Regulation

Ex-Bally CFO and E&Y Auditors Charged by SEC

In a fraud case stemming from a year-old charge related to overstated earnings, the SEC alleges that six E&Y auditors should have known better.
Alix Stuart and Marie LeoneDecember 21, 2009

Auditors at Ernst & Young wound up in the crosshairs of the Securities and Exchange Commission on Thursday, when six of the firm’s current and former partners were charged by the regulator for the part they played in an accounting-fraud scheme related to Bally Total Fitness Holding Corp. Three of the individuals charged were members of E&Y’s national office.

Former Bally CFO John W. Dwyer and onetime controller Theodore Noncek were also charged by the SEC. At press time, defense attorneys for E&Y and the former Bally executives could not be reached for comment.

In 2008 the SEC had charged the fitness company with accounting fraud, primarily for overstating gross revenue and therefore overstating net income, as well as understating expenses. These actions led to an overstatement of the Chicago-based company’s net worth.

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Neither Dwyer, who resigned as CFO in 2004, nor Noncek admitted or denied the charges leveled against him. Dwyer paid $250,000 to settle with the SEC and agreed to be permanently barred from acting as an officer or director of a public company, or practicing as an accountant before the SEC. Similarly, Noncek consented to permanent injunctions and a two-year bar from practicing as an accountant with the SEC.

The six auditors also agreed to settle with the SEC, without admitting or denying guilt, and E&Y agreed to pay $8.5 million to settle its SEC violations. The audit firm also agreed to take action to correct policies and practices related to its violations.

According to the SEC, E&Y issued unqualified audit opinions stating that Bally’s financial statements from 2001 to 2003 conformed to generally accepted accounting principles, and that the E&Y audits were conducted in accordance with standards of the Public Company Accounting Oversight Board. However, the SEC concluded that the opinions were “false and misleading,” noting that “E&Y knew or should have known about Bally’s fraudulent financial accounting disclosures.”

“Ernst & Young and its partners on the Bally engagement violated their fundamental duty to function as public watchdogs, even after E&Y personnel identified Bally as one of the firm’s riskiest audit clients,” added Fredric Firestone, an associate director in the SEC’s Enforcement Division.

The three current E&Y partners charged by the SEC are Randy G. Fletchall, partner in charge of the firm’s national office; Mark V. Sever, the firm’s national director of area professional practice; and Kenneth W. Peterson, the professional practice director for the Lake Michigan Area office. The former E&Y partners are Thomas D. Vogelsinger, area managing partner for E&Y’s Lake Michigan Area through October 2003; William Carpenter, the engagement partner for the 2003 audit; and John M. Kiss, the engagement partner for the 2001 and 2002 audits.

The SEC asserts that E&Y identified Bally as a “risky” audit for two reasons. One, Bally’s managers were former E&Y audit partners who had “historically been aggressive in selecting accounting principles and determining estimates.” Two, the compensation plans of the Bally managers placed “undue emphasis on reported earnings.” The SEC also noted that “out of more than 10,000 audit clients in North America, E&Y identified Bally as one of E&Y’s riskiest 18 accounts and as the riskiest account in the Lake Michigan Area.”

The charges against E&Y and Bally are the latest in what likely will be a long line of new enforcement actions, say experts. “Between the $1 billion budget [proposed for 2010 by the SEC] and the need to project that [the SEC is] tough, it’s reasonable to expect a pretty aggressive enforcement program,” says Eugene Goldman, co-chair of the SEC Defense Group at McDermott Will & Emery. He notes that the SEC is playing offense in a number of areas, including in its case regarding Bank of America’s purchase of Merrill Lynch. Although a federal judge struck down the SEC’s initial settlement with the bank and ordered the case to trial, the regulator has come back swinging, using the process to seek more information from the bank in hopes of filing additional charges against it.

In February SEC chairman Mary Schapiro announced she would make it easier for SEC staff to launch formal investigations of corporations. She also overturned the policy of her predecessor, Christopher Cox, of requiring commission approval for levying financial penalties against public companies. The latter move in particular represents a rebuke to Cox and to former SEC commissioner Paul Atkins. Atkins had long complained that financial penalties against corporations represented a form of double jeopardy for shareholders already wounded by financial fraud.

Tim Reason also contributed to this article.