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NYTimes.com Article from 2003: U.S. Charges Ernst & Young Ex-Partner in Audit Case  

COMMENTARY

Peter Burgess

Subj: NYTimes.com Article: U.S. Charges Ernst & Young Ex-Partner in Audit Case  
Date: 9/26/2003 5:10:31 AM Eastern Daylight Time
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U.S. Charges Ernst & Young Ex-Partner in Audit Case

A former partner with Ernst & Young was arrested yesterday and charged with obstructing a federal investigation of one of his clients by altering and destroying documents that were relevant to the inquiry.

The former partner, Thomas Trauger, who worked in Ernst & Young's office in San Francisco, was charged in a criminal complaint with destroying and altering audit work papers related to a federal examination of the bank subsidiary of NextCard Inc., a consumer loan company that is being liquidated.

According to the criminal complaint and related actions brought yesterday by the Securities and Exchange Commission, Mr. Trauger was assisted in the effort by Oliver Flanagan, a former Ernst & Young senior manager, and Michael Mullen, a former audit manager. Mr. Mullen, 33, was not charged in the criminal case. Mr. Flanagan, 34, entered a guilty plea last month, but that plea remained under seal until yesterday.

A lawyer for Mr. Trauger, Ed Swanson, said that his client planned to fight the charges. 'We are confident that he will be exonerated,' Mr. Swanson said.

Stanley Arkin, a lawyer for Mr. Flanagan, said that his client, who is cooperating in the case, now lives in Ireland. 'He has made his peace with our government,' Mr. Arkin said. 'And he only wishes that Mr. Trauber had been a better mentor.'

A lawyer for Mr. Mullen, Bob Breakstone, said that his client was 'dismayed' by the S.E.C. action but hoped to work out a resolution of the matter.

The criminal charges are among the first to be brought against an accountant under provisions in the Sarbanes-Oxley Act related to the destruction of documents. That law was adopted in 2002 in response to an array of corporate scandals, including an obstruction of justice case against Arthur Andersen accountants in the investigation of the collapse of Enron.

Indeed, according to the criminal complaint, the efforts by Ernst & Young accountants to eliminate certain details from their work papers about NextCard began in November 2001 - the same month that Andersen accountants were shredding Enron records. According to the complaint, the obstruction effort at Ernst continued into 2002, even as criminal charges were being brought in the Andersen case. Andersen ultimately collapsed after it was convicted of obstruction.

Prosecutors hailed the action yesterday, saying that it was a significant moment in the government's effort to combat white-collar crime because of its use of Sarbanes-Oxley.

'This is a bellwether day,' Robert McCallum, acting deputy attorney general, said of the case in a statement, adding that the case 'should remind accountants and lawyers not only of their commitment to represent their clients professionally, but also of our strong commitment to enforcing the law.'

Kevin V. Ryan, the United States attorney in San Francisco, said the case underscored the importance of professional standards to the nation's financial system.

'Financial markets depend on the integrity of auditors, lawyers and professionals to do their jobs ethically and fairly,' Mr. Ryan said in a statement. 'Where they fail to do so because of negligence, markets are compromised. Where they fail to do so because of criminal intent, all of us are at risk.'

Ernst & Young said in a statement that it began an internal investigation as soon as it became aware of what it called 'a clear and serious violation' of the firm's standards.

The firm is cooperating with the government investigation, it said, and has 'provided the government with full and unfettered access to our people and records to assist in its own investigation of the matter,' the statement said.

At the center of the accusations against Mr. Trauger is NextCard, a company that was once the largest issuer of credit cards over the Internet. But the company was cited by federal bank regulators for using improper assumptions to identify credit quality problems, and last November it filed for bankruptcy protection.

The investigation by bank regulators with the Office of the Comptroller of the Currency had already been under way for several months by November 2001 when the Ernst auditors began an effort to revise work papers on NextCard, the criminal complaint says.

Beginning in early 2000, the complaint says, NextCard began reclassifying losses attributable to nonpayment of bills by customers who were poor credit risks, categorizing the losses as fraudulent use of the credit cards. Bills that go unpaid have to be written off eventually as uncollectible; the larger the percentage of such bills, the greater the amount a financial institution must reserve as an allowance for loan losses.

But fraud losses do not count in that calculation, so by reclassifying the bad debts, NextCard would be able to keep down its required allowance for losses, giving it greater financial flexibility at a time when its earnings performance was suffering.

In October 2001, Mr. Trauger informed Mr. Flanagan that the banking regulators had requested the accounting work papers related to the audit of NextCard's 2000 fiscal year. Days later, NextCard announced that banking regulators had found the company to be significantly undercapitalized - in part, a result of its failure to account properly for credit losses. Immediately after that announcement, NextCard's publicly traded stock lost about 80 percent of its value.

In the days that followed, the complaint says, Mr. Trauger told Mr. Flanagan that he wanted to 'beef up' the work papers to make it appear as if the auditing team had been 'right on the mark' all along, the complaint says. To accomplish that, the men went into a computerized archive for the work papers and revised them. When the revised versions were saved, the complaint says, the original work papers were deleted from the system.

To ensure that the computer did not record the revisions as having taken place months after the work papers were filed, the accountants reset the internal clock on their computers to make an earlier date appear, the complaint says. Evidence suggests that some of the changes involved reclassifying NextCard's approach for allowing for loan losses to 'conservative' from 'aggressive,' the criminal complaint says.

Any such move would be highly inappropriate in the accounting industry, where filed work papers are considered to be almost sacred. Any revision to the papers must be noted as having been made after the fact because such changes could disguise the true actions of the accountants.

In the months that followed, the complaint says, the accountants made the bad situation far worse. In February 2002, bank regulators sent a subpoena for records to Ernst & Young, and Mr. Trauger supplied the revised work papers. In response to that, the complaint says, Mr. Trauger ordered Mr. Flanagan to destroy any documents related to the altered work papers.

Within a month, the S.E.C. began its investigation; again, Mr. Trauger was aware that the altered work papers were provided to investigators but said nothing about it.

While the government has obtained documents that appear to be versions of the original work papers that were preserved on one accountant's personal computer, investigators said that they could never be sure whether they knew the full extent of the information that was destroyed.

'We have no idea what the original audit work papers really were,' said Robert L. Mitchell, the assistant district administrator for the S.E.C.'s office in San Francisco. 'That is the real harm of what he did.'