ANOTHER DAY IN THE MARKETS...
SEC Says Ernst & Young Violated Independence Rules in Past Audits
By MICHAEL SCHROEDER and SCOT J. PALTROW
Staff Reporters of THE WALL STREET JOURNAL
WASHINGTON -- The Securities and Exchange Commission charged Ernst & Young LLP with violating SEC rules by entering into lucrative business deals with a software company that it also audited.
The SEC alleged that Ernst & Young's profit-making marketing agreement in the late 1990s with PeopleSoft Inc. prevented the accounting firm from serving as an unbiased auditor of the publicly traded company's books, a federally regulated role intended to protect the investing public.
The SEC charges likely will fuel the already-intense debate on Capitol Hill over further restricting auditors from earning consulting fees from clients they audit, an issue raised by questions over Enron Corp.'s collapse and auditor Arthur Andersen LLP's role in it.
The case against Ernst & Young also puts a spotlight on one of the SEC's top officials, chief accountant Robert K. Herdman, who was vice chairman of the accounting firm. Mr. Herdman was in charge of "professional practice" and was the firm's senior authority reviewing technical accounting matters during the period the SEC is examining. SEC inquiries into at least four Ernst & Young audit clients involve activities that occurred under Mr. Herdman's watch.
Ernst & Young denied wrongdoing in a statement and vowed to vigorously contest the charges. Its work for PeopleSoft, the accounting firm said, was "entirely appropriate and permissible under the profession's rules. It did not affect our client, its shareholders, or the investing public, nor is the SEC claiming any error in our audits or our client's financial statements as a result of them." The statement said the SEC was focusing on activities of the company's former consulting business, which was sold in 2000 and has no bearing on Ernst & Young's current business.
The case stems from a multiyear SEC investigation into Ernst & Young's auditing work for two major business-software developers, PeopleSoft of Pleasanton, Calif., and Baan Co. NV of the Netherlands, both of which make software that automates basic business processes such as human resources and accounting. The investigation of Baan, which involves a similar marketing arrangement, is continuing, according to a person with knowledge of the probe.
Ernst & Young confirmed that SEC enforcement attorneys requested that Mr. Herdman appear before them to discuss the PeopleSoft and Baan investigations last spring. SEC Chairman Harvey Pitt, who hired Mr. Herdman last October, represented Ernst & Young as a private attorney before his SEC appointment, but it isn't clear if he worked on the PeopleSoft or Baan matters. Mr. Pitt declined to comment.
'Value Bank'
The SEC also is probing whether Ernst & Young may have violated accounting rules in its audits of two companies that have already been the subject of enforcement actions, Cendant Corp. and Informix Corp., according to people with knowledge of the probes. The SEC raised objections about an arrangement in which Ernst & Young unsuccessfully proposed a "value bank" aimed at offering Cendant a break on annual audit fees in return for getting consulting business. Mr. Herdman's role is in dispute: Ernst spokesman Larry Parnell confirmed an account in which Mr. Herdman defended the proposal at a 1999 meeting with the SEC, but a statement by the SEC on Mr. Herdman's behalf denied it.
Ernst & Young also is under scrutiny of its audit work for PNC Financial Services Group Inc., these people say. The SEC investigation includes Ernst's dual role in helping to devise and market a series of transactions with American International Group as an accounting adviser to AIG, then approving the transactions as PNC's auditor. In another SEC investigation, Ernst & Young's audit materials for Computer Associates International Inc. have been subpoenaed, the accounting firm has said. (See article)
At issue in the PeopleSoft case was Ernst & Young's marketing agreement to sell and install PeopleSoft software. As many as 1,000 of the accounting firm's employees were assigned to install PeopleSoft's software at hundreds of companies, including Ernst & Young audit clients.
Coordinated Efforts
Under the deal, Ernst & Young's consulting unit agreed to pay its client royalties of 15% to 30% for each sale of the software product, guaranteeing PeopleSoft a minimum payment of $300,000. The accounting firm and PeopleSoft closely coordinated sales efforts, sharing customer information and leads and linking to each other's Web sites, the SEC said. The SEC wants Ernst & Young to agree to a cease-and-desist order, repay all fees from PeopleSoft for the audits in question, and be sanctioned for engaging in improper professional conduct.
"An auditor can't be in business to jointly generate revenues with an audit client without impairing independence," said Stephen Cutler, the SEC director of enforcement. The SEC didn't allege that the relationship led to the filing of improper financial statements by PeopleSoft, nor that PeopleSoft violated securities laws. The firm couldn't be reached for comment; it has since replaced Ernst & Young as its auditor with Arthur Andersen.
Mr. Herdman's exact role in the activities under question in the PeopleSoft and other cases is unclear because he has declined to discuss the matters. At the time Ernst audited the clients in question, Mr. Herdman had responsibility for reviewing unusual accounting treatments to make sure they complied with accounting rules. He also was one of the firm's experts on independence issues.
Mr. Herdman and Mr. Pitt have worked closely for years on accounting issues. In 1997, the American Institute of Certified Public Accountants hired Mr. Pitt to submit a long proposal on how an SEC-appointed board should govern auditor-independence issues. In a "white paper" dated Oct. 20, 1997, Messrs. Pitt and Herdman argued against the need for strict new independence standards in favor of improved industry self-regulation.
Powerful Position
As chief accountant, Mr. Herdman holds one of the most powerful jobs at the SEC -- a position that has gained heightened importance recently in the wake of the Enron scandal and almost daily disclosures since then of accounting problems at major companies. He normally is required to consult on SEC enforcement cases that involve accounting issues, and he has final say in SEC examinations of individual companies' accounting practices -- which, unless he has recused himself, would include those of companies audited by Ernst & Young.
Christi Harlan, an SEC spokeswoman, said that Mr. Pitt and Mr. Herdman have had no participation in the PeopleSoft case while they've been at the SEC. Mr. Herdman has declined to discuss whether he has recused himself from other matters.
In the Baan matter, the SEC is probing audits performed by Ernst & Young's Dutch affiliate over several years during which the accounting firm had hundreds of consultants installing software that Baan produces. In 1998, when the software company came under fire for aggressive accounting practices that may have contributed to its fast growth, Baan changed some of its sales-financing methods and said that the Ernst & Young affiliate resigned because of a potential conflict of interest.
Reached late Monday, a spokesman for Ernst & Young's Dutch affiliate said he had no immediate comment.
The Cendant inquiry stems from earlier SEC investigations into the company's statements. In 1999, Ernst agreed to pay $335 million to Cendant investors to settle a civil class-action suit alleging that it aided in a fraud. Ernst consistently has denied any wrongdoing and says it was the victim of deceit by one of Cendant's main predecessor firms, CUC International Inc., whose books it audited for years.
Write to Michael Schroeder at mike.schroeder@wsj.com and Scot J. Paltrow at scot.paltrow@wsj.com |
