Highest Compensation Audit Case in U.S. History - ***The Same Fund Management Corporation Audit Case Audit Case Introduction ***The Same Fund Management Corporation (***The Same Corporation) is about $500 million in size, and the owner of the company is Kornford. McCandy King (referred to as King) is the owner of King Resources Corporation (referred to as King) and a billionaire. In early 1968, Kornford and King began working together on the Agapulco Agreement, whereby * * * the same company would purchase oil and gas properties from King and establish a natural resource capital account (the Resource Account) to exclusively manage those investments. Although no formal contractual indenture was signed by the parties, it is clearly recorded in the minutes of *** Same's board of directors' meetings that "King's will supply the natural resource industries for the planned Natural Resource Capital Account and will settle them at normal prices, and that these sales prices will be more favorable than those given to more than two hundred purchasers in industry or other trades " * * * A manager of the same company also testified to the core of the agreement, namely, that King would sell the natural resource estate at cost * * * to the same company at a cost price which included the overhead expenses incurred in acquiring the estate and a reasonable profit margin, which margins would generally be about 7 or 8 percent. Initially, Kornford agreed to purchase from King approximately $10 million worth of oil and gas properties. By the end of 1969, however, the flamboyant King had persuaded the executives of * * * the same company to purchase from his company approximately $100 million more worth of oil and premature gas properties. Misfortune finally fell upon the shareholders of *** Same. King did not honor the Agabulco agreement in these transactions. According to a later court investigation, King routinely bought cheap oil and gas properties and then sold them to *** Same at exorbitant prices, sometimes at prices that were more than 30 times their original cost. After a few years, a steady decline in stock prices and the poor quality of the natural resources that King sold to ****Tongue forced the massive ****Tongue into bankruptcy. The liquidation of *** Same gave rise to a massive civil litigation dispute. One of the main defendants was the accounting firm Arthur Andersen. They had provided auditing services to both *** Tong and King. The person suing Arthur Andersen LLP was John Rohr, the trustee of the bankruptcy liquidation of ***The Same Company, who was a partner in the accounting firm of Tachy Ross, LLP. John sued Arthur Andersen LLP for failing to disclose to the executives of *** Same that the company had been defrauded by King & Company. When the results of the trial were announced, Arthur Andersen & Co. became the victim of the highest damages ever awarded against an accounting firm in the United States. I. Arthur Andersen's Dual Relationship with *** Tong and King Three offices of Arthur Andersen participated in annual financial statement audits relating to *** Tong. The Geneva office paid particular attention to the audit of *** Tong in view of its size, characteristics and complexity. The New York office was responsible for signing the audit engagement letter. It also signs the audit reports for the annual financial statements of *** Tong and assumes responsibility for the results of the audits. The Denver office plays an important role in the audit of *** Tong & Co. Its auditors perform extensive audit procedures to confirm the accuracy of the year-end balances of the resource accounts as required by the partners in the New York office on an annual basis. In addition, the Denver office also performs audits of the Denver-based King Companies. In addition, the partner and senior manager responsible for the audit of King & Co. also oversaw the audit of the resource accounts of *** Tong & Co. One of the key issues raised in the *** Same bankruptcy trustee's suit against Arthur Andersen & Co. was whether the firm knew that *** Same had paid an excessive price when it purchased the estate from King. The evidence gathered by the court showed that the auditors in the Denver office of Arthur Andersen & Co. did know that * * * the resource accounts of * * * Tong & Co. were in fact managed by King & Co. The audit work papers also specifically stated that King had "absolute discretion to purchase oil and gas properties" for the resource account. The Denver office also had complete freedom of access to information concerning the cost of the natural resource properties sold by King to * * * the same companies, as well as marginal profits. Another relevant and significant issue in the litigation is when exactly the auditors of Arthur Andersen & Co. became aware of * * * Tong's purchase of the oil and gas properties from King at inflated prices. It was February 5, 1969, when Arthur Andersen & Co. issued its audit report on * * * Tong's 1968 financial statements. Therefore, the court is particularly interested in finding out what the firm knew up to that date about the price of the natural resource industry transactions between the two companies? The final issue involved in the litigation is that Arthur Andersen & Co. knew of and was involved in several of the