By Guest commentary Friday, May 3rd, 2013

By Steven Mintz on May 3, 2013

What possesses an audit partner to trade on inside information and violate the accounting profession’s most sacred ethical standard of audit independence? Is it carelessness, greed or ethical blindness? In the case of Scott London, the former partner in charge of KPMG’s Southern California regional audit practice, it was likely a bit of each that motivated him to violate ethical standards and, in the course of doing so, caused the audit opinions signed by London on Skechers and Herbalife to be withdrawn by the accounting firm.

This case has a local twist, as pointed out by Business Times reporter Stephen Nellis in the April 19 article headlined “Deckers, PCBC were victims of auditor leaks.” Goleta-based Deckers and Pacific Capital Bancorp, the former parent of Santa Barbara Bank & Trust, which is now part of Union Bank, were both caught up in the scandal.

Overall, London is charged with leaking confidential information to his friend Brian Shaw about Deckers, Pacific Capital, Manhattan Beach-based Skechers, and Los Angeles-based Herbalife. The leak of information about quarterly earnings information led to Shaw being unjustly enriched by $1.27 million. Shaw, a jewelry store owner and country club friend of London, repaid London with $50,000 in cash and a Rolex watch, according to prosecutors.

The leaking of financial information about a company to anyone prior to its public release affects the level playing field that should exist with respect to personal and business contacts of an auditor and the general public. It violates the fairness doctrine in treating equals equally, and it violates basic integrity standards. As Business Times Editor Henry Duboff noted in his column on April 19, what London and Shaw admitted to “cuts to the core values of integrity and trust – the real foundations of our free enterprise system.”

The KPMG scandal concerns me because a pattern of such improprieties may be developing. In 2010, Deloitte and Touche was investigated by the U.S. Securities and Exchange Commission for repeated insider trading by Thomas Flanagan, a former management advisory partner and a vice chairman at Deloitte. Flanagan traded in the securities of multiple Deloitte clients on the basis of inside information that he learned through his duties at the firm. The inside information concerned market moving events such as earnings results, revisions to earnings guidance, sales figures and cost cutting, and an acquisition. Flanagan’s illegal trading resulted in profits of more than $430,000. In the SEC action, Flanagan was sentenced to 21 months in prison after he pleaded guilty to securities fraud. Flanagan also tipped his son, Patrick, to certain of this material non-public information. Patrick then traded based on that information. His illegal trading resulted in profits of more than $57,000.

The KPMG case is a particularly egregious one because it involves insider trading by an auditor of client stock. This incident jogged my memory and I came up with a characterization of London’s actions as “stupid is as stupid does.” Forrest Gump quotes are uncomplicated, basic and true. They are almost Zen-like in their simplicity. This one fits Scott London’s actions perfectly. However, in public accounting, stupidity is not a defense for violating the independence standard that protects the public from shortsightedness and egotistical behavior on the part of auditors who are charged to protect the public interest.

This isn’t the first time in recent years that KPMG has been investigated for gross violations of ethical standards. In 2005, KPMG agreed to pay a hefty fine of $456 million and cease its private-client tax practice after admitting that it defrauded the government and the IRS in a major tax shelter scandal. The firm agreed not to develop, sell, or implement any pre-packaged tax products.  Three staff members were sentenced to serve terms ranging from six-and-a-half to 10 years in prison as a result of providing opinion letters that endorsed the shelters and helped KPMG’s wealthiest clients claim bogus losses to offset their massive capital gains.

In withdrawing its audit opinion on Skechers and Herbalife, KPMG released a statement that should raise red flags for all CPA firms that audit public companies. The firm stated it had concluded it was not independent because of alleged insider trading. This is a weak statement at best and illustrates the moral blindness of some public accounting firms that do not seem to realize they are at fault for the actions of auditors with respect to the use of inside information.

Public accounting firms have an ethical obligation to monitor the actions of their partners, managers and staff for anything that may impair audit independence. The failure in this instance of KPMG is in its lack of quality controls to prevent and detect violations of basic ethical standards. I call on the California Board of Accountancy to investigate the KPMG insider information case for the firm’s failure to properly oversee its own internal controls on safeguarding client information and monitoring the independence standards that underlie audited financial statements and build trust in our financial reporting system.

• Steven Mintz is an accounting professor in the Orfalea College of Business at Cal Poly San Luis Obispo. He blogs about ethics issues at www.ethicssage.com.