SEC Sues Auditor for Failing to Audit
This world has a lot of problems that require fixing, but I dare say that scratch-off lottery tickets is not one of them. Still, that is the problem that Lee Cole and Linden Boyne ventured to solve through Electronic Game Card, Inc. (EGMI), a company that tried to develop credit card-sized electronic games that could be programmed for use by lotteries as alternatives to those scratch-off tickets. In trying to solve that problem, though, they allegedly created some others. Namely, they orchestrated a scheme in which EGMI enticed investors by claiming to have millions of dollars in annual revenue, hold millions of dollars in investments, and own an off-shore bank account worth $10 million. All of this is according to the SEC, which yesterday sued EGMI’s CEO Cole, its CFO Boyne, and Kevin Donovan, who followed Cole as CEO in 2009. Microcap frauds like this one happen all the time, and by itself EGMI probably would not be especially noteworthy. But the SEC also charged the company’s outside auditor essentially for failing to audit EGMI while saying publicly that he had. The SEC has gotten some criticism recently for a lack of similar claims, and the audit angle may be worth exploration.
The Audits
The firm engaged to audit EGMI’s financial statements was Mendoza Berger & Co., a public accounting firm based in Irvine, California, and the engagement partner for EGMI’s work was a CPA named Timothy Quintanilla. While Mendoza purported to issue audit opinions for EGMI’s 2006, 2007, and 2008 financial statements in accordance with PCAOB standards, the SEC alleges that the “audits” were not audits at all. In fact, it claims, Mendozas work was “cursory, time-constrained, and plainly insufficient under applicable auditing standards.” Members of the Mendoza audit team had many concerns with the accuracy of EGMI’s financial statements, yet failed to perform or document work necessary to substantiate the opinions later issued by the firm. One team member warned his bosses as much, writing this in an email after reviewing EGMI’s 2008 financial statements:
“”””I had brought up to Tim [Quintanilla] that the client was sketchy as we had to confirm material bank accounts and receivable transactions to offshore P.O. boxes. We were worried during the audit that there may be a misappropriation of assets and have also found very little outside information on their customers . . . . I significantly doubt the Company has any operations at all and believe it was more likely used as a vehicle . . . to fraudulently raise money from investors . . . or to launder dirty money. . .
One especially noteworthy area of concern was a bank account that purportedly held more than half of EGMI’s assets from 2006 through 2008. The SEC charges that Quintanilla should have applied a great deal of scrutiny to that account because (1) it was understood to be EGMI’s main operating account; (2) the audit team had determined that the “inherent risk” of EGMI materially misstating the value of its cash assets was high; and (3) the account statements were strangely formatted and suspicious on their face. Still, the audit team conducted only a cursory review of the account. The audit failures were so severe that shortly before the PCAOB’s anticipated inspection of Mendoza in September 2009, select employees “were instructed – with Quintanilla’s knowledge” to see that the EGMI audit files were in order. This re-ordering consisted of creating and backdating documents to conceal known holes in the audit. Oddly, the complaint is phrased in the passive voice as I quote it above, so it’s impossible to tell who besides Quintanilla instructed Mendoza employees to create and backdate those documents.
Other Issues
In addition to the fraud claims, the SEC also charges Cole and Boyne for violating Section 16(a) of the Exchange Act. That section requires officers and directors to timely and accurately report their holdings and trades of their company’s securities. It is a threshold provision, compliance with which is designed to prevent frauds that can otherwise happen. The idea is that if corporate insiders are selling shares in droves, investors ought to be able to know that. Here, if Cole and Boyne had recorded their sales of EGMI stock as the sales happened, investors would have been alerted and the underlying fraud might not have gotten off the ground. Cole and Boyne were also charged with aiding and abetting EGMI’s violations of the anti-fraud provisions, though EGMI itself was not charged. This is a bit unusual, but it does happen. EGMI’s bankruptcy in 2010 surely figured into the SEC’s decision not to charge it.
My Take
If the Mendoza/Quintanilla audits were as alleged by the SEC, they were pretty horrendous and merit enforcement action. But I suspect this case will not assuage those who think audits of public companies have been under-scrutinized by the SEC. Put another way, if Quintanilla wasn’t going to face action for its “audits” of EGMI, it’s hard to imagine which audits would be weak enough to clear that bar. It will be interesting to see if the SEC starts to push harder in this direction. The case continues in litigation.