CASE 9.1 freescale semiconductor, inc. Who will guard the guardians?

CASE 9.1 freescale semiconductor, inc. Who will guard the guardians? Juvenal During the summer of 2006, a syndicate of investors led by the blackstone Group, one of Wall street’s largest private equity investment firms, initiated a secret plan to acquire freescale semiconductor. based in austin, texas, freescale is among the world’s largest producers of semiconductors and for decades was a subsidiary of Mo- torola, inc., the large electronics company. in July 2004, Motorola spun off freescale in one of that year’s largest initial public offerings. blackstone retained Ernst & Young (E&Y) to serve as a consultant for the planned buyout of freescale. among other services, blackstone wanted E&Y to review frees- cale’s human resource functions and to make recommendations on how to stream- line and strengthen those functions following the acquisition. James Gansman, a partner in E&Y’s transaction advisory services (tas) division, was responsible for overseeing that facet of the engagement. similar to the other big four accounting firms, E&Y became involved in the invest- ment banking industry during the 1990s. in fact, by the late 1990s, the small fraternity of accounting firms could boast of having two of the largest investment banking prac- tices in the world, at least in terms of the annual number of consulting engagements involving merger and acquisition (M&a) deals. in 1998, KpMG consulted on 430 M&a transactions, exactly one more than the number of such engagements that year for pricewaterhousecoopers (pwc). Despite those impressive numbers, KpMG and pwc had not established themselves as dominant firms in the investment banking industry. in 1998, the total dollar volume of the M&a engagements on which KpMG and pwc consulted was $1.65 billion and $1.24 billion, respectively. those numbers paled in comparison to the annual dollar value of M&a transactions for industry giants such as Goldman sachs, which was involved in M&a deals valued collectively at nearly $400 billion in 1998. at the time, Goldman sachs, lehman brothers, Morgan stanley, and the other major investment banking firms consulted exclusively on “mega” or multibillion-dollar M&a engagements. by contrast, the “low end” of the M&a market–in which the big four firms competed–typically involved transactions measured in a few million dollars. E&Y’s involvement in the huge freescale M&a deal was a major coup for the big four firm. When the transaction was consummated in December 2006, the price paid for the company by the investment syndicate led by the blackstone Group ap- proached $18 billion. that price tag made it the largest private takeover of a tech- nology company to that point in time as well as one of the ten largest corporate takeovers in u.s. history. not surprisingly, blackstone demanded strict confidentiality from E&Y and the other financial services firms that it retained to be involved in the planned acquisi- tion of freescale. James Gansman, for example, was told that blackstone wanted the transaction to be “super confidential” and was instructed in an internal E&Y e-mail to “not breathe the name of the target [freescale] outside of the [engagement] team.”1
cHAPteR 9 advancEd topics concERninG complEX auditinG JudGmEnts During June and July 2006 while he was working on the freescale engagement, Gansman passed “inside information about the pending transaction”2 to Donna Murdoch, a close friend who worked in the investment banking industry. an fbi in- vestigation revealed that Gansman and Murdoch “communicated over 400 times via telephone and text messages”3 in the weeks leading up to the september 11, 2006, an- nouncement that the blackstone investment syndicate intended to acquire freescale. in that time span, Murdoch purchased hundreds of freescale stock options, which she cashed in on september 11–12, 2006, realizing a windfall profit of $158,000. the fbi also determined that between May 2006 and December 2007 Gansman provided Murdoch with information regarding six other M&a transactions on which E&Y consulted. in total, Murdoch used that inside information to earn nearly $350,000 in the stock market. Murdoch gave that information to three other individuals, in- cluding her father, who also used it to produce significant stock market profits. published reports indicate that Murdoch became involved in the insider trad- ing scheme to help make the large monthly payments on a $1.45 million subprime mortgage on her home. the funds she initially used to “play the market” were provided to her by one of the individuals to whom she disclosed the inside in- formation given to her by James Gansman. in addition, Gansman at one point loaned her $25,000. the securities and Exchange commission (sEc) uses sophisticated software programs to detect suspicious trading activity in securities listed on stock exchanges. in early 2007, the sEc placed Murdoch on its “watch list” of individuals potentially involved in insider trading and began scrutinizing her stock market transactions. information collected by the sEc resulted in criminal charges being filed against Murdoch. in December 2008, she pleaded guilty to 15 counts of securities fraud and two related charges. in May 2009, Murdoch served as one of the prosecution’s principal witnesses against Gansman in a criminal trial held in a new York federal court. During the trial, Gansman testified that he had been unaware that Murdoch was acting on the infor- mation he had supplied her. Defense counsel also pointed out that Gansman had not personally profited from any of the inside information that he had been privy to during his tenure with E&Y. nevertheless, the federal