Regulators Outgunned by Big Firms

SACRAMENTO —  In 1994, California regulators began investigating the accounting firm that had audited Orange County as it slid into the largest municipal bankruptcy in U.S. history.

It took eight years and $9 million for the state Board of Accountancy to discipline KPMG. The board has an annual budget of $10 million and 56 employees; the accounting giant earned $12 billion last year and employs nearly 90,000 people. KPMG tried to block the inquiry through two lawsuits and repeated attempts to disqualify some of the state’s key advisors, state records show.

“It was a bruising experience,” said Gregory Newington, the state board’s chief of enforcement. “When the other side is an entity the size of a major firm and they can bring legions of attorneys and expert consultants, a little agency like ours feels insignificant.”

KPMG’s penalty was mild: It had to repay part of the investigation’s cost and was placed on probation, which ended last year.

But California’s difficulties in monitoring the performance of large firms -- problems the KPMG case made apparent -- are persisting despite a major overhaul of the board that lawmakers enacted two years ago in the wake of the Enron and WorldCom scandals, board officials and outside observers say.

Those changes required accounting firms to report to the state board lawsuit settlements over $30,000; restatements of financial figures; and investigations by other regulatory bodies. Lawmakers also reduced accountants to minority membership on the 15-member board.

But the changes did not provide the board with new penalties it could levy against errant corporations.

Nor did the changes enable the board to increase its staff of four investigators, who must police 63,000 individual accountants and 4,500 firms. Those include the international corporations known as the “Big Four”: Deloitte & Touche, Ernst & Young, PricewaterhouseCoopers and KPMG.

“If the board were to undertake a major case against a Big Four firm right now, it would be literally prohibitive from undertaking any other case,” said Julianne D’Angelo Fellmeth, administrative director of the Center for Public Interest at the University of San Diego.

Instead, at the same time lawmakers were adding responsibilities to the board, they also were draining its finances to balance the state budget.

Since 2002, lawmakers have borrowed $6 million from the board’s reserves. A hiring freeze dating back to 2001 prevented the board from adding investigators, or even replacing some who left, even though the board is wholly supported by professional licensing fees, not tax dollars.

All these factors prompted the board to tell legislators it could not follow through on its mandate, unique among states, to discipline not only individual accountants but also large firms. Board officials say they are now more likely to defer to federal regulatory agencies, such as the Securities and Exchange Commission and the Public Company Accounting Oversight Board.

However, in some cases that is not an option, because only California regulators have authority to monitor auditing of private companies, nonprofits and governmental bodies within the state’s boundaries.

That was the case when Orange County lost $1.6 billion and sought federal bankruptcy court protection from creditors in 1994.

The board launched an inquiry into whether KPMG followed professional standards over the two years it signed off on the county’s books without raising alarms about then-Treasurer Robert L. Citron’s precarious investment strategies.

State law enforcement officials successfully prosecuted Citron for falsifying documents and misappropriating public funds, and he was sentenced to nine months of community service work.

But the accountancy board discovered there were plenty of reasons to question KPMG’s commitment to aggressively auditing the county.

The firm had won Orange County’s auditing account in 1992 by offering a $104,500 bid that was $41,500 less than the county’s previous auditor, according to a report issued in 1998 by Stuart Harden, an outside consultant hired by the board.

KPMG had sold itself on the experience of its senior partners, but many of them ended up doing limited or no work on the account, Harden found.

KPMG’s project head spent only 52 hours on the 1992 and 1993 audits -- 1.2% of the total hours KPMG auditors devoted. Another senior auditor who was supposed to review the team’s work devoted only seven hours over two years to the project.

Most of the work was performed by less experienced auditors, including one KPMG employee who had graduated from college earlier that year and had not yet been licensed as a CPA. She played “a significant role” in auditing the county, Harden’s report said.

Months before Harden’s report was completed, however, KPMG had already begun mounting an aggressive challenge to the board. Before the board and in the courts, the firm asserted that the investigation was part of a conspiracy of California governmental entities intent on pinning the collapse of Orange County on the accountants.

