Banking regulators announced in early 2015 a greater focus on evaluating ethical culture as part of their regulatory examination of a bank’s health. In a February 2015 speech, Thomas Baxter, Executive Vice President and General Counsel at the Federal Reserve Bank of New York, announced that the Federal Reserve was making ethical culture a priority for financial services in its efforts to prevent the bad behavior among some in the financial services industry preceding the financial crisis that emerged in 2007-2008.1 While acknowledging that organizations with the strongest ethical culture may have periodic episodes of bad behavior, Baxter argued that strengthening ethical culture of financial services institutions ought to lower the extent of bad behavior previously observed.
Soon after this speech, a February 1, 2015 article in The Wall Street Journal described challenges large banks might have in measuring a bank’s culture, which might extend from the teller serving customers in a single branch to the senior executive C-suite.2 In particular, the article featured how Wells Fargo was surveying employees annually to measure their satisfaction, which the bank’s CEO, John Stumpf, referred to as the “happy to grumpy ratio.”This was based on the bank’s theory that happier employees are more likely to make ethical decisions. The Wall Street Journal article went on to highlight how the ratio of satisfied to not-satisfied employees improved for Wells Fargo from 3.8:1 in 2010 to 8:1 in 2014.
SOMETHING WENT AWRY
Ironically, just three months later, the Office of the Los Angeles, California City Attorney filed a Complaint3 in May 2015 againstWells Fargo alleging the bank was engaging in unlawful, unfair, and fraudulent sales practices by opening banking and financial accounts, products and services for California customers without their consent. The Complaint alleged that the bank was victimizing its customers by engaging in improper sales practices that allowed those employees to achieve sales goals and incentives, including incentive-based compensation.
According to the Complaint, employees were encouraged to sell customers multiple banking products, which Wells Fargo referred to as “solutions.” Unfortunately, the sales quotas were unrealistic, which drove employees to engage in unfair, unlawful, and fraudulent practices to meet their goal of selling a high number of “solutions” to each customer. The Complaint went on to allege that the bank knew about and even encouraged these practices for years and did little to discourage this behavior or to inform affected customers.
That Complaint helped to trigger an investigation by the U.S. Consumer Financial Protection Bureau (CFPB). By September 2016, the CFPB issued a Consent Order4 alleging thatWells Fargo employees were found to have opened deposit accounts between May 2011 and July 2015 without customers’ knowledge or consent and then transferred funds from those consumers’ already existing accounts to temporarily fund the unauthorized accounts long enough for the employee to meet the sales incentive goals. Additionally, employees opened credit card accounts, enrolled customers in online banking services, and requested debit cards all without customer knowledge. Those activities gave the employees credit for opening new accounts that generated additional incentive-based compensation for them.
According to the Complaint filed by the City of Los Angeles, the bank put unrelenting pressure on its bankers to open numerous accounts per customer.Wells Fargo enforced its sales quotas by constant monitoring. The Complaint described how daily sales for each branch, and each sales employee, were reported and discussed by the bank’s District Managers four times a day, at 11:00 am, 1:00 pm, 3:00 pm and 5:00 pm. Employees who did not reach their goals often had to work hours beyond their typical day without being compensated or they were threatened with termination. But the quotas were often unattainable given there were simply not enough customers who entered the branch on a daily basis for employees to meet their sales goals through normal means.
Those employees who failed to meet daily sales quotas were approached by management and often reprimanded or told to “do whatever it takes” to meet their individual sales quotas. The Complaint noted that several techniques were used to game the system:
Sandbagging – this refers to the bank’s practice of failing to open accounts when requested by customers, and instead, accumulating a number of account applications to be opened at a later date in the next sales period.
Pinning – this refers to the bank’s practice of assigning, without customer authorization, Personal Identification Numbers (PINs) to customer ATM card numbers with the intention of impersonating customers on the bank’s computers, and enrolling those customers in online banking and online bill paying without their consent.
Bundling – this refers to the bank’s practice of incorrectly informing customers that certain products were only available in packages with other products, such as additional accounts, insurance, annuities, and retirement plans.
According to the CFPB Consent Order, over 1.5 million deposit accounts were opened without being authorized by customers. Of those, about 85,000 generated approximately $2 million in customer fees from overdraft charges on linked accounts the customers already had, or they arose from monthly service charges triggered by failure to keep the minimum required balances in the unauthorized accounts. Additionally, the CFPB reported that employees opened over 500,000 credit-card accounts without customer knowledge or approvals. Of those, about 14,000 accounts triggered over $400,000 for annual fees for the card and over-draft protection fees.
The CFPB ordered the bank to set aside a minimum of $5 million to repay affected customers for the unauthorized fees. The CFPB also noted that the Board of Directors of Wells Fargo was ultimately responsible for the proper and sound management of the bank and the Board would need to require timely and appropriate corrective action. Most notably, the CFPB ordered that the bank pay a civil monetary penalty of $100 million to the CFPB.
