The leadership of the Big 4 audit firms – Deloitte, Ernst & Young, KPMG and PricewaterhouseCoopers – are scared witless. The auditors prefer to be Switzerland. That is, they prefer to remain neutral. They don’t like the kind of attention that Ernst & Young is getting. They like the soft, managed, scripted kind of attention for Davos, diversity, charitable endeavors and support of higher education.
Until the Lehman Bankruptcy Examiner’ Report was issued on March 11th, the auditors had experienced a “good crisis.” No serious scrutiny of their behavior, no testimony before the various investigative committees of the US Congress and only a few lawsuits that had not yet come to trial.
October 2008, Gavin Hinks in Accountancy Age:
“Speaking at a meeting of accountants from across the world at the Mansion House yesterday, Paul Boyle said: ‘So far at least, auditing has had a good crisis.’
Detractors, Boyle added, had been vague in their complaints and had misunderstood the role of auditor, on the one hand, and corporate governance and financial services supervision, on the other. These statements are notable because Boyle is clearly sticking up for the profession. If he had thought the opposite he would presumably not addressed the subject during the speech. This is active backing for auditors.”
So much for that.
The Lehman Bankruptcy Examiner threw the word “fraud” into the financial crisis conversation.
The words “auditor malpractice'” followed.
It’s quite likely EY will be called before the US House Oversight Committee to testify about the Lehman bankruptcy. David Einhorn, a member of the much maligned “short club,” will probably be called to testify, too.
I criticized Ernst & Young in mid-2008 for not questioning Lehman’s CFO revolving door. Lehman had chosen another non-CPA CFO, the second one in less than three years. I was following the lead of another Cassandra, David Einhorn. Einhorn is now being heralded because he questioned Lehman’s accounting, in spite of being ridiculed and damned for it at the time. He’s getting almost as much applause as the “whistleblower” du jour, Matthew Lee.
Einhorn has also recently been vindicated in another case where he called foul and faced harsh criticism.
The SEC’s watchdog found that the agency failed to properly pursue serious allegations made against Allied Capital, a public company that invests in small to midsize businesses. But after heavy lobbying by Allied Capital, the agency aggressively pursued the hedge fund manager who had challenged the value of Allied’s investments…The case…began in 2002, when a hedge fund manager named David Einhorn explained in a speech that he bet against Allied Capital’s stock by short-selling it because he thought Allied overvalued its holdings.
Other investors proceeded to short Allied’s stock, which declined sharply in value.
About the same time, Einhorn began contacting the SEC by phone and letter to explain his skepticism about Allied Capital’s accounting techniques. Allied also worked behind the scenes to urge the SEC to investigate whether Einhorn was engaging in illegal behavior to undermine the company’s shares, according to the inspector general’s report.
Without any specific evidence of wrongdoing, Allied met with SEC investigators in June 2002 to urge them to investigate Einhorn. Shortly thereafter, the SEC opened a probe, questioning Einhorn about his trading activities, subpoenaing documents, and seeking his telephone records and a list of clients. Soon after investigators started looking at Einhorn, they concluded that he had done nothing wrong.
Sources tell me that the SEC Inspector General’s report on the Allied Capital investigation paints an even worse picture of the SEC than those involved ever expected. For example, it was the SEC lawyer who grilled Einhorn that later became a lobbyist for Allied and was the one who hired private investigators to steal Greenlight Capital’s phone records. Allied Capital’s auditor is KPMG. They are not yet accused of any wrongdoing, but the report also discusses the mis-valuations that Allied was originally accused of by Greenlight.
Maybe it’s time to start listening to the “shorts” and the contrarians.
Many ask me if Ernst & Young will fail because of Lehman. I have answered that in previous posts.
In short, not immediately.
Maybe E&Y won’t be the first of the remaining Big 4 to fail. The leadership of the Big 4 are terrified because any one of them could be thrust into the harsh spotlight the way Ernst & Young has been. At any time.
Because they’re all on the brink.
