The EY/Ventas Affair – In the End, Who Really Got Bonked?

“When I married an accountant, I always thought his eyes would go first.”

            -- Same Time Next Year (1975)

In the poignant Broadway play and later film, romance originating on an audit engagement could include a touching laugh line.

Less so today -- see the penalties for what the SEC’s enforcement release of September 19, 2016, delicately called the “close personal and romantic relationship” between the chief financial officer of Ventas, Inc., the Chicago-based REIT, and an audit partner on the team at Ernst & Young LLP.

Both were sacked in July 2014 when their affair became public. EY’s opinions for the two prior years were withdrawn, and it was replaced by KPMG. The recent order now censures EY, requires disgorgement of $3.2 million in fees plus interest, and adds a civil penalty of $ 1 million. The package of sanctions also includes fines of $ 25,000 each and SEC practice bans on the CFO (one year) and the EY partner (three years), with a similar ban on her superior to boot.

Time to revisit what I wrote back in 2014 – here.

First, as I predicted, the PCAOB’s then long-running project -- Docket # 029 -- at long last resulted in rules to name the lead partner, ultimately effective in May 2016. Under an awkward process satisfactory to nobody, those so inclined may now comb for the new Form AP, to obtain information of no discernible value or consequence.

A brief quibble: the EY partner involved did not lead its engagement for 2012 or 2013, so would not have been identified had the PCAOB’s rules then been in place. This annoyingly trivial regulation is not only unappealing under justifiable libertarian hostility. To the contrary, believing in the salutary role of government policies if effectively designed (see my review of the late Tony Judt’s achingly passionate 2010 book, Ill Fares the Land), I find all too depressing the ill-considered distractions of agency actions passed off under the guise of progress along with their unintended and frequently malign consequences.

Second, the Ventas action is companion to a second SEC enforcement release of the same day, under which EY and its personnel are also penalized for lack of independence – in this case based on “an inappropriate close personal relationship” between an EY partner and the client CFO – the former having generously plied the latter with “frequent social trips, gifts, and overnight out-of-town trips” along with shared family vacation trips and mutual visits.

Other commentators have risen to charge the SEC with an opaque failure of guidance on the independence impact of these personal auditor/client relations -- Matt Levine at Bloomberg and Caleb Newquist’s Going Concern; see also Tammy Whitehouse at Compliance Week and Francine McKenna at Marketwatch – beyond the high-level language of SEC Rule 2-01(b) under Regulation S-X as to what a “reasonable investor…would conclude.…”

In this area on which the SEC’s examples are silent (see Rule 2-01(c)), its senior associate chief accountant recently bailed out on an opportunity to clarify. Speaking before the American Law Institute conference on September 22, 2016, he disavowed any “appetite” for rulemaking, instead observing that, “I don’t think this is an area where you can really come up with bright lines and explicit guidance.”

Response to this default would well be that a government agency responsible to enforce rules it is unable to articulate is hardly in a position later to criticize those left in the dark, or to argue failure to comply.

Instead, the gist of the SEC’s message is that, “although we have no detailed rules, you did violate them -- so we censure and penalize you $ 9.3 million and ban your partners from practice.”

There is, however, another way to clear the SEC’s fog of uncertainty – by noting forthrightly the investor community’s clear indifference to the entire Ventas affair, including a lack of concern with bedrooms as compared with board rooms or audit rooms.

That is, between EY’s withdrawal of its opinions in July 2014 and the September 4 filing of the company’s amended 10-K with a fresh opinion by successor KPMG – in other words, while the company lacked audited financial statements – the company’s stock price actually increased by 3 %. And, flipping to the period that followed, after KPMG’s opinion became available to relieve any investor anxiety about the company’s non-compliant status, its stock price went into a brief but sharp decline, not recovering its early September price until October 17.

In brief – no stock price punishment for the absence of an independent auditor, nor any reward for re-achieving a state of virtue either. QED, the complex of rules regarding “auditor independence” is delivering nothing on which investors place value. As I put it in 2014:

The entire anachronistic edifice of “appearance of independence” rests on shifting and unstable sands, and deserves to be washed away with the tides of modernized assurance performance.

Until that day should arrive, these proceedings display once more the illusion of effective agency behavior – the infliction of penalties with only the most general guidance to the affected issuers and auditors, who are left to fulfill their compliance obligations even while forced to pretend that their regulators are offering something helpful.

 

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Comments

[Randy Green]

Hi Jim -

First, outstanding blog. Really enjoyed going back through previous posts.

Regarding the EY/Ventas affair (no pun intended), however, I disagree with your conclusion that the SEC guidance is insufficient. In what alternative universe would anyone believe that an illicit affair between the lead auditor and the CFO of a publicly traded company would not compromise independence? Apparently the two parties engaged in the affair believed it was an issue, as they strove mightily to keep it under wraps.

Whether or not audits, as currently constructed, are actually a valuable exercise is one discussion. But these two knuckleheads knew what they were doing was wrong under existing legal, professional and ethical rules. No sympathy for them.

And your observation related to the stock price impact strikes me as too one-dimensional. Many, many other factors impacted stock price during the period under discussion.

Let's think of it this way - if I had $1,000 to invest in either Company A or Company B, and I knew Company A's auditor and CFO were sleeping together, I'm guessing I might be more inclined to consider Company B.