February 19, 2009

The PCAOB’s International Inspections: Heightened Importance Post-Satyam?

Last month, the PCAOB adopted an amendment to Rule 4003 (as well as proposed a separate amendment to that rule) relating to the timing of certain inspections of registered non-US companies. Given the breath-taking revelation by Satyam’s CEO of prevalent fraud perpetuated by the CEO, it’s unfortunate that the PCAOB has not been inspecting the foreign affiliates of the US audit firms, such as the Indian firm auditing Satyam, because the budget that the PCAOB submits to the SEC has not provided sufficient funds for such inspections.

As we saw in the past month with Madoff’s auditor who was not undergoing inspections, a lack of independent inspection of auditors has led to undesirable results, and is a major shortcoming on the part of the regulator and regulatory system. This is also especially interesting as the major auditing firms are now outsourcing portions of their audit work to India. With the developments below, this should give investors great concern. Especially at a time when some on the PCAOB have espoused a view that the agency should just rely on their foreign counterparties thru a system referred to as mutual recognition.

Lynn Turner teaches us about how audits of non-US companies are conducted:

There are two types of foreign audits. The first one is one in which a foreign company that lists in the US, is audited by a foreign audit firm, who renders the auditors report on the financial statements. That could be one of the large international audit firms or a local firm in that foreign country.

The second type of foreign audit work, often called “referral work” is when a US audit firm, such as one of the Big 4, audits a large international conglomerate such as IBM or Coca Cola. The US audit firm audits the revenues, assets, internal control and accounting systems in the US. The US audit firm then refers the audit work on the foreign operations to one of the audit firms affiliated with them in the respective foreign countries where the foreign operations exist and are accounted for. These are two separate and distinct firms, with separate management but affiliated for marketing and branding purposes.

Referral work is becoming more significant and having additional risks evolve for investors as the US audit firms are now also farming out to foreign affiliates, such as in India where the cost of labor lower, some of the audit work that in the past, would have been performed on the audit of the US operations of these companies. They are in essence, now outsourcing a portion of the US audit work and writing into their audit engagement letters that this can be done.

I have also been told by various sources that some of the Big 4 have been trying to set up structures internationally to avoid inspections of their foreign audits. Also some foreign entities such as the EU have been pushing the PCAOB to just go along with whatever independent oversight or inspections ( in many cases which is none) are done internationally. However, it is unlikely they will be bailing out the investors who have suffered losses in Satyam.

A New Angle: Investor Liability for Ponzi Schemes?

From Keith Bishop: In light of Bernie Madoff’s alleged Ponzi scheme, this recent opinion in Donell v. Kowell from the 9th Circuit Court of Appeals should be of some interest. The case addresses the liability of a good faith investor in a Ponzi scheme. The appellate court upheld liability under the Uniform Fraudulent Transfer Act as adopted by California.

Liability was based on a positive netting of the amounts paid by the Ponzi scheme to the investor against the initial investment. Then the court applied the applicable statute of limitations to determine the actual liability. The investor advanced several legal theories for why he shouldn’t be liable, but all were rejected on appeal. Here is a memo on the case.

Some Thoughts on the Madoff Scandal: Blame Thyself

A member recently sent me this: “I feel a rant coming on to the effect that any charitable foundation or endowment that lost 100% – or even 50% – of its entire net worth with Madoff has itself to blame. Prudent allocation theory would say that an institutional investor should have no more than 10-20% of its assets in alternative investments like private equity, and then that commitment should be diversified among at least several managers. The Madoff fund, I believe, was not sold as a diversified fund – so how could a prudent fiduciary invest all or even half of his or her assets with that one manager? At most, any institution should have lost maybe 5-10% of its assets to Madoff.”

– Broc Romanek