Happy Friday! We’re currently working on a post about the practical, legal, and financial considerations surrounding employee theft cases, how to avoid them, and how to deal with them if you are unfortunate enough to have one crash-land in your universe. As noted philosopher Jeffrey Lebowski once said, “Lotta ins. Lotta outs. Lotta what-have-yous.” It’s a complicated subject, and there’s much to discuss.
So, while we work on that post (and do our day job(s)), we have news of a KPMG executive arrested for quite literally “stealing the exam”, which (allegedly) facilitated numerous subsequent malfeasances. Via the Atlanta Journal-Constitution:
A former leader at one of the world’s largest accounting firms was arrested on Monday as part of a sweeping fraud investigation, according to the Department of Justice.
David Middendorf, of Marietta, was one of six people charged and was the head of KPMG’s Department of Professional Practice, which oversees the training and internal/external quality control of auditing.
Others charged in the indictment reported to Middendorf, including those he allegedly helped hire away from an organization that inspects KPMG. And, as prosecutors allege, a couple of those hires upon their departure downloaded confidential information about what parts of the Big 4 firm would be inspected by that oversight group.
Having that information on which areas would be targeted by inspectors allowed KPMG to clean them up in advance, essentially making inspections useless.
Brian Sweet was an associate director at the Public Company Accounting Oversight Board, or PCAOB, before he was hired away by KPMG.
The PCAOB is a nonprofit with oversight from the Securities and Exchange Commission created after Congress passed the Sarbanes-Oxley Act of 2002, which increased scrutiny on corporations and their financial disclosures, the indictment explains.
Sweet pleaded guilty of giving PCAOB documents to KPMG and acting as a conduit to alert the accounting firm of where they’d be inspected. According to the Justice Department, Sweet has decided to cooperate with prosecutors.
“As alleged, these accountants engaged in shocking misconduct — literally stealing the exam — in an effort to interfere with the PCAOB’s ability to detect audit deficiencies at KPMG,” said Steven Peikin, co-director of the SEC’s Enforcement Division. “The PCAOB inspections program is meant to assess whether firms are cutting corners, compromising their independence, or otherwise falling short in their responsibilities.”
Middendorf allegdly used the information to make business decisions and moved resources around to be most efficent knowing what parts of of the company would and wouldn’t be inspected.
“He’s a career professional in the public accounting business. He’s dedicated his life to KPMG and intends to defend himself,” Middendorf’s attorney Gregory Bruch told The Atlanta Journal-Constitution on Wednesday. Middendorf, 53, faces a maximum sentence of 85 years, the Justice Department said.
The years of allegedly gaming the system was pre-empted by one bad year. KPMG got dinged about 2014 with twice as many negative comments by the PCAOB compared to its competitors. To improve their image after that year, KPMG promised bonsuses to teams that performed well when it came time for inspection by the PCAOB. So, “in an effort spearheaded by David Middendorf and Thomas Whittle,” they started in July 2014 to hire Brian Sweet away from the PCAOB to KPMG. Sweet interviewed with Middendorf and others and was offered a job in April 2015. Shortly before his last day at the PCAOB, “Sweet copied various confidential documents from the PCAOB internal newtork” onto a hard drive and took physical papers, the indictment said. Included in what he took was a list of specific divisions PCAOB was planning to inspect at KPMG, which he was asked about during a lunch with Middendorf in his first week at the firm.
Later that week, Middendorf “told Sweet to remember where Sweet’s paycheck came from and to be loyal to KPMG,” according to the indictment.
Days after, Whittle pulled the new employee aside and told him that “he was most valuable to KPMG at that moment and would soon be less valuable,” the indictment said.
Later that day, Whittle emailed Middendorf the list of inspection targets. “The complete list. Obviously, very sensitive. We will not broadcast this,” Whittle wrote, according to the indictment. At the request of his new bosses, Sweet also reached back out to folks at the PCAOB to see what at KPMG was slated for inspection and relayed that back to his bosses. According to the indictment, Sweet recruited Cynthia Holder, a PCAOB employee tasked with inspecting KPMG. Prosecutors allege that while she was being recruited, she would get documents that Sweet requested. Holder was eventually hired and allegedly copied PCAOB documents onto a flash drive.
And like Sweet did with Holder, she kept in touch with a PCAOB employee who funneled her information for 2016 and 2017 inspsections, which was forwarded to Middendorf, the indictment said. Middendorf then ordered “stealth” re-reviews of departments that were set to be inspected, according to the indictment.
In February 2017, Sweet told a high-ranking employee that their group would be inspected by PCAOB. That employee reported the conversation to the KPMG general counsel on Feb. 13, 2017. Middendorf “was separated” from KPMG in April 2017, the indictment said. “These defendants were each meant to be the watchmen of our financial system,” said Manhattan U.S. Attorney Geoffrey S. Berman. He continued: “The defendants who formerly worked for KPMG were vested with the responsibility to audit publicly filed financial statements and issue audit opinions relied upon by the investing public. The defendants who formerly worked for the PCAOB were supposed to help ensure the quality of the work behind those audits. But, as alleged, these defendants chose to cheat the system and to undermine the safeguards put in place to protect investors.”
The revolving door is nothing new, nor in any way exclusive to the PCAOB and the large public accounting firms. In fact, the European Finance Association published (academic access or purchase required) a 2016 study that found a nearly 25% increase in direct hires from financial regulatory agencies and, more importantly, a SIGNIFICANT change in regulated firm managerial strategy immediately following the hire. From the abstract:
The number of top executives with regulatory experience per firm has increased 24% over 2001–15, and hiring is associated with positive average announcement returns and a salary premium. In the quarter after hire, market and balance sheet measures of firm risk decrease significantly and measures of risk management activity increase, especially for hires from prudential regulators, who directly monitor financial firm risk. The absence of this result for unregulated firms and for exogenous shocks to regulatory experience suggests that firms hire ex-employees of their regulators when they perceive a need to reduce risk, consistent with a schooling hypothesis. (Emphasis added)
The KPMG/Sweet/Middendorf case might appear to be an extreme example of revolving-door malfeasance between the regulator and the regulated, but anecdotal evidence points to a higher incidence of such behavior than even pessimistic industry observers estimate. It will be very interesting to see how this plays out for KPMG and the public accounting industry as a whole.
Music Recommendation: Nigel Stanford, Automatica. cool song and a *spectacular* video from late last year. I, for one, welcome our new robot overlords. Worth watching in 4K HD: https://www.youtube.com/watch?v=bAdqazixuRY
Food Recommendation: Caramel apple fried empanada at Taco Bell. DON’T JUDGE ME! Besides, how do you know I’m not one of the Belluminati? Hint: I’m not.
The views of the author are his alone. Any similarity to real tacos, living or dead, is purely coincidental.