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Analysis: Insider trading probe impact on KPMG expected to be short-lived

The street level sign of the KPMG buliding in downtown Los Angeles is shown April 10, 2013. REUTERS/Sam Mircovich
The street level sign of the KPMG buliding in downtown Los Angeles is shown April 10, 2013. REUTERS/Sam Mircovich

By Nanette Byrnes

(Reuters) - KPMG will suffer some financial and reputational damage from insider trading charges filed against a former senior audit partner, but significant legal liability for the firm was unlikely, said audit industry experts on Thursday.

The global accounting giant fired Scott London, a long-time Los Angeles audit partner, after learning he shared privileged information on audit clients with a golf partner, Bryan Shaw.

Prior cases involving auditors inappropriately sharing internal client information, or trading on it for their own benefit, have resulted in jail time and fines for some individuals involved, but not for their employers.

London was criminally charged on Thursday with insider trading by the U.S. Department of Justice, while both London and Shaw were charged civilly with insider trading by the U.S. Securities and Exchange Commission.

The SEC charged that information on five companies was shared in a scheme that brought Shaw $1.3 million in illicit trading profits. In exchange for the information, Shaw paid London $50,000 in bags of cash, plus expensive gifts including a $12,000 Rolex watch, the SEC said.

London's lawyer Harland Braun told CNBC that London understood he was violating the law and he could face jail time. London has said KPMG is not to blame in the matter.

For KPMG , the most immediate cost will likely be paying for another firm to re-audit several years of financial statements for two former clients: vitamins maker Herbalife Ltd and footwear maker Skechers USA . London was the lead audit partner for both companies.

Lawyers who specialize in such cases said such re-audit arrangements are standard industry practice in cases where audits are compromised by independence violations.

Last year, Herbalife paid KPMG $4.8 million for audit and tax work, while Skechers paid the firm $2.1 million, according to SEC filings.

SEEKING NEW AUDITOR

Skechers Chief Financial Officer David Weinberg told Reuters the company has begun talking to new auditor candidates and is in a hurry to resolve audit issues because earnings season is near. KPMG pledged to help ensure a smooth transition, he said.

Herbalife and KPMG did not respond to requests for comment.

Insider trading involving auditors is rare, but not unheard of. Last October, Thomas Flanagan, former vice chairman of Big Four audit firm Deloitte & Touche LLP , was sentenced to 21 months in prison for insider trading involving four audit clients.

The SEC accused Flanagan of circumventing Deloitte's independence controls, failing to report trades, lying about independence policy compliance and giving false information about trading activities to his personal tax preparer.

In October 2011, Annabel McClellan, wife of former Deloitte tax partner Arnold McClellan, paid a $1 million penalty related to insider trading done by her sister and brother-in-law based on information she shared from her husband. The SEC dropped its initial claim that Arnold McClellan was involved, as well.

Deloitte was not charged with wrongdoing in either case.

8,000 VIOLATIONS

In January 2000, PricewaterhouseCoopers was admonished by the SEC for having more than 8,000 violations of auditor independence rules, due to investments by PwC employees or their relatives in 2,159 of the firm's 3,170 audit clients.

Today, PwC trains new hires on policies against misuse of confidential client information and requires annual firm-wide refresher training in which partners and staff attest they have not misused confidential information. The firm also randomly audits employee's securities trading, checking their reports against banking and brokerage statements, a spokeswoman said.

Deloitte has similar rules in place according to the firm's annual Transparency Report, as do the other major firms, lawyers familiar with their independence systems said.

Requests for comment from KPMG on its independence training were not returned. London acknowledged, according to the SEC complaint, that he underwent annual ethics training at KPMG, which explicitly prohibited sharing inside client information.

Such programs have generally proved an effective shield from regulatory action, so long as there is no complicity in the wrongdoing, said Peter Fontaine, a partner at law firm NewGate Partners and former Arthur Andersen partner.

SHAREHOLDER ACTION UNLIKELY

Shareholders could possibly sue KPMG on grounds it was not an independent auditor as represented in its audit opinions, but this would be unusual, said lawyers not involved in the case.

Similarly, shareholders could sue the companies involved to compel a breach of contract case against KPMG, but this would also be unlikely, they said.

Generally shareholders sue auditors in situations where there has been an audit failure that resulted in a material misstatement of a company's financial performance.

In a statement put out by the firm on Monday, KPMG said it had no reason to believe that was the case in these audits.

Shareholder suits against auditors on any topic are increasingly rare. Just 45 new cases were brought in 2012, down from 78 in 2011, according to a study published by Cornerstone Research on Wednesday. Settlements in the accounting cases that made it that far, however, remained high, at $2.9 billion in 2012, according to the study.

For KPMG, "the reputational harm's been done. No doubt about it," said Duke University law professor James Cox. But because it's not an auditing failure, and seems to be isolated, "at the end of the day it will have limited impact."

(Reporting by Nanette Byrnes in Chapel Hill, N.C.; additional reporting by Martinne Geller and Emily Flitter in New York; Editing by Kevin Drawbaugh and Phil Berlowitz)

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