Herbalife's Auditor Says You Can't Rely On Its Financials, But Not In A Fun Way

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CAN YOU FEEL THE EXCITEMENT? No, right? Okay good. A senior audit partner at KPMG Los Angeles did a bad thing and "was involved in providing non-public client information to a third party, who then used that information in stock trades involving several West Coast companies." And now KPMG has resigned as the auditor of a couple of companies, and withdrawn their 2010/2011/2012 audit reports, which, given that 10Qs are due in a couple of weeks, is a bummer for those companies. Bob's Auditing Service & Carwash of Rancho Palos Verdes is going to be busy.

And of course one of the companies is Herbalife, which has really had more than its share of excitement. Honestly if I was insider trading I'd probably pick a company a bit further from the limelight?1 Anyway HLF was halted for most of the morning while while they puttered around thinking things over, only to eventually release a pretty bland press release that stresses that KPMG resigned "solely due to the impairment of KPMG's independence resulting from its now former partner's alleged unlawful activities and not for any reason related to Herbalife's financial statements, its accounting practices, the integrity of Herbalife's management or for any other reason." It eventually re-opened down 2.3%.

The other company is ... currently a player to be named later? Speculation is focusing on Skechers, a California-based KPMG client that was also halted, which seems plausible enough. Who knows? [Update:Yep, Skechers.]

Okay further baseless speculation!

1. Why'd they need to resign and disclaim their audits? The answer is that auditors must be independent, and auditors shouldn't do anything that "creates a mutual or conflicting interest with their audit client" or "places them in the position of auditing their own work." Usually this means things like non-audit business relationships, contingent fees, etc.; I suppose "secretly profiting by trading in the audit client's stock" fairly clearly qualifies. This is clearly true on a backward-looking basis: KPMG's 2010-2012 audits were compromised, I supposed, by this insider trading.2

On a forward-looking basis, like, they fired the guy, what's the problem? The answer, I suppose, is that they'll have to go check his work, because it was compromised, and now they're compromised, because if they find out his work was wrong they'll be embarrassed/fired/sued, so they'll have incentives to cut corners in checking on him, so better to bring in a fully independent auditor. KPMG says "We have no reason to believe that the financial statements of these companies have been materially misstated," but they would say that wouldn't they.

It's worth noting that all of this is, substantively, sort of crazy - a perfectly good reason for KPMG to fire the audit partner, but a somewhat hypertechnical reason for KPMG to fire itself. Assuming - as I do - that the senior audit partner was not the one person at KPMG involved in Herbalife's audits, the best people to check his work and re-issue an opinion on Herbalife's historical audited financials are probably the rest of the KPMG audit team, who presumably weren't insider trading themselves. Would they be biased toward confirming their work? Well, sure, but they always would be: any auditor would prefer that its past audits be accurate, for both personal-satisfaction and not-getting-sued reasons. The insider trading has nothing to do with it.

But it's enough to get them to boot themselves, which means that Herbalife has no current audited financials, and that someone else will need to get up to speed quick on a company that has shall we say strong opinions on both sides of the should-you-trust-its-financials question. I don't particularly envy them.

2. What was the inside information? CNBC's reasonable supposition is that it was earnings data - Herbalife is scheduled to announce Q1 on April 29, Skechers on April 25; both announced their 2012s in February. "Herbalife and Skechers are both giant pyramid schemes!" seems less likely for various reasons; for one thing the disclosure would probably be a bit more interesting. As it is, Herbalife has said nothing about what the inside information was.

That suggests it's not very interesting? Under Reg FD, they need to promptly make public disclosure of material nonpublic information that they or anyone acting on their behalf discloses to people who trade on it. Auditors tend to be people acting on behalf of companies, though Reg FD specifically excludes an "agent of an issuer who discloses material nonpublic information in breach of a duty of trust or confidence to the issuer," so they should be safe.

Still you could imagine a company that knows that someone in the market has been trading on material nonpublic information might feel the need to make that information public out of general fairness to its other shareholders. If the information is now-stale earnings information - if, for instance, the guy traded on advance knowledge of Herbalife's 2012 earnings - then there's nothing to disclose. If it's still-interesting information, you'd expect them to disclose it. [Update: Skechers sort of kind of quasi previewed Q1 earnings, saying they "will show significant growth and the continuing strength and viability of our business."]

3. Who got the inside information? Apparently not Carl Icahn or Bill Ackman, which is sort of disappointing: if we're gonna have a Herbalife scandal, it really ought to involve someone interesting. Presumably it was just some friend of the KPMG audit partner who'd cut him in on the profits; the Herbalife press release refers to "insider trading in Herbalife's securities by one of KPMG's former partners," which makes it sound like he was doing it in his own account rather than leaking to others.

Still. How's this for an awkward coincidence: SAC Capital announced a 5.1% stake in Skechers yesterday after the close. This morning Skechers became involved (maybe!) in an insider trading rumors. SAC's timing remains impeccable.

Statement From KPMG LLP [KPMG]
Herbalife Announcement [HLF]
KPMG Said to Resign as Herbalife’s Auditor Over Investigation [DealBook]
KPMG Fires a Senior Partner in an Insider Trading Episode [NYT]

1.You could disagree I guess? Limelight gets you vol, and I guess if you're gonna insider trade you want to do it once and get out? Though he (allegedly!) did it at least twice. I don't know. I sort of stick up for insider traders a lot here but the mindset escapes me. It's just not worth it.

2.Because KPMG explicitly provides an opinion, as of February 2013, that HLF's financials for the three-year period ending December 31, 2012, are accurate. People who care about auditor independence would thus say that, if the guy insider traded at any point before February 2013, you can't trust his opinion on those three years of financials - even the past ones, he might have reopened if he hadn't been profiting by trading the stock, I guess. Even if he insider traded after that February 2013 opinion you could probably find a reason to disclaim the financials, which I leave as an exercise for the reader because I don't care. People are pretty anal about this stuff.

Related

Pershing Square: Herbalife Silenced Us

Earlier today it was noted that, to the surprise of many, Bill Ackman and Carl Icahn had refrained from asking questions or dialing in and making sudden outbursts during this morning's conference call to discuss Herbalife's fourth quarter earnings.  Obviously this came as a shock on account of Ackman and Icahn taking many opportunities in the past to share their feelings re: the company and each other. And while it's true both men personally held their tongue's today, according to Pershing Square, one of its analysts had planned to ask questions on Bill's and the hedge fund's behalf but was shot down.