PwC Fined 1.4 Million Pounds for JP Morgan Client Money Failings
Richard Powell | Bloomberg Law
Outcome of Disciplinary Hearing: PricewaterhouseCoopers LLP, ICAEW member firm in connection with JP Morgan Securities Limited – Accountancy and Actuarial Discipline Board Press Notice AADB PN 40 of 6 Jan. 2011
PricewaterhouseCoopers LLP (PwC) has been fined £1.4 million by the UK Joint Disciplinary Scheme Tribunal (Tribunal) over failures as client money auditor to JP Morgan Securities Limited (JPM).1 This decision comes 18 months after the Financial Service Authority’s (FSA) £33.32 million fine of JPM for breaches of the UK regulator’s Client Asset Rules (CASS) over a seven-year period.2 In that case, the FSA considered client money had been exposed to a significant risk if JPM had become insolvent, with a reduced likelihood of recovery. Finding PwC’s misconduct to be very serious, the Tribunal also imposed a severe reprimand.
JP Morgan’s CASS Breaches
The FSA does not regulate auditors; rather, in this respect, PwC is subject to the standards and guidance of the Auditing Practices Board, which is part of the Financial Reporting Council (FRC). A further FRC body, the Accountancy and Actuarial Discipline Board (AADB), is charged with investigating and bringing disciplinary cases.
After J.P. Morgan & Co. merged with The Chase Manhattan Corporation in 2000, JPM’s treasury department made changes to accounting systems in its futures and options business. These changes had an unintended and unfortunate consequence, as its treasury systems no longer distinguished between client and firm monies, which went unsegregated and, therefore, were held in breach of FSA rules. Staff, though, continued to believe that the treasury department would segregate client money when it was held overnight on JPM’s behalf with JPMorgan Chase Bank, N.A. (JPMCB). The contravention was only discovered by chance seven years later during internal discussions between the treasury department and members of the futures and options business. After investigation, the error was promptly corrected and the FSA informed.
Throughout this time, PwC, as auditors, had provided clean reports confirming compliance with CASS requirements.3 The firm admitted to the AADB and to the Tribunal that its audit work had “fallen short of the standards reasonably to be expected” and that it had “failed to obtain sufficient appropriate evidence on which to base these opinions.”4 The omission to segregate client funds would have been discovered earlier had PwC’s audit looked at the books of JPMCB rather than relying on what its staff mistakenly believed were extracts.5
This decision is of interest for a variety of reasons. In the first place, as an action against an auditor, it represents a further intensification of the FSA’s regulatory focus to improve the quality of compliance with CASS and, therefore, better safeguard client monies and assets in the event of an authorised firm’s insolvency.
The protection of client assets rose to prominence during the financial crisis with the insolvency of Lehman Brothers International (Europe) Limited, where substantial amounts of client money had not been adequately segregated. Since then, the FSA has created a specialist Client Assets Unit and has stepped up disciplinary action against authorised firms. The FSA has also sought to better communicate the standards it expects of authorised firms. To this end, a Dear Compliance Officer Letter was issued on 20 March 2009 and the following year, on 25 January 2010, a Dear CEO Letter was sent out to firms, accompanied by a Client Money & Asset Report.
Secondly, although the FSA holds authorised firms primarily responsible for compliance with CASS, it places considerable weight on the “independent assurance” provided by auditors.6 Early in 2011, it published new rules on the content of audit reports on authorised firms’ compliance with CASS in an attempt to improve their quality and consistency.7 This was triggered, in part, by a review of the quality of periodic reporting on client assets, which found weaknesses in some auditors’ reports including, on occasion, a failure by auditors to understand CASS obligations. Too often, authorised firms were given “clean reports.” The FSA considered that there was a widespread problem among audit firms.
Level of Penalty
Another aspect concerns the financial penalty imposed by the Tribunal. As PwC had admitted culpability, this was the main issue to be decided.
The FSA’s £33.32 million fine paid by JPM was calculated in accordance with its Decision Procedure and Penalties Manual (DEPP) at DEPP 6. This was equivalent to 1 percent of the average unsegregated client money held by JPM over the seven year period, less an early settlement discount of 30 percent. This sanction represented 6.9 percent of JPM’s after tax profits for the year in which it was levied. By analogy, and representing a similar percentage of PwC’s profits, the AADB proposed a financial penalty for PwC of £44.3 million, equivalent to £40,634 for each member of the partnership. While the Tribunal could impose an unlimited fine, it considered the AADB’s proposal to be at the limit of its discretion. Perhaps recognising this, in the alternative, the AADB put forward a figure of £6 million, emphasising that PwC’s profits were substantially greater than its audit client’s.
The Tribunal reviewed the principles governing the power of a Court to impose an unlimited fine for regulatory offences, as cited by the Lord Chief Justice, Lord Phillips, in R v Balfour Beatty Rail Infrastructure Services Ltd  EWCA Crim 1586.8 These were:
- Contravention of regulations to protect the public represents serious misconduct;
- Financial penalties have historically been too low;
- Absence of a specific link between a fine and profit or turnover;
- Degree by which a firm falls short of the appropriate standard;
- Degree of risk and extent of the danger posed;
- Available resources and the effect on a firm’s business;
- Making of a prompt admission and any remedial action;
- Importance of demonstrating compliance to others;
- Proportionality is more important than consistency; and
- Whether a risk to the public has crystallised (i.e., JPM did not become insolvent).
Applying these principles, the Tribunal rejected the idea that PwC’s penalty should be fixed by analogy to that imposed on JPM, and further held that linking it to the same percentage of profits would be irrational. Rather, the Tribunal considered that very different considerations should apply to JPM, an authorised firm, compared to its auditor. It concluded that the starting point should be £2 million and that penalties should generally not exceed £5 million. It would then consider any mitigating and aggravating factors, such as PwC’s admission of fault and co-operation, in order to arrive at a penalty, in this case, of £1.4 million, plus costs.
Focus on Compliance
This action should be seen by authorised firms and their auditors as a further sign, if needed, that the regulatory focus remains on improving standards in the protection of client money and assets. The FSA is not only holding the firms it regulates to account for breaches of CASS, but is seeking to enhance audit as a quality assurance tool. Audit firms may, perhaps, be relieved that the Tribunal is not prepared to impose fines at the level administered by the FSA.
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