Are InterOil's Auditors Capable of Finding Fraud in Plain Sight?

Fraud Discovery Institute (co-founded by convicted felon turned fraud buster Barry Minkow) is putting PricewaterhouseCoopers (PwC), InterOil's (NYSE: IOC) auditors, on notice that they must look out for possible fraud by the company as required by Statement of Auditing Standards No. 99. Fraud Discovery released a video to provide a road map to PwC "in an attempt to give investors clearer picture of the inside workings of the controversial company." Minkow believes that InterOil is "a financial crime in progress." In addition, former LA Times investigative reporter William Lobdell, who now writes for Fraud Discovery's iBusiness Reporting blog, issued a report detailing a "troubling pattern of behavior" by InterOil since its founding in 1997.




However, I am skeptical about PwC's capability to find any fraud at InterOil based on my prior experience with them as the auditors of Overstock.com (NASDAQ: OSTK) another scam company investigated in this blog. I correctly identified certain GAAP and SEC disclosure violations by Overstock.com and PwC still certified the company's financial reports as being in compliance with GAAP and SEC rules. A year later, Overstock.com admitted to those same GAAP and SEC disclosure violations exposed in my blog and restated its financial reports to correct its violations.

Both Barry Minkow and William Lobdell have publicly disclosed holding short positions in InterOil securities. I do research for Fraud Discovery on InterOil and I do not own any securities in InterOil, long or short. More disclosure at the bottom of this blog post.

Statement of Auditing Standards: Consideration of Fraud in a Financial Audit

According to SAS No. 99, "The cornerstone of an effective antifraud environment is a culture with a strong value system founded on integrity." Unethical behavior by company management is considered a red flag for possible fraud and auditors are required to increase the scope of their audits to detect potential fraud to insure that financial reports are free from material errors. Fraud Discovery Institute's InterNoOil.com website and its iBusiness Reporting blog have published many reports detailing a troubling pattern questionable behavior by InterOil management.

Forensic accountants look for a "pattern of inconsistent and conflicting disclosures" in investigating fraud at public companies, like InterOil. Likewise, PricewaterhouseCoopers is required by SAS No. 99 to look at "inconsistent and conflicting disclosures" to determine if InterOil is committing fraud, such as those described below.

Previous examples of a "pattern of inconsistent and conflicting disclosures" by InterOil

In my June 2009 blog post entitled, "InterOil, John Thomas Financial, and Clarion Finanz: Anatomy of a Stock Market Manipulation Scheme," I detailed how InterOil filed a false report with the Securities and Exchange Commission claiming that the company paid no fees for a private placement $95 million convertible debt offering. However, documents submitted in another court case reveal that Clarion Finanz (a major shareholder of InterOil) had in fact received $5.7 million in fees, contrary to InterOil's SEC filings.

In March 2010, William Lobdell went to a Texas courthouse to examine documents filed in a litigation by the original investors of InterOil against CEO Phil Mulacek alleging fraud by him dating as far back as 1997 (Details here, here, and here).

In another blog post, entitled, "Did InterOil Commit Securities Fraud?" I detailed how CEO Phil Mulacek made sworn statements in that court case which conflicted with InterOil's financial disclosures to investors. In his sworn court testimony, Mulacek claimed that a $50 million judgment against InterOil would bankrupt the company, while InterOil's financial disclosures to investors claimed that a judgment in excess of $125 million would have a material adverse impact on the company.

Under SAS No. 99, "Misrepresentation in or intentional omission from the financial statements of events, transactions, or other significant information" is considered "relevant to the auditor's consideration of fraud." In both of the situations cited above, InterOil told one story to investors in its SEC filings and financial reports and its management told a conflicting story to the courts in sworn statements. If one story is true, the other story simply cannot be true. In each of the cases cited above, InterOil misrepresented or omitted material information in its financial reports to investors, as evidenced by its management's conflicting disclosures to the courts.

Based on InterOil's conflicting disclosures, PwC is required to investigate such irregularities under SAS No. 99, as part of its audit of the company. However, I am skeptical of PwC's auditing abilities and it's capability to uncover any fraud committed by clients such as InterOil. So far, they seem to have ignored significant management integrity issues at InterOil, like the two issues detailed above.

Why I am skeptical about PwC's capability to find fraud at InterOil

PwC was Overstock.com's auditors from 1999 to 2008. During that period, every initial financial report for every reporting period issued by Overstock.com and reviewed or audited by PwC violated Generally Accepted Accounting Principles (GAAP) or some other SEC disclosure rules. Overstock.com CEO Patrick Byrne blatantly lied to investors over a ten year period about the company's financial performance, internal controls, and compliance with GAAP and other SEC disclosure rules.

