The SEC Whacks Ernst & Young Over Bally Total Fitness -- Now for the Spoils of Victory

The SEC’s proceedings last month against Ernst & Young and six of its partners, relating to the financial statements of Bally Total Fitness, for the long-ago years 2001 – 2003 (here), threaten a double hazard under the axiom attributed to Winston Churchill, that “history is written by the victors.”

It’s not just tough enough for the accounting profession’s risk and quality managers, seeking to understand what really happened in Bally -- not only because the entire narrative is drafted by the enforcers, but also because without recourse to a public forum, the “consent decree” process acts as a muzzle on the targets. 

Worse – conceding that the only script available is written by the SEC itself – the array of sanctions and undertakings inflicted on E&Y signals that the environment for application of quality-oriented judgments has just become a lot more volatile, unpredictable and challenging.

This cannot be the place to debate either the facts or the justice of Bally; offered an exit from the SEC’s eternal grip, a target’s only strategy is to grit the teeth and roll over in silence.

Questions for the profession worth attention post-Bally, rather, are what to expect in the future, and how will behaviors be changed.

To start, with all other government agencies coming off the back foot in the financial crisis aftermath, the SEC carries three extra pieces of baggage: defensive reaction to its blinkered short-comings in failing to unmask Bernie Madoff, the passage of a half-decade in bringing the ancient Bally proceedings, and the lurking reality that pursuing a death-threat outcome against a Big Four firm itself would risk disintegration of the entire large-company assurance franchise.  

From these, it can be predicted – and the accounting profession should expect – that going forward, the SEC will aggressively aim its macho enforcement testosterone at the big firms’ individual personnel. Nuances and subtleties of professional judgment be damned, the agency will seek to show that its gun-slingers clank when they walk.

Which means, as Bally itself shows, that professional decisions will be second-guessed to the last degree. Where credit might be earned for careful risk considerations, E&Y had identified Bally as one of its highest risk clients – a sorting-out effort reflective of a profession-wide aspiration to differentiate levels of client complexity and reduce the commodity nature of the audit itself.

And E&Y also brought into consultations an entire circle of senior help, beyond the engagement and review partners – the geographic area manager, national practice quality assistance and even the firmwide head of practice and risk.

These actions should be encouraged. Picture the counter-factual: if Bally’s problems had gone as wrong as they did, and E&Y had not done so. The enforcement hounds at the SEC would have bayed to the skies. Instead, now, the firm’s personnel suffer individual censures and bar orders of up to three years, for conduct worthy of respect – albeit for results now deemed unsatisfactory.

What messages are sent to the profession’s quality and risk functions? Ought they to reduce the exposure of their senior personnel, by hanging out the line operators to struggle on their own? And by the way, who would aspire to the headaches of a consultative role, if only to finish a long career by dangling from the SEC’s noose?

One of E&Y’s undertakings in Bally is to re-visit, under the scrutiny of an outside examiner, its documentation of higher-level issue consultations.

So, under a sanction that only a bureaucrat could love, Bally will impel the Big Four’s national office boffins to “re-audit” information they receive from the field, and to build a fortress of memoranda to defend against the assaults of later second-guessing.

With the secondary effect that the time and energy available for real problem assessment must now be side-tracked to the same kind of self-protective file stuffing that is strangling American enterprise ranging from product safety to medical treatment to airport security. 

The SEC’s goal in the Bally settlements may not have been deliberately to degrade the large firms’ risk management capabilities. But the direction and effect will all go that way.

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Comments

[Final Four Guy]

This is already starting to happen.

Real quesion is whether the cost can or will be passed on.

A Big Four Partner