SEC Lesson To Individual White Collar Defendants: Just Hold Out And We Will Settle For Peanuts

March 2006

According to the Securities Exchange Commission, "The Xerox fraud was a wide-ranging, four-year scheme to defraud investors."  Given the seriousness of this charge (and the evidence that backs it up), one would expect that punishments would be severe.  In contrast, because the Xerox fraud was overshadowed by the press attention paid to WorldCom, Enron, and other frauds that were occurring at or before the Xerox charges came to light, Xerox has not received the attention that it deserves.  Consequently, Xerox's auditors, KPMG, have been blessed with relatively little attention for its role in the Xerox fraud.   

In late February 2006, the Securities and Exchange Commission (SEC) congratulated itself on reaching settlements with four remaining KPMG auditors who were personally involved in the Xerox financial fraud.  The trial against these four defendants was slated to start in around two weeks.  In announcing the settlement, the SEC said, "This case represents the SEC's willingness to litigate important accounting fraud allegations against major accounting firms and their audit partners, even where the accounting was complex." 

The SEC's bragging to the press is way overdone.  While these Xerox-related settlements are larger than most settlements against individual auditors, the SEC has typically done little in this area.  To those who followed the Xerox saga, the SEC's settlements really show (i) how scared the SEC is take a case to trial, and (ii) how little punishment is actually delivered to individual defendants who have managed to stay out of the press's spotlight.  

By way of background, the current settlements involve the individual auditors who purposefully looked the other way with Xerox's violations of accounting principals. The SEC said that "This is a fairly egregious fraud on the part of Xerox, and KPMG did not live up to its role as gatekeeper". According to the SEC, without these accounting tricks, Xerox would have missed earnings targets in 11 of 12 quarters.  In April 2005, when KPMG settled the SEC's charges against the firm for $22.5 million, the SEC found that:

"KPMG was intimately familiar with the accounting actions Xerox used on a quarterly and annual basis to increase reported revenues and earnings during 1997 - 2000. … KPMG willfully violated [securities laws] … and willfully aided and abetted Xerox's violations..." [emphasis added]

The SEC's Litigation Release further describes KPMG's role in the Xerox accounting fraud:

"…from 1997 through 2000, KPMG permitted Xerox to manipulate its accounting practices to close a $3 billion "gap" between actual operating results and results reported to the investing public. During this period, Xerox used topside accounting actions at the end of financial reporting periods to increase equipment revenue and earnings through the improper acceleration of revenue from long term leases of Xerox copiers and through manipulation of excess or "cookie jar" reserves. Most of Xerox's topside accounting actions violated generally accepted accounting principles (GAAP) and all of them inflated and distorted Xerox's performance but were not disclosed to investors. These undisclosed actions overstated Xerox's true equipment revenues by at least $3 billion and overstated its true earnings by approximately $1.5 billion during the four-year period."

So, what punishment should one get for willfully aiding and abetting a multi-billion dollar securities fraud?  In this case, the lead engagement partners received a penalty of either $150,000 or $100,000.  The concurring partner for all four of the failed audits will pay nothing.  The individuals also received suspensions of their ability to practice before the SEC for from one to three years. 

These leaders were personally paid many times their penalties for their dishonest employment.  By any measure, these penalties are small when compared to the following:

1. Six Xerox executives personally paid over $22 million (an average of $3.7 million each) to settle their misdeeds involving the same circumstances.  
2. In this very same case, every KPMG partner in the entire firm will likely pay as much for (i) the firm's SEC settlement, and (ii) the related class action litigation.  Obviously, practically all of these KPMG partners had nothing to do with Xerox.    
3. Every KPMG partner in the entire firm will pay at least twice as much to settle the government's fines from KPMG's tax shelter shenanigans.  Again, the vast majority of these partners had nothing to do with these tax shelter program misdeeds. 
4. For belonging to a firm that the government prosecuted because of Enron, every Andersen partner lost his entire capital account, plus all accumulated but unfunded retirement benefits.  Even the most junior Andersen partner lost two to three times what these individual KMPG partners are now being fined.  Andersen partners with similar seniority to these settling KPMG partners lost capital accounts of five to ten times what these individual KMPG partners are now being fined.  This is just for the capital accounts - the retirement losses are an additional loss.  Of course, practically all of these Andersen partners had nothing to do with the Enron fraud, and the verdict against Andersen was ultimately overturned.    

Even the relatively small amounts paid by the settling KPMG partners would not have occurred had the U.S. District Court not dismissed the individual partners' claims that none of them could be held liable because KPMG as an institution signed off on the Xerox financial statements, not them as individuals.  This ruling of personal responsibility may be a key precedent for future cases.     

This current settlement with the KPMG individual partners continues the government's practice of going after the deep pockets of the entire firm, instead of punishing the individuals that were involved.  In following this practice, the government continues to issue press releases claiming large penalties, while ignoring the individual bad guys.  This punishes the wrong people, and ultimately weakens the Big Four firms' ability to attract and retain top talent to perform this important auditing service.   

Recognize that the settling KPMG auditors aided and abetted a fraud that caused billions of investment losses.  These losses are quite real, with little practical difference from losses that would occur with a bank robbery.  In the same way that the government does not worry about the extent of monetary recoveries when deciding to pursue individual gun-toting bank robbers, the government should not care about a limited monetary recovery when prosecuting individual white-collar criminals that were involved in billions of dollars of investment losses.  Instead of bragging about this settlement, the SEC should be ashamed for letting these individual KPMG partners walk away with little punishment.   

Fulcrum Inquiry performs financial investigations, and assists lawyers with the accounting and economic aspects of litigation.