jury convicted Gansman of six counts of securities fraud. a federal judge later sentenced him to a prison term of one year and one day. EpiloguE in october 2007, the surging stock market pro- duced an all-time high of 14,164.53 for the Dow Jones industrial average. one year later, stock prices began plummeting in the face of an eco- nomic crisis triggered by the collapsing housing and subprime mortgage markets in the united states. the frenzied stock market over this time frame produced a record number of insider 2. Ibid. 3. Ibid. trading cases as unprincipled investors either attempted to make a “fast buck” when stock prices were trending ever higher or attempted to mitigate their losses when stock prices began nosediving. personnel at all levels of the big four account- ing firms routinely gain access to highly confi- dential inside information, information that can be used to gain an unfair advantage over other stock market investors. unfortunately for the ac- counting profession, James Gansman is not the only partner or employee of one of those firms who has been implicated recently in a major in- sider trading scandal. in January 2008, the sEc charged two former pwc employees with using confidential client information to earn large profits in the stock mar- ket. one of the individuals was on pwc’s audit staff, while the other was assigned to pwc’s trans- action services group, the pwc division compa- rable to E&Y’s tas department.4 the individual in the transactions services group accessed the confidential information while working on sev- eral M&a consulting engagements for pwc. he then provided that information to his friend on pwc’s audit staff, who relied on it to purchase securities of companies that were acquisition tar- gets. this latter individual’s name was recognized by a pwc audit partner when he was reviewing a list of securities transactions for a client that an- other company was attempting to acquire. the audit partner informed the sEc, which then filed insider trading charges against the two friends. in november 2010, the u.s. Department of Justice filed insider trading charges against a former Deloitte tax partner and his wife, who had also been employed by that firm.5 the couple allegedly obtained confidential informa- tion regarding seven Deloitte clients that were involved in M&a transactions. according to the sEc, the couple communicated that informa- tion to family members living in Europe who then engaged in securities involving the com- panies that were parties to those transactions. the sEc reported that the former Deloitte part- ner and his wife netted more than $3 million in stock market gains between 2006 and 2008 from the insider trading scheme, while their british relatives netted more than $20 million in profits.6 in investigating this case, the Justice Department and sEc sought and received the cooperation of the financial services author- ity, the british agency charged with regulating Great britain’s securities markets. to date, the most publicized case of insider trading directly linked to the accounting profes- sion involved thomas flanagan, a former vice chairman of Deloitte who spent 38 years with that firm. in october 2008, Deloitte announced that it was suing flanagan for allegedly trading in the securities of at least 12 Deloitte audit clients for which he had served as an “advisory”7 partner. Deloitte claims that Flanagan held and traded securities of his own clients for the past three years. The firm alleges he bought one of his client’s stock one week before it announced an acquisition of a public company. He is also accused of violating the firm’s independence and conflict-of-interest policies and hiding his personal securities holdings from Deloitte. In his role as an advisory partner, he attended the audit committee meetings of seven of the twelve clients affected.8 press reports indicated that the clients linked to the allegations surrounding flanagan included all- state, best buy, Motorola, sears, and Walgreens. in august 2010, the sEc announced that it had settled insider trading charges that it had filed against flanagan. the terms of the settlement required flanagan to pay more than $1 million in fines and penalties. flanagan consented to the settlement without admitting or denying the sEc’s allegations. flanagan’s son, who had alleg- edly made securities trades based upon inside information given to him by his father, reached a similar settlement with the sEc and paid fines and penalties of approximately $120,000. other litigation cases linked to flanagan’s alleged in- discretions are still ongoing, including the law- suit that Deloitte filed against him.
Questions 1. identify the specific circumstances under which auditors are allowed to provide confidential client information to third parties. 2. suppose that you and a close friend are employed by the same accounting firm. You are assigned to the firm’s audit staff, while your friend is a consultant who works on M&a engagements. What would you do under the following circumstances: (1) your friend discloses to you highly confidential “market- moving” information regarding a soon-to-be announced merger; (2) your friend not only discloses such information to you but also informs you that he or she plans to use it to make a “quick” profit in the stock market? in your responses, comment on your ethical responsibilities in each scenario. 3. E&Y was providing a consulting service to the blackstone Group in connection with its planned acquisition of freescale semiconductor. Explain how a cpa’s professional responsibilities differ between consulting engagements and audit engagements

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