so-called revaluation transactions arranged by King for * * * the same companies? The evidence indicates that many of the revaluation transactions arranged by King were deceptive. For example, on at least two occasions, King claimed to have found a third party willing to purchase a small portion of an oil and gas property belonging to either *** Tong or King at a price well above fair market value. However, unbeknownst to the management of ****Tongue, King and the purchasers of these properties had secretly entered into prior "collateral agreements" to ensure that the latter would not suffer any loss in these transactions. The existence of the collateral agreements meant that the revaluation transactions were not arm's-length, public transactions, and thus could not serve as an objective basis for establishing the fair market value of the natural resource properties. Obviously . King orchestrated these fraudulent revaluation transactions in order to convince * * * the managers of the same companies that their resource accounts were appreciating in value. Of course, these revaluation transactions clearly overstated the net asset value of * * * Same's stock, which on the one hand enabled investors who had withdrawn their shares to obtain excess returns, while on the other hand jeopardizing the interests of those who had held their shares for a long period of time. II. ANDERSON'S AUDIT OF THE 1968 FINANCIAL STATEMENTS OF ***TONGUE The court record reveals that Arthur Andersen & Co. was aware of the high risk nature of its audit of ***TONGUE. These risks were primarily in the form of large-scale investments in natural resource industries. The firm wrote on * * * Tong's 1968 audit workpapers that "in any one of the natural resource transactions, the property rights purchased by * * * Tong were part of the property rights initially owned by, or concurrently owned by, King." This is highly irregular. The court record also mentions that since 1961, "King & Co. has caused Andersen & Co. serious trouble as an audit client on a number of occasions." These troubles caused Arthur Andersen & Co. to recognize the need for a detailed review of * * * Tong's business dealings with King & Co. and to pay more attention to several instances of suspicious economic operations by King & Co. In * * * Tong's 1968 audit, auditors in the Denver office of Arthur Andersen & Co. analyzed in detail the prices at which King sold natural resource properties to * * * Tong. The results of the analysis revealed that King's sales prices to * * * Tong were substantially higher than those to other customers. The gross margins recorded for the five sales of natural resource industries from King's to *** Same were 98.6%, 98.7%, 56.7%, 58%, and 85.6%. Because most of the properties were only held by King for a relatively short period of time before they were sold to *** Same, these gross margins appear to be particularly high. After summarizing the circumstances under which Arthur Andersen & Co. had knowledge of King's pricing policy in connection with the sale of the industries to * * * Tong, the court concluded that "[w]e are reasonably certain that the price * * * Tong paid for the natural resource industries at the time of their purchase by * * * Tong in 1968 was known prior to the signing of * * * Tong's auditor's report by Arthur Andersen & Co. on February 5, 1969". the prices paid, the costs incurred by King in acquiring these properties, and the profits made in these transactions." Despite the fact that Arthur Andersen & Co. was in possession of these facts, however, there was a protracted controversy during the trial of the case as to whether Arthur Andersen & Co. could and should have applied this information to * * * Tong's audit. The key issue in the controversy is whether the firm could have refrained from applying the price information obtained from the King audit to the audit of *** Tong's natural resource investments on the ground of client confidentiality. Attention to this issue should be drawn to the fact that the *** Tong audits and the King audits are closely related, and that the audits of *** Tong's resource accounts were accomplished through a review of King's accounting records. In some instances, Arthur Andersen & Co. even conducted the King audit and the resource account audit simultaneously. Thus, it is clear from the firm's audit files for King and the Resource Accounts, as well as from the evidence gathered in the course of the audits, that the firm was well aware of the longstanding business relationship between * * * Tong and King. Another key issue in the audit was the acceptability of what is known as a revaluation transaction, i.e., the sale of a small portion of the natural resource estate to determine the fair market value of the remainder.In December, 1968, King sold 10 percent of the natural resource estate to Hawks Ruff on behalf of * * * Tong. The Hawkes-Ruff Company was also an audit client of Arthur Andersen & Co. ***The same company recognized approximately $900,000 of appreciation on its investment based on this sale. The firm was skeptical about the reasonableness of this sale. This was because ***The Same Company had held the property for a short period of time and had not made any geographic new discoveries that would justify the value of