The firm unsuccessfully tried to get a judge to stop the investigation until after a civil lawsuit against KPMG was resolved. (The firm paid $75 million to Orange County in a 1998 settlement.) KPMG also charged that it was being unfairly singled out because the board was not investigating other accountants who had worked for Orange County.

In motion after motion, KPMG attempted to block the board from hiring an outside law firm that had once represented a KPMG partner and had allegedly been privy to confidential information about the firm. The firm tried to disqualify several of the board’s advisors, complaining that one was a retired partner from PricewaterhouseCooper, which had been a consultant to Orange County’s lawsuit against KPMG.

Ultimately, KPMG was unable to convince any independent arbiters that the board’s investigation was “tainted.” In February, 2002, Administrative Law Judge Humberto Flores ruled that KPMG and its auditors had made “extreme departures from professional standards” by taking too many of Orange County’s statements about its finances at face value and not disclosing in their audit reports that the county treasurer was investing money in ways that were not permitted.

An appeals court in 2000 dismissed KPMG’s accusations against the board, ruling, for instance, that the conflict the firm alleged concerning the retired PricewaterhouseCooper partner was “too remote” to matter. A Los Angeles Superior Court rejected a separate KPMG lawsuit last July; KPMG is appealing that ruling.

A KPMG spokesman last week called the appeal “necessary and appropriate” and said that “such appellate proceedings normally do not generate a great deal of costs.” The company declined to discuss the case further.

The accounting board’s victories came at quite a price, however. KPMG’s extensive public records requests -- the company asked for just about every document related to the case -- took the equivalent of one staff member working 11 weeks to compile, according to a report the board gave legislators in December.

The board spent about $4 million to investigate and bring a formal accusation in 1998. It took an additional 4 1/2 years and double the investigation’s cost to prosecute the case before an administrative law judge and issue a decision, the board said.

These were substantial sums for an agency that allots only $4 million for enforcement. (Most of the board’s disciplinary actions concern individual accountants and small partnerships.)

The hearing spanned 101 days of testimony, with KPMG’s team of lawyers -- usually five or six on a given day -- outnumbering the board’s team of two to four lawyers. The more than 5,000 exhibits in the case filled 43 boxes.

Yet the ultimate penalty meted out against KPMG in July 2002 was hardly severe.

The board placed KPMG’s team leader on probation for three years and put two other KPMG auditors on probation for two years. The firm itself was placed on probation for one year and ordered to pay the accountancy board $1.8 million to help cover costs of the portion of the investigation that the administrative law judge had validated. (The board is not allowed to recoup the costs of trials and appeals.)

KPMG also had to pay an additional $21,898 for taking 10 months to turn over reports -- a delay the administrative law judge had ruled was excessive.

Board officials justify the discipline by saying that they did not want to harm innocent employees by closing the firm’s doors.

The Legislature’s Joint Sunset Review Committee, headed by Sen. Liz Figueroa (D-Fremont), has recommended giving the board more punishment options than simply placing firms on probation or suspending or revoking their licenses.

The proposal, which the board has endorsed, would allow up to $5 million in fines against large firms that repeatedly violate accounting standards. Figueroa’s panel also wants to give the board more latitude to dip into its reserves for major cases such as the one concerning KPMG.

“We think the board today does not have the resources that it needs,” said Susan Waters, chief executive of the California Society of Certified Public Accountants. “They should be able in the near term to rectify that.”

But some of the board’s impediments are not yet behind it. Although Gov. Arnold Schwarzenegger’s administration has lifted the three-year hiring freeze, authorization to increase its investigative staff has been incorporated into Schwarzenegger’s ongoing overhaul of state government, which will not be enacted for many months.

Carol Sigmann, the board’s executive officer, says even if she gets approval to add staff, the maximum salaries for investigators -- currently $65,868 a year -- are too low to effectively recruit trained accountants, who can find better paying work in private firms and the Securities and Exchange Commission. The board has already lost two investigators to other state agencies, and Sigmann fears that may increase.

“We are at risk of losing the talent we currently have, which would be disastrous,” she said.