On August 5, 2008, the SEC announced the settlement of administrative proceedings against Ernst & Young and Mark C. Thompson, a former director of three public audit clients of Ernst & Young. The proceedings arose from a business relationship between Ernst & Young and Mr. Thompson which the SEC determined impaired the audit firm's independence and, thereby, caused each company to violate the federal securities laws. The proceedings clarify certain aspects of the SEC's rules regarding auditor independence, and highlight the need for public companies to periodically review any changes in the relationship between each director and the company and its audit firm that might affect auditor independence.
The business relationship between E&Y and Thompson involved their collaboration over a 19 month period in creating a series of audio CDs. Thompson, who is in the business of facilitating and coaching others to facilitate interviews and discussions with business, political and entertainment leaders, moderated each CD which featured E&Y partners interviewing industry leaders. The CDs bore the logos of E&Y and Thompson and were provided to prospective E&Y clients for business development purposes. E&Y paid Thompson $377,500 for his contribution to the production of the CDs, which comprised approximately one-half of Thompson's net income during this period.
During the entire 19 month relationship, Thompson was a director of one company. For a portion of that period, Thompson was a member of the Audit Committee of that company, and was a director of two other companies. Each company was an audit client of E&Y. At the end of each fiscal year during the period, E&Y confirmed to each company that it was independent in its letters delivered pursuant to Independence Standards Board Standard No. 1 (Independence Discussions with Audit Committees) and failed to disclose E&Y's business relationship with Thompson. In addition, by failing to disclose their lack of independence, E&Y's audit reports violated Rule 2-02(b) of Regulation S-X which requires the report to state whether the audit was performed in accordance with generally accepted auditing standards (including the independence requirements of GAAS). Each company, with E&Y’s knowledge and consent, included (or incorporated by reference) E&Y's audit report in its annual report on Form 10-K and proxy statement filed with the SEC, thereby violating Sections 13(a) and 14(a) of the Securities Exchange Act of 1934, and Rules 13a-1 and 14a-3 thereunder (which require annual reports and proxy statements to include or incorporate independently audited financial statements). In addition, by recommending E&Y’s retention as auditor without disclosing that one of the directors favoring the recommendation had a business relationship with E&Y, the companies further violated Rule 14a-9 (which prohibits misstatements or omissions in proxy soliciting material).
Although the SEC has not identified the three companies, Best Buy Co. and Korn/Ferry International have disclosed the issue. In addition, the Wall Street Journal has publicized that Thompson was a director of TeleTech Holdings, Inc., a Denver technology consulting firm, during this period. Only Korn/Ferry is still an E&Y client. Thompson has resigned as a director of each company.
Thompson failed to fully furnish the details of his relationship with E&Y in response to the annual director and officer questionnaires of each company. He also took part in votes to retain E&Y as each company’s auditor and to recommend approving this retention to the shareholders in the annual proxy solicitations, all without disclosing the relationship. As a director, Thompson signed annual reports on Form 10-K incorrectly stating that each company's auditor was independent. As a member of one company's Audit Committee, he shared the responsibility for the appointment, compensation and oversight of the auditor and signed the Audit Committee report incorrectly stating that the company's auditor was independent. As a result of Thompson's actions, the companies' proxy statements recommending shareholder approval of E&Y's retention as auditor failed to disclose the relationship, and the companies' annual reports and proxy statements failed to include or incorporate the required independently audited financial statements and included or incorporated audit reports falsely asserting that E&Y was independent.
Rule 2-01(c)(3) of Regulation S-X provides that an accountant is not independent if during the audit the accounting firm or any "covered person" has any direct or material indirect business relationship with an audit client or person associated with the audit client in a decision-making capacity, such as an officer, director or substantial shareholder. A "covered person" includes those partners, principals, shareholders and employees of the accounting firm who meet specified criteria. The rule exempts a business relationship in which the accounting firm or covered person is "a consumer in the ordinary course of business."
The SEC rejected E&Y's reliance on this exemption. The SEC noted that the exemption requires the relationship to be in the normal course of business for both parties and at least one of the parties must be acting in the capacity of a consumer. In the case of the collaboration between E&Y and Thompson, the SEC concluded that neither prong of the exemption had been met. This determination is consistent with the SEC’s discussion of business relationships which impair auditor independence in Section 6.02.02.e, Example 18, of the Codification of Financial Reporting Policies (available at 7 Fed. Sec. L. Rep. (CCH) ¶ 73, 272) and Commission Letter dated 2/14/89, responding to 3/29/88 Petition of Arthur Andersen & Co. and others.
The SEC found that E&Y and certain of its partners had engaged in improper professional conduct, had violated Rule 2-02(b) of Regulation S-X, or had caused each of these three audit clients to violate Sections 13(a) and 14(a) of the Exchange Act and Rules 13a-1 and 14a-3. The SEC ordered E&Y to disgorge approximately $2.9 million in audit fees and interest and the named partners to cease and desist either from violating Rule 2-02 and causing violations of Sections 13(a) and 14(a) and Rules 13a-1 and 14a-3 or from appearing or practicing before the SEC as an accountant (with the right to petition for reinstatement in one year). E&Y and the named partners, without admitting or denying the SEC's allegations, consented to the entry of the order.
The SEC found that Thompson was a cause of each company violating Sections 13(a) and 14(a) and Rules 13a-1, 14a-3 and 14a-9, and ordered Thompson to disgorge approximately $124,000 in director compensation and interest and to cease and desist from violating such sections of the Exchange Act and the rules thereunder. Thompson, without admitting or denying the SEC's allegations, consented to the entry of the order.
Despite the inadequacy of the current definitions of director “independence” under the stock exchange rules and the virtual absence of enforcement of their own independence rules by the exchanges, director independence remains a center piece in the SEC’s efforts to promote sound corporate governance. By finding that Thompson’s failure to disclose his relationships with E&Y resulted in violations of the periodic reporting and proxy requirements under the Exchange Act, the SEC effectively sanctioned Thompson for his lack of independence.
These proceedings illustrate the importance of ensuring the completeness and accuracy of director and officer questionnaires by periodically reminding directors that they should promptly inform the company of any changes in their relationship with the company or its auditors which could affect their independence.