Starting in February 2009, I wrote a series of blog posts correctly identifying certain GAAP violations by Overstock.com in 2008 and prior years. Both Overstock.com and PwC ignored my requests for them to correct those GAAP violations and restate the company's financial reports. Patrick Byrne responded by orchestrating a smear campaign to discredit me and other critics who agreed with my findings, while PwC improperly certified the company's financial reports as being in compliance with GAAP.

In March 2009, Overstock.com hired Grant Thornton to replace PwC as its auditors. In September 2009, the SEC started investigating Overstock.com's accounting irregularities that were pointed out in my blog. In November 2009, Overstock.com fired Grant Thornton after they agreed that I correctly identified certain GAAP violations and wanted the company to restate its financial reports. PwC still stuck to its guns and claimed that Overstock.com did not violate GAAP.

In December 2009, Overstock.com hired KPMG to replace Grant Thornton. In February 2010, Overstock.com finally admitted that the company violated GAAP and restated its financial reports to correct GAAP violations, previously identified by me. I was right and Overstock.com and PwC was wrong.

Overstock.com's financial reports that were audited by PwC were restated three times in ten years and every single audit report issued by PwC was wrong. PwC ignored serious management integrity issues at Overstock.com and I have no reason to believe that they will address any management integrity issues at InterOil.

A "troubling pattern of behavior" by InterOil

William Lobdell's latest report details even more questionable behavior by InterOil's management team. Lobdell cites "InterOil’s 12 years of hyping gas and oil fields in Papua New Guinea" and points out that InterOil still has no proven commercially exploitable reserves to date. Lobdell lists ten wells that InterOil hyped to investors, only to abandon them later on.

Many short sellers, including Minkow and Lobdell, are skeptical of InterOil's claimed estimates of contingent resources (not proven reserves). Lobdell examined the track record of GLJ Engineering, a firm hired by InterOil in 2009 to estimate its oil and gas resources. He found three major blunders by GLJ in the past and questioned the reliability of their reports on InterOil.

Then, Lobdell details how InterOil was apparently shopping for a favorable engineering report on its reserves before the company hired GLJ:

InterOil’s Netherland Sewell report is MIA.

GLJ's past mistakes might not be that much of an issue if it weren't for the "Case of the Missing Netherland Sewell Report."

In March 2007, InterOil CEO Phil Mulacek told attendees at a Raymond James conference in Orlando, Florida that three "world-class" firms were in the process of performing reserve analysis on InterOil gas fields. Mulacek named one firm, the iconic Netherland Sewell, stating that InterOil had hired the company, according to a reliable source.

This news of an imminent evaluation from Netherland Sewell was frequently mentioned in fawning investor reports by Raymond James and on blogs and message boards promoting InterOil.

But the report never came.

About 17 months later, Mulacek indicated in a conference call to investors that an international firm hired by InterOil would finish its reserve analysis report by the end of October 2008.

Again, the report never came.

So what happened to the Netherland Sewell report? Netherland Sewell nor InterOil will comment. And since InterOil is never shy about releasing good news, this should be worrisome to investors.

In the balance of his report, William Lobdell takes issue with InterOil's hype on the company's long term viability. He analyzes how InterOil is running out of cash and questions and other roadblocks facing the company in the future.

Closing comments

I cannot understand how auditing firms like PwC with their access to a company's books and records can miss red flags and financial reporting violations correctly pointed out by outsiders such as short sellers like Barry Minkow and William Lobdell and independent whistleblowers like me. Unlike us, PwC seems to be incapable of finding fraud, even fraud in plain sight .It seems that the reliability of PwC's audit reports is nothing more than pot luck in most cases.

Written by:

Sam E. Antar

Disclosure:

I am a convicted felon and a former CPA. As the criminal CFO of Crazy Eddie, I helped Eddie Antar and other members of his family mastermind one of the largest securities frauds uncovered during the 1980's. I committed my crimes, simply because I could.

If it weren't for the efforts of the FBI, SEC, Postal Inspector's Office, US Attorney's Office, and class action plaintiff's lawyers who investigated, prosecuted, and sued me, I would still be the criminal CFO of Crazy Eddie today.

I do not own Overstock.com securities short or long. My research on Overstock.com and in particular its lying CEO Patrick Byrne is a freebie for securities regulators and the public in order to help me get into heaven, though I doubt that I will ever get there anyway.

I do research on InterOil for Fraud Discovery Institute. However, I do not own any InterOil securities, short or long.

I plan on meeting corporate miscreants, such as fifth rate crooks like Patrick Byrne, in hell. In addition, it is likely that InterOil CEO Phil Mulacek may join Patrick Byrne and me in hell, too. We will all fry together.