…Over the past 20 years I have had the pleasure (and occasional displeasure) of meeting hundreds of bullish business leaders on both sides of the Atlantic. But two lunches with British companies – one in the late 1980s, the other about five years ago – have always stood out in my memory for the quite extraordinary degree of certainty displayed by their management teams. Smug hardly describes it. Each seemed almost giddy with the cleverness of its business model.
The first was Equitable Life, the life assurer eventually brought low by an adverse legal ruling and its strategy of distributing surpluses instead of building up reserves. The second was Northern Rock, with its unusual reliance on short-term wholesale financing.
My impressions were superficial and extremely subjective, and gave me no real idea that there might be any problem with their models. But arrogance is a classic cause of business failure, preventing you thinking flexibly or seeing that you might be wrong. And both Equitable Life and Northern Rock developed reputations for being mighty pleased with themselves.
Northern Rock is the UK’s big subprime mortgage crisis. For more details go here. The bank has now borrowed £8bn from the Bank of England – the equivalent of a third of its retail deposits at the end of June. The bank scrapped a proposed £59m dividend pay-out to ordinary shareholders after pressure from politicians and the public, but admitted distributing £40m to holders of preference shares last week. The Treasury brought in Goldman Sachs as an adviser but it has its work cut out to find a buyer for the Newcastle- based bank.
Now we have news that their auditors, PwC, have made more money from advising Northern Rock on how to stay above the flood waters via securitisation schemes and Special Purpose Vehicles than they did from auditing their financial statements.
I thought this kind of thing was not supposed to happen anymore? Oh, that’s right, the UK does not have Sarbanes-Oxley. We wouldn’t allow this kind of scope of services conflict here, but the UK branch of “global” audit firm PwC is allowed to do it there.
Remember, Special Purpose Vehicles or SPVs, were the structures that Enron used to take losses and other debt off their balance sheet. Andersen continuously gave them a pass on these structures, looking the other way. But Andersen never aided and abetted and collected big advisory fees by helping Enron to leverage up to the extent that it seems PwC did at Northern Rock.
Northern Rock’s accountant PricewaterhouseCoopers is facing accusations of a damaging conflict of interest after it emerged that it earned bigger fees for helping the crisis-hit lender to sell on its loans, and borrow funds in the wholesale markets, than for auditing the business.
The bank’s annual report reveals that PwC was paid £500,000 in 2006 for auditing and £700,000 in ‘non-audit fees’, specifically ‘in respect of securitisation transactions and the raising of wholesale funding’.
It was the mortgage lender’s heavy dependence on short-term borrowing from the wholesale markets that forced it to call on emergency funding from the Bank of England this month. ‘This appears to be a serious conflict of interest,’ said Vince Cable, LibDem Treasury spokesman. ‘I would worry about the fact that the auditor appears to be making enormous fees from what turned out to be the most disastrous aspects of the Northern Rock situation.’
Chancellor Alistair Darling has said he wants a return to ‘old-fashioned banking’ from the complex, highly-leveraged business model that has left the banks vulnerable to the credit crunch that began in the US. But for PwC, and the other accountancy giants, scrutinising the proliferating ‘special purpose vehicles’ used to parcel up and sell on the loans has proved a lucrative sideline.
‘It’s a complete conflict of interest: it’s absolutely absurd,’ said Richard Murphy, of the Tax Justice Network. ‘Once they’ve endorsed these structures, for the purposes of raising the money, they can’t turn around and say, this is no good for the purposes of an audit.’
Corporate governance campaigners have long argued that the sums accountants can earn in non-audit fees should be restricted, to avoid compromising their independence. ‘The conflict of interest comes where they make the highest profits on other services, which means the audit becomes more compliant; more accommodating,’ said Labour MP Austin Mitchell. ‘They don’t want to alienate the clients: the audit becomes a market stall from which they sell other services.’
Rosemary Radcliffe, a non-executive director at Northern Rock, is a former chief economist at PwC.
Northern Rock did not hide its securitised loans off its balance sheet, but PwC still faces questions about why it failed to warn investors that the rapid pace at which the bank was taking on new business might leave it exposed in the event of a liquidity crunch.
One senior figure in the accountancy world said: ‘When 73 per cent of your balance sheet is due in three months, you’ve got to ask yourself how confident you are.’ Analysts at Deutsche Bank warned in April that Northern Rock was ‘the most leveraged bank in Europe’, and advised investors to sell their shares. A spokeswoman for PwC said she was unable to comment on matters relating to specific clients. The Bank of England is thought to have lent up to £8bn to Northern Rock, and the Treasury is urgently looking for a buyer, to secure the bank’s future.