KPMG's Independence, Herbalife's Stock Price, and the Game of Name Blame

What does this say about the value placed by investors on the independence of outside auditors: 

Two trading days after KPMG withdrew its audit reports on the financial statements of its Los Angeles clients Herbalife and Skechers, because of inside information shared by its promptly sacked and criminally charged engagement partner Scott London, the stock price of both of those stocks has actually risen!

The consequences of London’s passing on, to the million-dollar benefit of his golfing pal Bryan Shaw, will be swift and nasty:

• Ratted out by Shaw, London will cut the fastest plea deal the prosecutors will offer.

• KPMG will hurl its checkbook at every dollar of costs incurred by its ex-clients to obtain replacement auditors.

• Aggressive plaintiffs’ lawyers will fashion some theory of shareholder harm – despite the stock price upticks – doubtless spinning a conspiratorial connection with the long-running spat over Herbalife between raider Carl Icahn and shortseller Bill Ackman, and eventually coercing a nuisance-level settlement.

• And the American securities and accountancy regulators – the SEC and the PCAOB – will vie with each other in a pell-mell rush, recalling the unseemly post-Enron haste with which the Sarbanes-Oxley law was passed in 2002, to push a requirement that auditors of US public companies identify by name their partners signing client audit reports.

This last has been opposed with intensity by the American accounting profession, although long in place in much of the world without measurable adverse effects.   

Nor, it should be noted, with measurable benefits either – as client managements and audit committees in the US have never lacked access to the decision-qualifying information necessary about the engagement personnel at their audit firms.

In the wishful search for magic bullets aimed at the structural weaknesses in the auditor-client business model, “partner naming” is a distinctly small-bore and ineffective weapon. 

But London’s downfall does require re-framing my opening question, this way, heretical as it may seem:

What value to the operation of the capital markets – if any -- is actually delivered by the entire structure of auditor independence? 

London’s professional position was destroyed, and his liberty put in jeopardy, not because he violated the elaborate dictates of the auditor independence rules, but because of his multi-year violations of the insider-trading prohibitions of the American securities laws.

And on the other hand, despite KPMG’s immediate and apologetic resignation and report withdrawals, the stock market has given credence to the assertions that the substantive content of the Herbalife and Skechers financial statements are unaffected (even given the charges hurled in the Icahn/Ackman dust-up).

In short, the indifference of equity investors to the state of KPMG’s independence speaks volumes.

I’ve long been saying (here and here) that – under the “client pays” business model for financial statement assurance, invented back in the Victorian era – the accounting profession has gained nothing positive for years, by way of reputation, stature or risk and exposure mitigation, from the intellectually unsatisfactory edifice of “appearance of independence.”

Now, the stock price non-event of Scott London’s misadventures equally shows the converse – that investors impose no downside price penalty on even a slam-dunk independence violation.

Conclusion: the time, energy and cost of maintaining the outmoded and anachronistic structure of “independence” should be re-directed to the long roster of topics legitimately worthy of the effort.

 

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Comments

[James Ulvog]

Oh, forgot to include in the consequences seeing his name on the front page of the Wall Street Journal and Los Angeles Times, and having every business writer in the country talking about how what a bum he is.

[James Ulvog]

Here’s what I meant to say before the preceding comment –

If the possibilities of losing your license, losing your job, going to jail, financial destruction, and spending months in depositions and hearings don’t motivate a CPA to doing a good job, seeing your name on the opinion page won’t have any impact at all.

[david k waltz]

Jim,

I am not sure that the consequences of this event entirely translate to the broader context.

If the market perceives that what has occurred is not indicative of inaccurate financials, then the price response should be muted, even though insider trading rules have been violated, as valuations based on the numbers are not suspect.

If the reports were pulled because they, as well as ones prior, are inaccurate due to auditors being 'in the pocket' of the firms, one is likely to see a more dramatic reaction, as there is no longer confidence in the numbers and consequently any valuation methodology that relies on them.

I was in Asset Based Lending for a number of years, and independent valuations, financials, etc. are highly valued as they provide objective (at least relatively) information which helps to manage what would be very risky loans if this type of insight was not available.

In any "data integrity scenario" independence should be valued, as it provides a different perspective which one can use to "triangulate" or compare to the perspective of the company.

In this case data integrity was not the issue, merely the dissemination of that data.

Note: David -- thanks for this. Assuming your position for the sake of discussion, does it not indicate the dysfunctionality and need for change in an independence structure unable to differentiate explicitly between "data integrity" and other scenarios? And, by the way, might it not be premature based on information disclosed to date under this dysfunctional system, to leap to the inference that "data integrity" is not involved?
Jim