Updated from 5:50 p.m. EDT

The

Securities and Exchange Commission

Monday charged accounting firm Ernst & Young with violating auditor independence requirements in a business relationship with client

PeopleSoft

(PSFT)

.

In a suit against E&Y, the commission alleged the firm, while serving as PeopleSoft's auditor, jointly developed and marketed a product with the software maker from 1994 to 2000.

According to the allegations, E&Y sought to gain a competitive advantage by incorporating PeopleSoft's source code into its tax product, in exchange for paying PeopleSoft royalties ranging from 15% to 30% for each sale, with a guaranteed minimum payment of $300,000.

Throughout the relationship, E&Y and Peoplesolft had frequent discussions, meetings and email correspondence about how their businesses and joint market initiatives were progressing, with audit partners included in at least some of the communications, the SEC said in its order.

As a result of that arrangement, E&Y violated rules regarding auditor independence and caused PeopleSoft to file SEC documents that failed to include required independently audited financial statements, the SEC charges.

In a statement, Ernst & Young said it will defend itself "vigorously" against the charges." "Our conduct was entirely appropriate and permissible under the profession's rules," the firm said. "We are surprised and disappointed that the SEC has chosen to take action on this matter."

Ernst & Young noted the activities involve former consultants and have no bearing on the firm's current business. E&Y sold its consulting business to Cap Gemini in May 2000.

A PeopleSoft spokeperson could not be reached for comment. In 2000, PeopleSoft switched auditors from Ernst & Young to Arthur Andersen, currently embroiled in an obstruction-of-justice trial against the U.S. Justice Department related to its involvement in the Enron disaster.

The SEC is seeking a cease and desist order against E&Y and wants the firm to be ordered to disgorge the fees it was paid for its "tainted" audits.

A public hearing will be held in between 30 and 60 days on the matter. Ernst & Young is required to file an answer to the allegations within 20 days after receiving the order.

The SEC noted that the case is the second auditor independence case against Ernst & Young. It follows a 1991 suit against the firm for aiding and abetting two other audit clients by failing to maintain its independence. That case was settled in 1995.

The SEC did not institute proceedings against PeopleSoft. Whether PeopleSoft's financial statements would need to be reaudited would have to be determined at a later date, said Paul Berger, associate director of enforcement at the SEC.

Shares of PeopleSoft fell $1.85, or 7.8%, to close at $21.84. In recent trading Tuesday, PeopleSoft was down another 8%.