Registered broker-dealers, and their auditors, are under intense scrutiny. Just last week the Securities and Exchange Commission (SEC)issued an alert warning broker-dealers they would be held responsible for customers selling unregistered securities. The SEC said 80% of the 22 firms it recently inspected had deficiencies in this area and many were referred to the Enforcement Division for further action.
The Public Company Accounting Oversight Board (PCAOB), the independent audit firm regulator established by the Sarbanes-Oxley Act of 2002, is having even worse luck getting the auditors of broker-dealers to shape up over the last three years. In its third report under an interim broker-dealer auditor inspection program, published August 18, 2014, the PCAOB identified audit deficiencies or auditor independence findings in 56 of the 60 audit firms inspected and in 71 of the 90 audits inspected.
“Many of the observations noted during 2013 have not changed from prior inspections and relate to fundamental auditing principles,” said Robert Maday, Deputy Director of the Division of Registration and Inspections and Program Leader of the Broker-Dealer Firm Inspections Program.
The PCAOB staff found deficiencies in 100 percent of the audits performed by auditors with only one broker-dealer audit client. PFG Best, where the owner embezzled more than $250 million of customer funds before the firm plunged into bankruptcy, was audited by a one-woman audit firm, operated out of her home. She had no public company clients and only two broker-dealer clients including PFG Best.
Audits of broker-dealers are required under the Securities and Exchange Act of 1934, Section 17(e). For fiscal years ending after December 31, 2008 these audits must be signed by an accounting firm that is registered with the Public Company Accounting Oversight Board (PCAOB).
An audit performed by a PCAOB-registered firm, even one of the largest global audit firms, provides no guarantee against devastating failure. A long audit relationship between PricewaterhouseCoopers (PwC) and MF Global did not, unfortunately, prevent the loss of $141 million as a result of lax software controls exploited by a lone trader in 2008 or the later failure of MF Global on October 31, 2011. More than $1.6 billion of customer funds were missing when the firm filed for bankruptcy.
PwC is the Big Four global audit firm that also counts broker-dealers run by Goldman Sachs, JPMorgan, Bank of America, Merrill Lynch, and Barclays as audit clients. PwC was sanctioned and fined a record $2.17 million in 2012 for its failure to catch non-compliant reporting for client funds safeguards at JPMorgan’s London unit. PwC was also investigated for similar deficiencies at Barclays Capital. Barclays will end its 120-year audit relationship with PwC in time for the 2017 fiscal year.
Audits performed by global audit firm KPMG, inspected every year by the PCAOB like PwC, also did not deter CEO’s shenanigans at broker-dealer Sterne Agee or a “misallocation” of £15m of client money between 2007 and 2011 at UK broker Towergate. KPMG’s audit presence did not dissuade Credit Suisse representatives from illegally providing broker-dealer and investment adviser services in the United States when the bank was not registered with the SEC as a broker-dealer or investment adviser.
What’s worse than the auditors’ failures to prevent, detect and mitigate these frauds, failures and illegal activities at their clients is that the Big Four global audit firms choose the cheapest auditors or the least qualified — or both — to cover the regulatory requirement to file an audit opinion for their own broker-dealer units. In one case, the audit firm chosen by a Big Four firm was slow to comply with the requirement for PCAOB registration.
The Big Four choose cheap, unqualified firms to audit their own broker-dealers — firms funded with partners’ capital contributions. Why would the Big Four global audit firms force broker-dealer audit clients to do more and spend more to protect customers?
In June of this year the PCAOB announced its refusal to register a California firm run by David Widerman. What were the grounds? Widerman prepared or issued an audit report for broker-dealer TCFG Wealth Management, LLC for its fiscal year ended December 31, 2013. Widerman was not a PCAOB-registered public accounting firm at the time. That’s illegal. Audits performed by an unregistered audit firm are invalid and could result in legal action by the SEC against the audited company for non-compliance.
Deloitte’s registered broker-dealer, Deloitte Capital Markets LLC, is audited by a firm from Rosewell, Michigan named Carnaghi Schwark PLLC. Carnaghi has only four employees and only two of them are CPAs. The firm does not audit any public companies.
Per SEC records, William I. Minoletti & Co., PC, the predecessor firm of Carnaghi Schwark PLLC, applied for registration with the PCAOB in April 2009. William I. Minoletti & Co., PC audited Deloitte Capital Markets LLC for the periods ending May 2008 and May 2009, prior to applying for and obtaining PCAOB registration. The firm ceased operations at the end of 2012 when it sold its assets and client list to the junior partners of Minoletti and they formed Carnaghi. Minoletti passed on its PCAOB registration to Louis Carnaghi, a 50% owner of the Minoletti firm and now a partner at its successor.
Ernst & Young Capital Advisors, EY’s broker-dealer, used to be audited by PCAOB registered firm Rothstein Kass. Rothstein Kass specializes in hedge funds, asset managers and broker-dealers and also audits public companies. It’s not big enough to be inspected annually by the PCAOB — you have to audit 100 issuers to merit that distinction — but it is a big enough firm and a good enough firm to have been acquired by KPMG this year.
So which firm did EY move its broker-dealer audit to when its competitor bought its auditor? Was it a similarly well-qualified firm with broad and deep expertise? Not hardly. EY chose the firm Demarco Sciaccotta, a firm that does not audit any public companies, has 6 employees who are the firm’s only CPAs and only recently became PCAOB-registered.
KPMG and PwC, at least, have selected audit firms that audit public companies but neither firm — McGladrey LLP and Crowe Horwath LLP, respectively — have any particular reputation for or strength in auditing broker-dealers. McGladrey audits, by my count, only non-public small broker-dealers, none of which have any customer segregated funds to speak of.
If Crowe Horwath audits any broker-dealers of substance besides PwC’s, I can’t find them. PwC’s recent reporting to the SEC, inadvertently, I suspect, included an income statement showing its broker-dealer is operating at a loss. Employee compensation and benefits eat up 80% of fee income.
PwC and Crowe Horwath have another thing in common. The firms are being sued together by the FDIC for their audits — external and internal, respectively — of fraudulent failure Colonial Bank.
The PCAOB noted in its recent report that auditors that do not audit public companies at all , like Carnaghi Schwark PLLC and Demarco Sciacotta, have a higher percentage of auditing deficiencies than the firms that also audited public companies. Firms like McGladrey and Crowe Horwath that audit 100 or fewer broker-dealers but do audit some public companies had a lower percentage of deficiencies than firms that audited no public companies at all. But they do have a higher percentage of inspection violations than firms that audited more than 100 brokers and dealers.
