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A Plot Twist at Herbalife Draws in the Auditors

Patrick Fallon | Bloomberg | Getty Images

Herbalife, which describes itself as a global nutrition company, and which critics deride as a purveyor of overpriced products that is really a pyramid scheme preying on naïve people with dreams of easy wealth, has already provided one of the best stock market dramas in years. Now, through no fault of its own, it could become a catalyst for change in the auditing profession.

Herbalife lost its auditor, KPMG, this week after it was revealed that Scott I. London, the partner in charge of the audit until he was fired, had been providing inside information about Herbalife and the shoe company Skechers to a frequent golf partner who was trading on the tips.

(Read More: FBI Launches Probe as KPMG Quits Herbalife, Skechers)

The audit firm decided that it would not only resign as auditor at Herbalife and Skechers, whose audits Mr. London also led, but would also withdraw its certification of the old audits, even though it said it had no reason to doubt the accuracy of the reviews. That left the two companies scrambling to find new auditors who will have to reaudit results from recent years, an expensive and time-consuming process.

Skechers presumably will have no trouble getting one of the other Big Four firms—PricewaterhouseCoopers, Deloitte & Touche and Ernst & Young—to take over its audit. And it seems reasonable to think that KPMG will end up paying the extra costs, since it was the misconduct of its partner that led to the mess.

But it will be interesting to see which firm signs on as Herbalife's auditor. When an auditor is selected, that firm will be under close scrutiny by the participants in the Herbalife stock market war being fought by hedge funds. That war pits Bill Ackman of Pershing Square Capital Management, who has loudly shorted the stock, against Daniel S. Loeb of Third Point, who bought the shares after Mr. Ackman disclosed his position. Carl C. Icahn, who has an unrelated complaint with Mr. Ackman, has also leapt in to buy the stock.

(Read More: Ackman, Icahn Hurl Accusations, Insults)

Financial statements are not at the heart of Mr. Ackman's argument that Herbalife is an illegal pyramid scheme that will be the target of federal regulators. But he has complained about inadequate and misleading disclosures. It is at least conceivable that an auditor might seek to force additional disclosures.

All audit firms have risk groups that review new business, including the quality of the company to be audited, and that decide that some prospective clients are not worth the risks. It will be interesting to see if any of the other major firms conclude that the risks are acceptable, particularly given that Herbalife's 2012 audit fee was under $4 million, which is not a large sum to a major firm. If Herbalife turns to a second-tier audit firm, it will be embarrassing to the company.

Then there is the issue of conflicts of interest. Any audit firm that did certain types of consulting work for Herbalife over the last three years might be disqualified, since the new auditor will have to review those periods.

More From The New York Times:
KPMG Cancels Audits Over Insider Trading Inquiry
How Herbalife Was Drawn Into KPMG Insider Trading Inquiry
Former KPMG Partner Charged With Insider Trading

Herbalife's annual meeting is April 25, and it no doubt would like to have the new auditor on board by then.

Some studies have indicated that financial restatements are more likely when a new auditor is brought in, but the data involved makes it hard to know if there is a causal connection. After all, as a general rule auditors are changed only when either the client or the audit firm is unhappy about the relationship, and a dispute over accounting or even suspicion of management may be at the heart of such a split.

There is no evidence of such a split here. KPMG has been the company's auditor since before the company went public in 2004, and the two seem to have been getting along fine. If Herbalife's new auditor does seek to force a restatement, that will be seized upon by advocates of mandatory auditor rotation as support for their argument that auditor independence is inevitably compromised by long tenures of the incumbent firm, and that companies should be required to change firms every decade or so. Such a requirement is fiercely opposed by the accounting industry, but it has been approved by the Dutch Parliament for companies in the Netherlands.

This controversy could also give new life to a proposal by the Public Company Accounting Oversight Board, the American audit regulator, to force the disclosure of the name of the lead partner on each audit in a company's annual report. That is already required in some countries, but the industry has fought it here, and it is not clear that James R. Doty, the accounting board's chairman, can persuade two of his four colleagues to join in adopting such a rule.

The industry has a variety of objections to such a rule. It argues that providing a name would dilute the collective responsibility of the firm for each audit and that providing a name could make a partner an innocent scapegoat if it turns out that he or she failed to uncover a fraud.

That sense of secrecy played out in the disclosures from KPMG this week. The auditing firm announced the departure of an unnamed "rogue" partner late Monday night, after it had notified the two companies and regulators.

On Tuesday, Mr. London's name began to circulate, and he went public to declare he was the man involved and admit he had leaked information.

Mr. London was the audit partner in charge at KPMG's Los Angeles office, supervising more than 500 accountants, which presumably gave him the authority to seek information on the progress of audits other than the ones he was directly supervising. KPMG's statement said he had leaked information on "several West Coast companies," and said it had resigned as auditor of two companies, which it did not name.

Mr. London now faces criminal and civil charges. Bryan Shaw, the golfing friend who paid for the tips, faces civil charges. Once caught, Mr. Shaw turned in Mr. London. The charges say that Mr. London gave Mr. Shaw insider tips on earnings and mergers from 2010 through last month and that Mr. Shaw made more than $1 million on illegal trades. In return, Mr. London received about $50,000 in cash, as well as jewelry and concert tickets.

KPMG's chief executive, John B. Veihmeyer, says the firm will file its own suit against Mr. London.

At other auditing firms, there was surprise at how little it took to get Mr. London to commit acts that destroyed his career and may lead to prison. An auditor in Mr. London's position would be expected to earn an annual salary in the high six figures.

The charges say Mr. London provided information on three other KPMG clients. Two of the leaks were related to takeovers that subsequently took place, meaning that the companies no longer were independent and did not need their own auditors. The third company, a shoe company named Deckers Outdoors, remains a KPMG client.

KPMG seems to believe that because Mr. London was not in charge of the Deckers audit, its independence was not compromised and it therefore did not need to resign or withdraw its past audit certifications.

For KPMG, its salvation may be, once again, that there are only four firms in the Big Four, and no one wants to reduce that to three. Mr. London's lawyer, Harland Braun, said in an interview with CNBC that federal officials had been "relieved" when Mr. London assured them that no one else at KPMG was involved. The investigators had been concerned, he said, that Mr. London might be "the tip of an iceberg" of corruption at the firm.

(Watch: KPMG Lawyer: London Understood Violations)

In 2005, when KPMG signed a deferred prosecution agreement stemming from its marketing of illegal tax shelters, it agreed to maintain an effective compliance and ethics program. It does not seem to have done that, at least in one office. But no one expects the government to claim that agreement was violated, a move that could force KPMG to face the original criminal charges. For big accounting firms, there is strength in—low—numbers.

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