Take KPMG. When the New Century Trustee v. KPMG US and KPMG International lawsuit comes to trial, you can bet the media will suddenly remember there’s an auditor smoking gun there, too. Mr. Missal, the New Century bankruptcy examiner, found emails that uncovered the same kind of disregard for KPMG’s experts and their risk and quality gurus that we saw in Arthur Andersen’s handling of Enron. New Century is more like Enron for that reason than EY/Lehman is. So far. That we know of.
Depending on how well Steven Thomas tries it, the media will be all over the “KPMG will fail” scenario. Losing the case carries a $1 billion dollar price tag for KPMG. There’s also significant implications for the global network business model in addition to the enormous costs of KPMG defending themselves in the meantime.
Arthur Andersen’s partner ignored his own expert’s advice in Enron. KPMG is accused of doing the same in New Century. All for the sake of keeping a lucrative client. EY may have done the same to hold onto Lehman. Certainly the long, lucrative relationship between EY and Lehman paints a similar picture of mercenary motivation.
When EY’s Lehman audit team ran into the growing use of Repo 105 transactions, or the declining market value of the CDOs, or the Archstone REIT or any of the other problematic accounting issues mentioned in the Examiner’s report, one of four scenarios took place:
- The audit team didn’t ask for advice from their technical GAAP and SEC reporting/disclosure specialists at EY headquarters. The team went along and did what had always been done in the past: They acquiesced to Lehman CFOs. After all it was the Lehman CFO Goldfarb, an EY alumni who designed the transactions and approved the accounting treatments. When Sarbanes-Oxley outlawed the revolving door of audit partners moving into high level positions at clients, Dick Fuld chose non-accountants who didn’t know better, would not question and weren’t interested in accounting.
- Or…The audit team asked for advice from their technical GAAP and SEC reporting/disclosure specialists at EY headquarters. The headquarters specialists blessed the existing treatment. After all it was Lehman CFOs who were EY alumni who had designed the transactions and approved the accounting treatments.
- Or…The audit team asked for advice from their technical GAAP and SEC reporting/disclosure specialists at EY headquarters. The audit team received advice that the problematic issues represented unacceptable treatments according to current standards. And/or the experts suggested disclosures to clarify Lehman’s position. When this answer was brought to the audit partners they dismissed it and acquiesced to the Lehman executives. That’s similar the KPMG/New Century scenario.
- Or…The audit team asked for advice from their technical GAAP and SEC reporting/disclosure specialists at EY headquarters. The audit team received advice that the problematic issues represented unacceptable accounting treatments according to standards. When this answer was brought to the audit partners they raised the issue with Lehman executives, encouraged them to stop manipulating the balance sheet without disclosures using Repo 105 or to write down assets such as Archstone or the CDOs and were rebuffed. Lehman executives threatened to fire them and replace them with another firm like KPMG and EY backed down. We may never know if this happened unless or until EY partners are forced to settle charges and flip on the Lehman executives.
Or take the massive Satyam fraud-related litigation facing PricewaterhouseCoopers. When the courts in the Southern District of New York decide that PwC’s motions to dismiss are denied, PricewaterhouseCoopers will face a flood of lawsuits that will dwarf New Century v. KPMG. The publicity over EY/Lehman should make it difficult for the court to accept any lame excuses from PwC. PwC’s argument is that the case should be tried in India but they are fighting in India to have the case dismissed.
New York courts will now hear age discrimination litigation that names PwC as a defendant because the courts agreed that decisions about PwC partnership are made in New York. That same theory can certainly be applied when it comes to PwC global leadership (elected to represent the interests of the owners of its largest member firms) and their control over a global client like Satyam. Satyam is a PwC client that was listed on the New York Stock Exchange. The global leadership exerted control over member firm India because it has significant strategic importance to the global leadership. The global leadership exerted that control using the PwC International Limited legal construct.
The Satyam saga is far from over. The PCAOB recently sanctioned two fairly low-level PW India staff. (They are actually employees of local Indian member firm Lovelock and Lewes.) These employees are now “barred from being an associated person of a [PCAOB] registered public accounting firm” because they would not cooperate in the Satyam investigation.
