Are you shocked by the news that Scott London, global public accounting firm KPMG’s audit practice leader for Southern California, had been caught passing insider information for five of his clients to his friend, a jeweler? Don’t be. There have been several cases in recent years of senior level Big Four public accounting firm partners trading or passing along confidential client information for fun and profit.
Two senior partners at Deloitte, Tom Flanagan and Arnie McClellan, were involved in separate insider trading cases during the same timeframe, 2008-2009. They both had direct contact with inside information about earnings and merger activities as trusted advisors to big name public company audit and consulting clients.
Tom Flanagan, Deloitte vice-chairman and Chicago charity circuit regular, traded on the inside information of several Fortune 500 companies including Berkshire Hathaway. FINRA, the securities self-regulatory organization, saw trading activity by an audit firm partner in an M&A target and called the SEC. The SEC called the companies. Deloitte found out from the clients and volunteered to pay for the investigations at the audit clients to prove the firm was still independent. Regulators did not sanction Deloitte, the firm, and no clients were lost. The SEC fined Flanagan and his son and Flanagan is serving a 21-month jail sentence for securities fraud.
Deloitte tax partner Arnie McClellan’s wife “eavesdropped” on his phone calls discussing his client’s M&A targets. Mrs. McClellan, who had previously worked at Deloitte, then called her sister and brother-in-law in London who traded on the inside information. Deloitte didn’t know about the activities until London authorities called. McClellan’s wife said her husband was innocent, and he was not charged. She served eleven months for initially lying about her own involvement.
Ernst & Young tax partner James Gansman passed M&A tips to his lover between 2005 and 2007 who, in turn, passed them to her other lover. Gansman was paid for his trouble with the currency of love only. His “swinging” partner ended up on an SEC watch list and Gansman went to jail in 2010 for one year for securities fraud based on his lover’s testimony against him.
The biggest unanswered question about the KPMG case is, “Why did Scott London do it?” According to the civil and criminal complaints filed by the SEC and Department of Justice, London was paid a pittance compared to his probable compensation. Based on my sources, a partner at his level of responsibility—more than 50 audit partners and 500 staff reported to him—earns between $1.5 and $2 million dollars per year, at least. His take in the multi-year scheme, recorded on wiretaps and in photos after the tippee, who made about $1.2 million, agreed to cooperate against him? About $50,000 in cash and gifts, including a $12,000 Rolex watch.
KPMG fired London as soon as they found out about the scheme and plans to sue him. London, who moved up the ranks at KPMG over a twenty-nine year career, now faces up to five years in prison and up to $250,000 in fines if convicted. Deloitte brought swift legal action against former Vice-Chairman and 38 year veteran Tom Flanagan after a full internal investigation. KPMG’s suit, like Deloitte’s, is intended to recover any costs incurred to assuage audit client victims and will probably seek to cancel London’s retirement benefits. His partner capital account is a start towards any restitution that will be required by an eventual judgment in KPMG’s favor. If KPMG’s suit is anything like Deloitte’s, we’ll see even more allegations of client confidentiality breaches than in the civil and criminal complaints.
The London case also raises at least two issues studied repeatedly by academic researchers:
• Should insider trading be legal?
• Does auditor independence and prohibitions against financial interests in clients by auditors protect investors?
A 1983 article, The Regulation of Insider Trading, published in the Stanford Law Review by Dennis W. Carlton, David McDaniel Keller Professor of Economics at Chicago Booth and Daniel Fischel, former Dean of the University of Chicago Law School who was a professor at Northwestern University Law School at the time, said the literature on insider trading at the time was too voluminous to cite in detail. Some of the arguments against legal insider trading they cite include unfairness and that it undermines public confidence in capital markets. Insiders can profit on bad news as well as good, which contradicts executives’ stewardship role. Inside trading may also impede timely public disclosure of material information by self-interested insiders. Prohibitions against insider trading were limited in 1983, rarely enforced and had very little impact on behavior.
That’s changed. High-profile cases for insider trading moved to the front of the enforcement line. Only foreign bribery and investment advisor Ponzi scheme indictments trump them. The SEC and Department of Justice are reacting to enormous pressure after the financial crisis and the Madoff fraud. As a result, accounting fraud enforcement has taken a back seat. Insider trading cases are much simpler to prosecute than accounting fraud. They also focus on individuals who end up at odds with their employers, not the corporations that employ armies of attorneys to defend against allegations of systemic fraud and who often employ post-public service SEC and DOJ lawyers.
A 2007 paper in the Journal of Law, Economics, and Policy by Darren Roulstone, then an associate professor of accounting at Chicago Booth (and now at Ohio State) and Joseph D. Piotroski of Stanford, agrees that insiders are still trading their company’s stock and making money from trades even though laws have gotten stricter. “Regardless of past, present, or future returns on their company’s stock, insiders buy or sell their shares in anticipation of future earnings reports. They have an advantage regarding earnings news and they exploit it.”
In spite of KPMG’s quick resignation as auditor of the two companies where London was directly responsible for the opinion, and withdrawal of several years of opinions, the stock market didn’t react dramatically, preferring to believe KPMG’s statements that the financial statements of Herbalife and Skechers were unaffected by the loss of independence.
Even though London’s actions meant KPMG, as a firm, violated auditor independence rules, investors seem to have discounted the impact of one man on the markets. However, an auditor who betrays a client’s trust betrays investors and the capital markets. Auditors have a public duty to protect investors and, like it or not, should be held to a higher standard of integrity than your average hedge fund manager or even corporate executives.