the property in excess of its cost at the time of acquisition. Moreover, whether * * * Same's presumption, based on the sale of ten percent of the estate, that appreciation had also occurred in the remaining ninety percent, was sufficiently persuasive. It was later discovered that there was indeed a "collateral agreement" between King and Hawkes-Ruff. King gave Hawks Ruff the deposit it needed to purchase its property and relieved the company of all obligation to pay the purchase price. Phil Card, a partner in the Denver office of Arthur Andersen LLP, who was responsible for auditing the source accounts of King and * * * the same companies, discovered in January 1969 that the Hawkes-Ruff transaction was not a normal sale. Phil Card communicated this information to John Robinson, a partner in the New York office of Arthur Andersen & Co. Court records show that there were heated discussions within Arthur Andersen among the "top partners" about the Hawkes & Ruff transaction. For reasons which it did not wish to disclose, the firm ultimately decided not to inform * * * Tong of the illegality of the Hawks-Rave transaction and, on February 5, 1969, issued an unqualified audit report on * * * Tong's December 31, 1968, financial statements. III. The Audit of * * * Tong's 1969 Financial Statements by Arthur Andersen & Co. In making plans for * * * Tong's 1969 audit, Phil Card, a partner in the Denver office, established a new set of audit guidelines to govern the audit of * * * Tong's subsequent revaluation transactions. Apparently the establishment of the audit guidelines was motivated by both considerations of the suspicious nature of the Hawks-Rave transactions in the prior year's audit and by the increased responsibility which was to be assumed for * * * Tong's 1969 audit. The court's evidence indicated that in the *** Same Company 1969 audit, the Denver office was to assume audit responsibility for the accuracy of the cost and market value of the resource accounts. A partner in the Geneva office of Arthur Andersen & Co. gave Phil. Card a stern warning that mere disclosure of * * * Tong's method of valuing its investments in natural resources was inappropriate if it did not fairly reflect the whole truth. In November, 1969, Phil Card drafted a memorandum of audit guidelines which auditors were required to follow in reviewing subsequent revaluation transactions of * * * Tong. The memorandum was reviewed and approved by the regional head of the West Coast audit practice of Arthur Andersen & Co. and by the administrative partner of the Chicago headquarters, both of whom were in favor of it. * * * The executives of the same firm received copies of the memorandum at the same time. At the end of 1969, King was selling a portion of its own interest in the Arctic property (a substantial portion of which had been sold by King to * * * Tong at an earlier time) and needed to revalue that portion of the interest. The King personnel were aware of the specifics of the audit guidance memorandum and endeavored to bring the revaluation transaction into compliance with the key terms of the memorandum. Ultimately, King sold slightly less than 10 percent of the Arctic Property to McCann, the principal shareholder of Louisiana Oil Company of America (who was experiencing a severe financial crisis at the time). This transaction allowed *** Tong to incorrectly recognize in its revaluation that the Arctic estate it owned had increased in value by more than 25 per cent, for a total increase in value of approximately $119 million. However, unbeknownst to the auditors, King, like in its previous dealings with Hawks Ruff, had entered into a prior affiliation agreement with McCann. Phil Card was very cautious when he realized that the revaluation of the Arctic property had a very significant impact on the market value of * * * the same company . According to the court record, Phil Card reported the situation to the regional director of Andersen & Co. who was in charge of the West Coast audit practice. He stated that the Denver office's review of the revaluation transactions alone did not yield sufficient evidence to establish that the market value of * * * Tong's Arctic Industries investment had appreciated. The Regional Director concurred in this view. Phil Card also points out that the Chicago headquarters of Arthur Andersen & Co. should have exercised final decision-making authority and responsibility for agreeing or not agreeing that * * * the value of * * * Tong's natural resource investments had been appreciated. The senior partners of Arthur Andersen did, in fact, engage in lengthy discussions about the investments, which centered on whether an affirmative or negative audit conclusion could be reached as to the fair market value of the investments. In the end, however, the auditors issued a qualified audit report on the December 31, 1969, financial statements of * * * Tong. In evaluating the audit of the Arctic Industries revaluation transaction, the judge gave special weight to the fact that the accounting firm had the true facts of what came to be known as the Blakely-Walcott transaction, which increased King's net earnings by nearly 40% in 1966, and that in the Blakely-Walcott transaction King and the buyer had entered into an illegal secret affiliation agreement in