Concerned about the erosion of auditor independence, securities regulators sued Ernst & Young yesterday, accusing the firm of violating ethics rules by having a seven-year business partnership with a client, PeopleSoft.
In a complaint filed by the Securities and Exchange Commission, government lawyers said that while Ernst was auditing PeopleSoft, a maker of computer software, the firm's tax department and PeopleSoft jointly developed and marketed a computer program to help clients manage payroll and tax withholding for overseas employees. As part of the joint venture, Ernst agreed to pay PeopleSoft royalties of 15 percent to 30 percent from each sale of the program. The firm also earned "hundreds of millions of dollars in consulting revenues" from its sale of the software to clients, the complaint said.
Ernst issued a statement saying it was "surprised and disappointed" by the complaint and vowed to fight the accusations before an administrative law judge.
"We did carefully consider the potential independence implications of our consultants' actions before they undertook them," said Leslie Zucke, a spokesman for the firm. "We correctly concluded at the time that the actions were permissible under the profession's rules and that they were commonplace. Therefore, we are confident that our conduct was entirely appropriate, and we will defend ourselves vigorously."
Mr. Zucke said the relationship had not created any errors on PeopleSoft's financial statements, which S.E.C. officials acknowledged. Mr. Zucke described the issues raised by the complaint as "purely technical" and out of date. PeopleSoft is no longer a client of Ernst, the licensing arrangements between the two companies are no longer in effect, and Ernst sold its consulting business to Cap Gemini two years ago.
But government officials said that the violations were serious because they compromised the independence of the auditors.
"The accountants are gatekeepers and are essential to the integrity of the system," said Paul Berger, a lawyer in the enforcement division of the S.E.C. "When they engage in joint ventures with clients, the entire audit process is subverted."
Stephen M. Cutler, the enforcement director of the agency, said that the violation was significant and that it did not matter that the relationship had not led to errors on the financial statements that Ernst had audited.
"When an auditor enters into a joint business relationship to generate revenue, its independence is fundamentally impaired," he said.
Officials said the S.E.C. was calling for the firm to give back audit fees, which amounted to less than $1 million a year for the licensing period. If Ernst is found to have violated the independence rules, it could receive sanctions ranging from censure to disbarment from performing work for companies that make filings with the commission.
The case comes as Congress considers whether to impose new restraints on auditing firms in light of the collapses of Enron and Global Crossing and the record number of financial restatements over the last few years. A bill that recently passed the House would impose no significant new restraints, but legislation proposed by Senator Paul S. Sarbanes, the chairman of the Senate Banking Committee, would prohibit accountants from performing some consulting services for clients that they also audit.
Administration officials, as well as Harvey L. Pitt, the S.E.C. chairman, have opposed the restraints, as have lobbyists for the largest accounting firms.
Christi Harlan, an S.E.C. spokeswoman, said that Mr. Pitt did not participate in the decision to bring the case. Ernst was a client of Mr. Pitt while he was a lawyer in private practice before he was appointed to the commission last summer. Mr. Pitt has agreed not to participate in any enforcement matter involving a client during his first year in office.
The Ernst case is the second one involving auditor independence filed in recent months by the S.E.C. Earlier this year, KPMG settled a complaint accusing it of violating independence rules by making significant investments in the Short-Term Investments Trust, one of the AIM mutual funds, while it was the funds' auditor. KPMG agreed to a consent decree without admitting or denying it had violated the rule.
Yesterday's lawsuit against Ernst is the second time in recent years
that the S.E.C. has accused it of violating auditor independence rules.
In 1991, Ernst was sued by the agency over business dealings that its partners
had with the Republicbank Corporation, a former Texas banking company,
and the Cullum Companies, a supermarket chain. That case settled in 1995,
with Ernst consenting to a final order under which it agreed to comply
with the auditor independence rules.