Audit Firm And Engagement Partner Settle SEC Allegations Stemming From 2011 Audit Of A New Client

by Shearman & Sterling LLP
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On August 15, 2017, KPMG LLP (“KPMG”) and one of its engagement partners settled claims brought by the U.S. Securities and Exchange Commission (“SEC”) that they violated Section 4C of the Securities Exchange Act of 1934 (“Exchange Act”) and Rule 102 of the SEC’s Rules of Practice in connection with KPMG’s 2011 audit of the financial statements of Miller Energy Resources, Inc. (“Miller Energy”).  In the Matter of KPMG LLP and John Riordan, CPA, Admin. Proc. File No. 3-18110 (Aug. 15, 2017).  This is the second SEC enforcement action to grow out of the Miller Energy financial statements. 

In 2015, the SEC brought an administrative proceeding against Miller Energy, one of its former officers, a then-current officer, and the audit team leader at Miller Energy’s former independent auditor, alleging that after acquiring oil and gas properties in Alaska in late 2009, Miller Energy overstated its value by more than $400 million.  Specifically, even though Miller Energy paid only $2.25 million plus the assumption of certain liabilities for these properties, Miller Energy later recorded its value as $480 million based on a reserve report rather than based on an estimate of fair value (as required by GAAP).  This represented approximately 95% of Miller Energy’s total reported assets.  Accordingly, for a certain time, the valuation allegedly had a massive impact on Miller Energy’s stock price, which went from being a penny stock to a stock listed on the New York Stock Exchange that ultimately traded for almost $9 per share in 2013.  But ultimately, Miller Energy filed for bankruptcy in 2015.

KPMG became Miller Energy’s independent auditor in 2011, after Miller Energy had already acquired the assets at issue and another independent auditor had signed off on its valuations of the Alaska properties.  Nevertheless, neither KPMG nor Riordan called the amounts into question in conducting KPMG’s initial audit. 

According to the SEC, KPMG and the settling audit partner thus failed to comply with the standards promulgated by the Public Company Accounting Oversight Board (“PCAOB”).  The PCAOB standards required KPMG, as a successor auditor, to analyze the impact that Miller Energy’s opening account balances had on the current year’s financial statements.  Among other things, the SEC alleged that KPMG failed to obtain sufficient competent evidence regarding the impact of the opening balances, despite knowing that no fair value assessment had been performed the prior year.  More broadly, however, the SEC claimed that in myriad ways, KPMG and the partner failed to express sufficient skepticism in dealing with a new client—particularly one that only years before had been a penny stock company and where there were multiple red flags regarding the valuations at issue (including a public blog post calling them into question, of which the partner allegedly became aware).  According to the SEC, despite these alleged red flags, KPMG issued an unqualified opinion on Miller Energy’s 2011 financials, just months after becoming engaged and just weeks after the SEC’s Division of Enforcement sent Miller Energy a subpoena seeking information related in part to the purchase and valuation of the Alaska assets. 

In settlement of the allegations, KPMG agreed to pay $6.2 million and agreed to various undertakings focused on enhancing its quality controls, including the retention of an independent consultant and certifications by its Vice Chair.  The audit partner separately agreed to pay a $25,000 penalty and to a bar from appearing or practicing before the SEC as an accountant for at least two years, after which he can request that the SEC consider his reinstatement.   

The case serves as a warning shot to other audit firms about the dangers in taking on new clients and the need for careful oversight, and provides insightful guidance as to the SEC’s expectations.  

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