private. The transaction was similar to the Hawks-Rave Company transaction and the McCann transaction. Andersen & Co. was skeptical about the nature of the transaction, judging from the workpapers of King's 1966 audit. The workpapers stated that the Blakely-Wolcott transaction was plausible and appeared to be merely a maneuver to inflate the book value of assets. Despite the auditors' concerns, the firm ultimately accepted King's accounting treatment of the transaction. Arthur Andersen & Co. made this decision because it received a statement of assurance from King. In the statement letter, King categorically denied that Blackley. Walcott's sales operations had any collateral agreements, and assured that King's officers and the economic operations conducted were compliant and lawful. Managers and key employees have never been involved in any of the business activities of outside

economic entities in the purchase or sale of natural resources from King, whether such involvement was direct or indirect. In early 1970, prior to signing * * * the same company's 1969 annual audit report, the Denver office of Arthur Andersen & Co. discovered that the Blakely-Walcott transaction was a fraud, thus proving that the declaration letter issued by King in 1967 was false. This discovery rendered questionable the veracity of all relevant audit evidence gathered by the firm from King which was used to support * * * the credibility of the 1969 financial statements of the same company. Particularly implausible is that evidence which was used to corroborate the statement's claim that * * * Tong's investment in the Arctic industry had appreciated significantly in value. The Tribunal regrets to find, however, that despite having obtained the most recent information concerning the Blakely-Walcott transaction, Arthur Andersen & Co. continued to rely on audit evidence gathered from King and King in connection with * * * Tong's 1969 audit. After the events of the Arctic Property revaluation transaction in December, 1969, and the realization of the truth of the Blakely-Wolcott transaction, Arthur Andersen & Co. continued to perform its audit work and obtained from King an assurance statement that "the Arctic Property sale was a bona fide arm's-length transaction," and likewise obtained from McCann another similar assurance statement. A similar assurance statement was also obtained from McCann. The firm did not, however, inquire of McCann about the status of the ancillary agreements. Prior to the signing of the audit opinion on the 1969 financial statements of * * * Tong, an article published in the Wall Street Journal again drew the attention of the firm's auditors to the possibility of undisclosed collateral agreements in connection with the McCann transaction. For this reason the Firm again and again asked King to further determine whether the transaction was genuine, and King again stated that the true facts of the McCann transaction were identical to those initially told to the Firm. IV.*** Tong's Bankruptcy Trustee's Complaint and Court Decision Against Arthur Andersen LLP *** Tong's bankruptcy trustee's allegations against Arthur Andersen LLP were that: the firm had allowed *** Tong to be defrauded by King; the firm had failed to inform *** Tong's managers of the cost and pricing information that the Denver office had gathered from King; it had failed to tell the managers of Arctic Industries that the Arctic Industries transaction was fraudulent; the sale failed to meet the requirements of the audit guidelines established by the Firm. *** Same repeatedly asserted that had the Firm disclosed its view of the substance of the Arctic Estate transaction, they would not have used King's sale of a portion of the property rights in the Arctic oil and gas estate as a basis for assessing the value of the Company's interest in that estate. Finally, the trustees of * * * Tong also allege that the firm failed to comply with its obligation under the engagement letter to inform the management of * * * Tong of the improprieties discovered during the course of the audit. An excerpt from the engagement letter for the audit reads in part, "In order to perform our duties, we will examine the balance sheet, statement of net assets and investments of the company as of December 31, 1968, and the related statements of income, appreciation in net assets, and changes in net assets for that year, so that we may express an audit opinion on the financial condition and results of operations. Our examination will be conducted in accordance with generally accepted auditing standards and will include all procedures that we consider necessary in the circumstances. These procedures will be used on a cross-cutting basis and will include reviewing and testing accounting procedures and internal controls, examining documentary evidence used to support recorded transactions in the accounting system, and selective correspondence with customers, creditors, attorneys, banks, and other entities and individuals to directly corroborate certain asset and liability balances. The examination may reveal certain embezzlement and similar improprieties. However, our audit procedures are not designed for this purpose, and it is unlikely that we will be able to review a sufficient number of transactions to assure that all