Abuse of Audit Committee Auditor Selection Process Triggers an Independence Violation
The Securities and Exchange Commission has charged Ernst & Young (EY) and three of its former partners with violations of the auditor independence rules as a result of conduct that interfered with an audit committee’s competitive bidding process for the company’s audit engagement. The SEC also charged the company’s former Chief Accounting Officer (CAO) with causing reporting violations based on his efforts to aid EY in obtaining the engagement. (While the SEC’s orders do not name the company, prior SEC filings and press reports disclosed that it is Sealed Air, a North Carolina-based manufacturer of packaging material. The company was not charged.)
According to the SEC’s order, the CAO, while employed at another company, worked with one of the EY partners and viewed him as a “trusted adviser.” In 2013, the CAO was hired by Sealed Air and became involved in discussions about initiating a solicitation for bids to perform its audit. The audit committee authorized an RFP and invited EY and three other firms, including the incumbent auditor, to submit bids.
The SEC finds that the audit committee intended to conduct a competitive and fair RFP process. The RFP stated that firms would have an “equal opportunity to provide their best proposals” to the committee, that information submitted by firms would be treated as confidential, and that “all competitors that submitted proposals represented that: (i) Issuer personnel have not participated in the preparation of the firm’s pro-posal; and (ii) Issuer personnel have not conveyed to the competitors any information pertaining to this RFP.”
Despite the audit committee’s intentions, and unknown to the committee, the CAO provided EY with confidential information and other assistance. In particular, the CAO furnished EY, through the partner with whom he had previously worked, with the other firms’ proposals and submissions and with the internal documents prepared for the audit committee. For example:
The CAO sent EY a slide deck that he planned to present to the audit committee on the pros and cons of each bid and asked for “additional talking points that you think might be beneficial.” After consultation with other EY partners, the partner with whom the CAO had previously worked provided CAO with a detailed list of additional “cons” against the incumbent audit firm.
The audit committee selected EY and the incumbent firm as finalists and gave each a deadline to submit final bids. The CAO forwarded the incumbent firm’s final bid to two EY partners. Five days later – and after the audit committee’s deadline -- EY submitted its final bid, which was almost identical to the incumbent’s, but slightly higher when expenses were taken into consideration. The CAO deleted the expenses from the final bid summary provided to the audit committee, creating the appearance that EY’s bid was lower.
Unaware of these matters, the audit committee selected EY as its new auditor. Sealed Air thereby became EY Charlotte’s largest audit client. On the evening the selection was announced, the CAO sent an EY partner (his former college roommate), a congratulatory email with the message: “Back in the family!!!”
In connection with the 2015 and 2016 annual audits, the EY engagement partner signed letters to the audit committee purporting to disclose, as required by PCAOB rules, all matters that could reasonably bear on EY’s independence. These letters did not disclose EY’s or the CAO’s conduct related to the RFP.
Under its auditor independence rule, the SEC will not recognize an accountant as independent “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 its order, the SEC finds that a reasonable investor with knowledge of all the facts and circumstances concerning the RFP process would conclude that the three EY partners involved were not capable of exercising objective and impartial judgment regarding Sealed Air’s 2015 audit. An individual accountant’s lack of independence may be attributed to the firm in which the auditor practices. Therefore, the SEC also finds that a reasonable investor with knowledge of all relevant facts and circumstances would conclude that EY was not capable of exercising objective and impartial judgment.
On this basis, the SEC finds that EY violated the auditor independence rules, that the three former partners caused that violation, and that the firm and its partners caused Sealed Air to violate certain SEC reporting requirements. The CAO aided and abetted the reporting violations.
Settlement and Sanctions
EY and the individuals all agreed to settle without admitting or denying the Commission’s findings. EY was censured, agreed to pay a fine of $10 million, and undertook to comply with various procedures to prevent future violations. The three former EY partners, and the former CAO, were barred from practicing before the Commission and agreed to fines ranging from $15,000 to $51,000.
Comment: This case involved a deliberate effort by the CAO, with the knowledge of his preferred accounting firm, to mislead the audit committee and to undermine its competitive selection process. It is difficult for audit committees to anticipate and defend against this kind of abuse of trust. While this type of situation is – hopefully – rare, the case is a reminder that management may have an undisclosed bias in favor of a particular firm and that the audit committee should be vigilant to protect its decision-making against the effects of such bias.
Another point illustrated by this case is that the audit committee is dependent on the information it receives about issues that may impact independence. While the auditor is normally the primary source of such information, management needs to be involved as well. The audit committee should set an expectation with management that it will inform the audit committee of any prior, unusual, or new relationships between the auditor and senior members of management, especially those involved in financial reporting. In this connection, company staff that interact with the auditor should have some basic understanding of the principles of auditor independence so that they will be sensitive to issues that could impact the reasonable investor’s view of auditor objectivity and impartiality.