At the same time, the City of Los Angeles reached a settlement agreement5 with the bank that ordered the bank to pay additional civil penalties of $50 million to the city. Simultaneously, the Office of the Comptroller of the Currency (OCC) fined the bank $35 million. So, in total the bank was fined $185 million for practices that generated less than $3 million in unauthorized fees.
Apparently, leaders within the bank became aware of these practices among branch level employees before the Complaint was filed by the City of Los Angeles. Between 2013 and 2015, the bank fired 5,300 employees for these inappropriate practices. At the time, the bank employed over 270,000 individuals.
Soon after the settlements were announced in early September 2016, the bank’s CEO, John Stumpf defended the bank’s efforts to stop the behavior and he called the conduct “not acceptable.” Stumpf claimed there was “no incentive to do bad things” and that the employees involved did not honor the bank’s culture.6
In a September 20, 2016 hearing held by the U.S. Senate Committee on Banking, Housing, and Urban Affairs, Stumpf apologized for the bank’s failure to fulfill its responsibility to its customers, team members, and the American public and for not doing more sooner to address the cause of this unacceptable behavior. He noted that wrongful sales practice behavior was counter to the bank’s values, ethics, and culture and he defended bank management by asserting that there was no orchestrated effort or scheme that directed employees to engage in this behavior.7
Press reports noted that both Republican and Democratic Senators grilled Stumpf over the sales practices. Some suggested that the bank could have been better prepared and that Stumpf and other executives failed to answer a number of questions. The week following the hearing, Senate Democrats pressured Stumpf to answer dozens of questions to clarify and supplement his testimony given his inability to answer them at the Committee hearing. The Senators pushed for more details on the timeframe and scope of wrongdoing. In particular, they asked how he was confident that this type of fraudulent behavior did not exist in other business lines at Wells.8 Two weeks later, Wells Fargo announced that Stump was stepping down from both his role as Chairman and CEO, effectively immediately.
At the end of October 2016, Senator Elizabeth Warren (Democrat – Massachusetts), Senator Bernie Sanders (Democrat – Vermont), Senator Mazie Hirono (Democrat - Hawaii) and Senator Edward Markey (Democrat - Massachusetts) issued a letter9 to Lynne Doughtie, Chairman and CEO of KPMG that contained a number of questions for the firm to answer by November 28, 2016. This letter is reproduced on the pages that follow.
REQUIRED  Describe the impact of this event on Wells Fargo’s financial statements; specifically how the alleged inappropriate sales practices would have affected Wells Fargo performance and financial position in the 2011 through 2014 time period. Identify where the $185 million in fines was reflected in Wells Fargo’s 2016 financial statements.  Visit the website of the U.S. Securities and Exchange Commission (www.sec.gov) and locate the Form 10-K filed on February 25, 2015 by Wells Fargo & Company/MN (CIK#: 0000072971) for the 2014 fiscal year (Note: The financial statements are contained in the link to Exhibit 13 of that 10-K filing). Based on that financial information filed with the SEC just prior to the first public announcement of the alleged sales improprieties, assess the following: [a] Would the cumulative effect of the inappropriate recording of customer fees be considered material to the Wells Fargo financial statements for 2014? [b] Would the $185 million fines be considered material to the Wells Fargo financial statements?  Because Wells Fargo is a publicly traded company, KPMG would have performed the audit of the financial statements and internal control over financial reporting using PCAOB Auditing Standards. Research those standards (visit www.pcaobus.org) to answer the following questions: [a] What is the auditor’s responsibility to detect fraud? [b] What is the auditor’s responsibility to detect an illegal act?  In their letter to the KPMG CEO, the four Senators refer to the sales practices as representing a “massive fraud.” Discuss whether or not you agree with their claim.  How would knowledge of the alleged sales practices shed insights about the effectiveness of internal controls over financial reporting?  Would the alleged sales practices be considered a significant deficiency or material weakness in internal control over financial reporting?  KPMG issued an audit opinion stating that Wells Fargo’s internal controls over financial reporting were operating effectively as of December 31, 2014. Had KPMG known about the alleged sales practices before they issued their audit opinion on internal control over financial reporting for the 2014 fiscal period, how might that knowledge impact their audit opinion?  Because the letter from the four Senators is a public document accessible under the Freedom of Information Act, the response from KPMG would need to be carefully crafted. If you were in Lynne Doughtie’s position, would you respond to the letter from the Senators? If so, what would be some of the challenges in crafting your response?  How might information about the $185 million settlement with the CFPB, City of Los Angeles, and the OCC trigger additional issues for the bank? What implications might that have for the 2016 and beyond financial statements for Wells Fargo?