KPMG Insider-Trading Scandal Leaves Some Clients in the Lurch

An insider-trading scandal has left Big 4 accounting firm KPMG reeling, but it has also created a crisis for the audit clients pulled into the fray, which now find themselves with a mess to clean up.

Faced with the sudden loss of their audit firm, which was forced to resign the engagements, and the nullification of a total of five years worth of audit opinions, officials at Skechers and Herbalife are now scrambling to find new auditors and catch up on regulatory filings.

Both companies filed the required Form 8-K to indicate that KPMG had resigned and withdrawn audited financial statements because of allegations of insider trading involving the engagement partner in charge of their audits. Meanwhile, the Department of Justice and the Securities and Exchange Commission are pursuing insider-trading charges against Scott London, the former partner in charge of KPMG's Los Angeles audit business, whom KPMG fired when it learned of the unfolding investigation.

The Justice Department and SEC say he provided confidential information regarding five KPMG clients to a friend and golf partner, Bryan Shaw, who used the information to trade in those companies' securities. Shaw reportedly paid London for the information in cash, jewelry, and entertainment valued at about $55,000.

While Skechers and Herbalife have not been accused of any wrongdoing, they must still work to lessen the consequences from the scandal. Herbalife published a brief statement to say it was working proactively with New York Stock Exchange officials on a detailed plan to replace KPMG as its auditor, and it does not anticipate any proceeding by the exchange to delist the company. Herbalife said it also has confirmed that KPMG's resignation and withdrawal of audit opinions will not result in any credit defaults.

The DOJ and SEC charges named three additional KPMG clients whose confidential information London allegedly traded—Deckers Outdoor Corp., RSC Holdings, and Pacific Capital. The SEC says London was an account executive for Deckers but his role with the other companies is not described. KPMG has not indicated whether it might also resign additional audits, and it did not respond to questions regarding London's role on those accounts.

It's possible KPMG is still discerning whether it will resign or withdraw any other audits depending on London's role with those other companies, says Brian Fox, a former Big 4 auditor and founder at audit services firm Confirmation.com. "It depends on whether he was actively part of the engagement team or he just had access to the information because he was heading up audit in that region," he says. "If he had a hand in the audit itself, I'd expect them to withdraw those audits as well. If he used inforamtion but didn't have a hand in the audit, they may not pull those audits." 

Neither company has discussed their efforts any further to get back into compliance with the requirement to have audited financial statements on file with the SEC, but the process includes submitting to new audits for those withdrawn by KPMG. That includes fiscal years 2011 and 2012 for both companies, plus 2010 for Herbalife. The SEC is expected to give companies some grace to get caught up on their audits under the circumstances, says Lynn Turner, a former chief accountant at the SEC. “They'll allow their stock to continue to trade,” he says. “They have the power to do that.”

Still, there's a substantial amount of work to be done to get back into compliance, says Carol Stacey, vice president at training firm SEC Institute and a former chief accountant in the Division of Corporation Finance at the SEC. The first critical task for each company is to find a new audit firm that's independent of the company­—meaning one not already providing tax or other consulting services to the company.

With only four major firms, there's not a lot of choice. “Most companies try to keep one audit firm aside and not work with them at all so if something like this happens, they have someone to turn to,” Stacey says. “Hopefully they have at least one audit firm left over. If not, then they're looking at a second-tier firm.”

“Most companies try to keep one audit firm aside and not work with them at all so if something like this happens, they have someone to turn to. Hopefully they have at least one audit firm left over.”

—Carol Stacey,

Vice President,

SEC Institute

The companies also need to quickly decide what they will do about their first-quarter filings, says Stacey. Both companies are calendar-year filers, so their first quarter closed on March 31, and their filings are due 40 days later. “If you've just lost your auditor and you don't have anyone to review it, you might have to file the 10-Q unreviewed,” she says, which has several negative implications. Companies that are deficient in their filings, for example, are severely limited in their ability to raise new capital, Stacey adds. “I got many calls like that when I was at the SEC,” she says. “And I would say file as much as you can as soon as you can.”

