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Ex-Auditors Settle Securitization Charges

A securitization scheme results in civil charges for three former auditors of a now-defunct factoring firm.
Marie Leone, CFO.com | US
September 21, 2007

The securitization fraud that is partly responsible for putting a financial-services firm out of business is now causing problems for that company's former auditors. On Wednesday the Securities and Exchange Commission reached a settlement with three former auditors of National Century Financial Enterprises (NCFE), who were charged with "improper professional conduct" linked to their audit of a receivables securitization.

Press C. Southworth, a retired PricewaterhouseCoopers auditor; Robert M. Harbrecht, a retired Deloitte and Touche auditor; and Brian R. Spires, a former audit manager with Deloitte; were cited by the SEC for violating generally accepted auditing standards (GAAS) and generally accepted accounting principles (GAAP). Without admitting or denying the commission's findings, all three agreed to a bar from practicing before the SEC, which means they cannot sign off on audits of public companies or hold the CEO or CFO position at a public company. Southworth can request reinstatement in two years; Harbrecht and Spires can request the same in 18 months and one year, respectively.

"Press is glad to have this unhappy chapter put behind him," says Southworth's attorney, Christopher Davies, a partner at Wilmer Cutler Pickering Hale and Dorr, noting that the auditor had retired from accounting before he ever became involved in the investigation. Attorneys for the other two former auditors did not return CFO.com's request for comment.

A spokesperson for PwC notes the allegations made against Southworth stem from audits that are nearly a decade old, and that the former auditor, who retired from the firm in 2001, no longer practices accounting. Deloitte declined to comment.

At issue are various violations of GAAS and GAAP related to fraud at NCFE that went undetected until 2002, the same year the finance company filed for bankruptcy. In 2004 NCFE began liquidating its assets.

The SEC contends that inaccurate financial reporting and disclosures related to the securitization should have prompted the auditors to question management's integrity, as is their responsibility under GAAS. In particular the SEC charged that the auditors failed to properly address evidence of possible fraud and illegal acts by the company and its officers. Instead, the auditors placed an "undue reliance on management representations," with Southworth giving an unqualified audit opinion to NCFE in 1998, and Harbrecht doing the same for the 2000 audit. Spires participated in the 2000 audit.

Securitizations have come under intense scrutiny in recent months as a result of the subprime mortgage crisis. While securitizations of corporate receivables represent a much smaller proportion of the asset-backed commercial paper market than securitized mortgages, they share the same basic structure. That structure has been criticized for poor disclosures and its dependence on legal and rating-agency opinions that are paid for by the issuer.

Although the SEC characterized the deal as "complex," the NCFE structure is considered a plain vanilla securitization by industry players. NCFE was in the business of buying up medical receivables at a discount from health-care providers that wanted cash up front. NCFE raised funds by securitizing those receivables — selling notes to investors backed by the receivable assets. Investors received regular interest payments and a lump-sum payment when the debt was retired, according to the U.S. Attorney General's office in Ohio, which has charged eight former NCFE executives with fraud.

Instead of investing the funds in the purchase of high-quality accounts receivable as promised in the indenture, however, the company "diverted the funds to healthcare providers, many of whom they owned in whole or in part, creating shortfalls in account balances," added the Attorney General. In all, the NCFE sold $4.4 billion worth of notes to investors between May 1998 and May 2001. The SEC estimates that $2.5 billion of that total was linked to fraud.

The eight NCFE executives are accused of fabricating data in regulatory reports, double-counting money by moving it back and forth between funds, making other false statements, and loading false data into the accounting systems to conceal the shortfalls. The trio of auditors was accused by the SEC of being aware of the possible fraud and not taking appropriate action. None of the auditors were charged in federal court — rather, their deeds were cited in an SEC administrative proceeding. The reason for that, says Robert Burson, an SEC attorney involved in the case, is SEC enforcement attorneys were seeking only a practice bar in this case, not disgorgement or fines.

The securitization agreements required an annual audit of NCFE's consolidated financial statements. And Harbrecht and Spires admitted to the SEC that the company's purchased receivables were one of the most significant areas of the 2000 audit. NCFE had $2.3 billion of receivables outstanding at the end of 2000, which represented 81 percent of the company's $2.9 billion of total assets.

Nevertheless, the SEC says Harbrecht and Spires never obtained "sufficient competent evidential matter" supporting the supposed purchase of the receivables. As a result, the auditors failed to discover that NCFE's receivables included a significant amount of ineligible, or low quality, assets.


The SEC charged that Harbrecht and Spires also devised inadequate internal-control tests, failed to design substantive audit procedures, and did not deem the "collectibility" of the receivables a significant issue, because they believed that the indenture provisions were being followed. For example, the pair assumed that only low-risk borrowers were allowed into the program, and that any receivables older than 180 days were replaced. Neither assumption turned out to be correct, however.

Similarly, the SEC asserted that because Southworth conducted the PwC audit of NCFE, he knew about the "widespread violations of the indenture agreements and also should have recognized the threats those violations posed to the noteholders' interests." In fact, Southworth stated in a June 1999 memo to NCFE management that there was a need to meet with the securitization trustees and investors to discuss several open issues, including not forcing providers to repurchase all receivables that have aged past 180 days, as per the indenture; inaccurately aged receivables being included on the report to investors; and ineligible receivables brought on as collateral.

In July Jon A. Beacham, one of the eight NCFE executives indicted on criminal charges, pleaded guilty to charges of securities fraud in the U.S. District Court in Ohio. Beacham was the director of securitizations at NCFE and was responsible for raising money from investors. He faces a maximum of 10 years in prison and a maximum fine of $500,000. The remaining seven defendants are slated for trial on November 5.




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