embezzlement and other improprieties are revealed. Generally, the revelation of such acts should rely primarily on a company's system of internal controls and effective oversight of accounting procedures and records. We will, of course, notify you as soon as possible of any improprieties that come to our attention (material statement noted by the court)." Counsel for the firm responded to the allegations of * * * the bankruptcy trustee of the same company - with rebuttals. One was that it would be a breach of auditor's confidentiality to tell * * * the same company about the information obtained from King's. Two, it was maintained that the board of directors of *** Same was primarily responsible for using the sale of a portion of the title in King's Arctic estate as the basis for assessing the market value of *** Same's estate. There was no evidence before the transaction took place, and very little evidence after it took place, that the revaluation transaction was fraudulent. Moreover, plaintiffs have not shown that the revaluation transaction resulted in a material overstatement of the value of * * * Tong's investment in the Arctic industry. Third, the firm asserts that it found no transactions or activities in the course of the audit that could be characterized as "improprieties," and, of course, there is no question of reporting improprieties to * * * Tong's management. In the case of King's overpriced sales to *** Tong, the court concluded that the firm should have reported them to *** Tong's management. The court found that the firm was fully aware of the fact that *** Tong had been defrauded by Kim . and

further stated:The failure of Arthur Andersen LLP to clarify the different relationships of the parties involved and the prices at which they traded with each other materially affected the fair presentation of *** Same's financial position...." The court held that the firm had a duty to ascertain whether the Arctic Industries sale was a public transaction? Did it satisfy the requirements of the audit guide established in November 1969 to support revaluation transactions? The firm led to * * * the same erroneous decision because the audit team had reason to be skeptical as to whether the Arctic Industries sale was a public transaction. Not only that, but from all the facts available, it has been reasonably shown that the Firm should have known that the 1969 revaluation of the Arctic Estate was false from its methodology to its results, and yet continued to insist on misleading and incomplete disclosures? Although * * * the management of the same company is primarily responsible for business decisions, when aspects of an economic transaction are so confusing as to make it impossible to understand the true financial position of the client, the auditor must inform the client. On the issue of breach of contract the Tribunal held:The firm did not properly fulfill its obligation under the engagement letter to inform *** the same company of any improprieties discovered in the course of the audit. The Tribunal ruled that the revaluation of the Arctic Estate was fraudulent. Three main considerations were taken into account in arriving at this judgment; (1) Prior to signing the audit opinion on * * * Tong's 1969 accounting statements, Arthur Andersen & Co. knew that the Blakely-Walcott transaction, which took place in 1966, was a fraudulent activity. (ii) The firm knew that McCann, who was facing a financial crisis, was not in a financial position to purchase 10 percent of the Arctic property. (iii) The firm did not inquire whether there was a private collateral agreement between McCann and King in the Arctic Property transaction. Two aspects of the *** Tong case are of particular significance to the CPA profession: first, the principle of auditor confidentiality; and second, the fact that the issuance of a qualified audit report on *** Tong's 1969 accounting statements did not lessen the firm's legal liability. In seeking protection by invoking the principle of auditor confidentiality, the firm ignored the fact that it had utilized King's accounting records in its audit and had repeatedly requested information from King concerning the relationship between King and *** Tong. Assuming that the principle of confidentiality was to be observed under these circumstances, the auditors could have: (i) strongly urged a client to make the necessary disclosures; (ii) disclosed the existence of certain information that was not valid for another client; and (iii) withdrawn from the audit of one of the clients. However, the firm did not take any of these measures. In response to the qualified audit report signed by Arthur Andersen & Co. on * * * Tong's 1969 accounting statements, the judge ruled that the qualifications in the audit report did not adequately indicate to * * * Tong's management the firm's skepticism about the valuation of the natural resource industry and did not completely avoid substantial harm to * * * Tong's economic interests. After an eight-week trial and two weeks of deliberations in the summer of 1981, Arthur Andersen & Co. was ordered to pay $80.79 million in damages to *** Same (which was later modified to reduce the award by approximately $10 million). This was the highest damages awarded by an accounting firm in an audit case in U.S. history.