It's possible, Stacey surmises, that a new audit firm might be able to get comfortable enough with a company's first-quarter report to provide a review for filing purposes, but she considers it unlikely. A firm will typically provide a first-quarter review only after it has completed the audit for the prior year, she says.

David Weinberg, CFO and COO of Skechers, said in the company's prepared statement that the timing of KPMG's resignation was “an unfortunate development,” as the company prepared its first-quarter results. He said the company believes the first quarter will show significant growth. “We are working diligently to replace KPMG as quickly and efficiently as possible as we look forward to releasing positive results for the first quarter of 2014 later this month,” he said.

KPMG STATEMENTS

Below are two statements from KPMG regarding the insider-trading scandal.

KPMG LLP Chairman and CEO John Veihmeyer issued the following statement upon reviewing the criminal complaint filed today against former partner Scott London. London was charged today in the Central District of California for conspiring to commit securities fraud through insider trading.

“I was appalled to learn of the additional details about Scott London's extraordinary breach of fiduciary duties to our clients, KPMG and the capital markets. We unequivocally condemn his actions, and deeply regret the impact that his violations of trust and the law have had on our clients and our people. KPMG will be bringing legal actions against London in the near future.

“As a result of his unlawful activities, it was clear that our independence had been impaired with respect to the two companies for which he served as lead partner, Herbalife and Skechers. Due to this impairment, we were professionally obligated to take the regrettable action to resign as the independent auditor for these two companies and withdraw our previously issued audit reports. The sole reason for these steps was the actions of our former partner and we have no reason to believe that their financial statements are materially misstated.”

—John Veihmeyer,

Chairman and CEO,

KPMG

Late last week, we were informed that the partner in charge of KPMG's audit practice in our Los Angeles business unit was involved in providing non-public client information to a third party, who then used that information in stock trades involving several West Coast companies. The partner was immediately separated from the firm.

KPMG's 22,000 partners and employees unequivocally condemn this individual's rogue actions. This individual violated the firm's rigorous policies and protections, betrayed the trust of clients as well as colleagues, and acted with deliberate disregard for KPMG's long-standing culture of professionalism and integrity.

KPMG is resigning two clients after concluding today that the firm's independence has been impacted as a result of this individual's behavior, and we have informed those companies it is necessary to withdraw our auditor reports. We have no reason to believe that the financial statements of these companies have been materially misstated.

We regret the impact this individual's actions have had on any of our clients. KPMG remains committed to the highest standards of professionalism, integrity and quality, and we are dedicated to the capital markets we serve.

Sources: Veihmeyer Statement; KPMG Statement.

Completing a Do-Over

Once each company selects a new auditor, the work of recreating years of audit reports will get under way quickly, experts say. They differ, however, on the degree to which the new audit firm might rely on KPMG's work. Christopher Davies, a partner at law firm WilmerHale, says the exact nature of the transition can sometimes depend on the reasons for it. “One could imagine in circumstances like this that the outgoing auditor might be more expansive in what it might share with its successor than in the typical change in auditor,” he says.

Turner believes it's likely KPMG will be involved in some way to help the companies' transition to new auditors. “They will probably give the auditor coming in all the assistance they need,” he says, including providing their work papers. It also helps that the audit profession has just finished its usual busy season, wrapping up year-end audits for calendar-year companies, so the new firm is likely to have plenty of available staff to assign to the task.

The seniority of London before he was fired will also affect the reliability of previous audit work. Confirmation.com's Fox believes the new firm will place little faith in anything produced by KPMG. KPMG withdrew the reports because its engagement partner, who had a heavy influence over the entire audit process, was allegedly tainted by his own self interest as he engaged in insider trading. “When someone on the audit team is compromised, the new audit firm would not want to rely on anything that team did,” he says.

Jonathan Feld, an attorney with law firm Dykema, says he believes the new audit firm will rely little on KPMG's work. “They don't want to incorporate whatever oversight or alleged mistake was there, so they're going to want to verify everything,” he says. “I would think this will be almost starting from scratch.”