I asked PCAOB spokesperson Colleen Brennan if there was more to come. What about the Price Waterhouse India partners that were jailed?
The order says formal investigation started Jan 8, 2009. It is now 14 months later and the outcome is that they wouldn’t talk to you. What took so long? Generally speaking the investigative process requires getting relevant audit work papers and other documents and scheduling the testimony of witnesses. Particularly in cases where witnesses are located abroad, which is the case here, the staff works with the witnesses and their counsel regarding an appropriate location for the testimony. Depending on the location, different planning goes into scheduling the testimony. Under the Board’s rules, witnesses are allowed to have counsel present during their testimony. In this instance, the auditors obtained new counsel during the investigative process which led to a postponement of the original testimony.
Is this it on your Satyam activities? What else is PCAOB doing to address the Satyam matter? The order mentions that the Board issued an order of formal investigation relating to the audits of Satyam. We cannot comment further.
What are next steps for PCAOB on Satyam? The disciplinary proceedings as to these respondents are complete. The Board does not comment one way or another about the specifics of its investigative inventory. (We cannot confirm that we have an ongoing investigation because Section 105(b)(5)(A) of the Act. This is the first case where we barred someone only for non-cooperation with Enforcement.)
Has the Board charged any other Lovelock & Lewes personnel, or Lovelock & Lewes, the firm, in connection with the Satyam audit? We cannot comment on whether others have been or will be charged. These orders only address the conduct of Messrs. Ravindernath and Prasad.
Are the Board’s investigation and disciplinary proceedings in connection with this matter completed? These disciplinary proceedings are completed as to Messrs. Ravindernath and Prasad. The Board does not comment one way or another about the specifics of its nonpublic investigative inventory, or about any proceedings that may be in litigation before the Board, which are non-public as required by the Sarbanes-Oxley Act.
What prompted the Board to investigate the audits and reviews of Satyam’s financial statements? The orders disclose that Satyam filed a Form 6-K with the SEC on January 7, 2009, that its chairman had revealed that he had inflated key financial results, and the Board issued an order of formal investigation on January 8, 2009.
Is the SEC also investigating this matter? Do you expect the SEC also to take enforcement action against Satyam management, or the auditors in this matter? As a matter of policy, the Board does not comment on SEC investigations.
Don’t forget Deloitte has its own subprime/crisis litigation already on the docket. They are named in lawsuits related to the acquisition of Merrill Lynch by Bank of America and the failure of Bear Stearns, as well as the bankruptcy of Washington Mutual.
PwC, EY and KPMG are named in significant Madoff feeder fund litigation and it looks like those cases are starting to move through the courts. There are billions of dollars in damages that will probably be paid.
Each of the largest global audit firms could take a hit of $1 billion if forced to. They would find a way to come up with the cash. But they don’t want to. A $1 billion dollar settlement would make a significant impact on any of the firms. A settlement or judgment, especially of that size, would make it very difficult to stay in business even if the firm remained technically viable.
But there are several $1 billion claims out there. All four of the largest firms are suffocating under the weight of the potential claims and the cost to defend them as well as the distraction from normal business activities and the impact on morale.
The Big 4 feels the pain on a rotating basis, only for a short for a while, and only whenever a painful exposé such as the Lehman bankruptcy report surfaces or a case gets closer to trial. Then the media moves on. Very few cases against the auditors went to trial in the past. There are many reasons for this. But the sheer volume of cases filed given number of scandals, frauds and failures, is giving plaintiff’s lawyers and regulatory enforcement more practice than ever before. The plaintiff’s lawyers, in particular are talking to each other, sharing information and getting better at their arguments with each filing.
The tide’s gone out and left the audit firms high and dry.
Which case will be the showcase trial of the new millennium? Which billion dollar case will make it to the jury first? Which case will force legislators and regulators to admit the business model for public accounting is irreparably broken?
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