s and Engagement Partner’s relationship with the audit firm’s U.S. Independence group.  Now that may be an easier lift.  He did mention his concerns to other members of the engagement team, but that doesn’t appear to be enough.  For people in Coordinating Partner’s position – viewing a personal relationship with an officer at an audit client – don’t keep that information to yourself, and don’t just gossip about it.  Make sure the right people at your firm know what you know.  Here, it was the audit firm’s U.S. Independence group.  At another firm, it might be another group.  But let the group know, and document the communication.  Coordinating Partner here can’t appear before the SEC for three years because he didn’t do that.