The financial crisis is now about fraud.
The word that dared not be uttered, even behind closed doors, has now disturbed the peace of a nascent “recovery.” Why did it take so long for the media, the regulators and the legislators to acknowledge what some of us have known for a while?
“Gentlemen, not one of you could have done this on your own. This was a team effort.” Casey Stengel after the Mets 40-120 season.
Why didn’t the Big 4 audit firms warn that these obscenely over leveraged institutions threatened our financial future? Why didn’t the auditors question, push back, or raise objections to illegal and unethical disclosure gaps? Every one of the failed or bailed out financial institutions carried non-qualified, clean audit opinions in their wallets when they cashed the taxpayers’ check.
Lehman Brothers. Bear Stearns. Washington Mutual. AIG. Countrywide. New Century. Citigroup. Merrill Lynch. GE Capital. GMAC. Fannie Mae. Freddie Mac.
The largest four global audit firms – Deloitte, Ernst & Young, KPMG and PricewaterhouseCoopers – have combined revenues of almost $100 billion dollars and employ hundreds of thousands of people. There’s no hard proof they’re completely corrupt, but they’ve proven themselves to be demonstrably self-interested and no longer singularly focused on their public duty to shareholders.
Something is rotten with the accounting industry.
America’s public accountants – in particular, the Big 4 audit firms – aren’t protecting investors. And no one is holding them accountable.
The crisis that culminated in the near-collapse of the global financial system is still the subject of Congressional hearings.
Almost every player has been called to account.
Last month the Lehman Bankruptcy Examiner’s report told us that, “sufficient evidence exists to support colorable claims against Ernst & Young LLP for professional malpractice arising from [their] failure to follow professional standards of care.”
This week the Securities and Exchange Commission charged Goldman Sachs and one of its vice presidents with fraud for misleading investors by “misstating and omitting key facts about a financial product tied to subprime mortgages.”
That financial product was a structured collateralized debt obligation (CDO) that hinged on the performance of subprime residential mortgage-backed securities (RMBS). Goldman Sachs, according to the SEC, failed to disclose vital information about the CDO to investors. In particular, John Paulson’s hedge fund, a Goldman client, played a leading role in the portfolio selection process and the hedge fund took a short position against the CDO, without disclosure to Goldman’s other clients.
In one of the most egregious cases of auditor complacence during the financial crisis, Pricewaterhouse Coopers LLP (PwC), the firm that audits both AIG and Goldman Sachs, sat on the sidelines for almost two years while their clients disputed the value of credit default swaps (CDS).
There’s been no public explanation of how PwC presided over the dispute between AIG and Goldman—a dispute that eventually pushed AIG to accept a bailout – without doing something decisive to help resolve it. This long-running “difference of opinion” between two of PwC’s most important global clients was arguably material to at least one of them. Why didn’t PwC force a resolution sooner based on consistent application of accounting standards?
PwC was paid a combined $230 million by the two firms for 2008 and remains the “independent” auditor to both companies.
Gatekeepers? Or foxes in the hen house?
The auditor’s role is to be a gatekeeper. A watchdog. An advocate for shareholders. This is their public duty.
This public trust is subsidized by a government-sponsored franchise. All companies listed on major stock exchanges must have an audit opinion. Audit firms are meant to be shareholders’ first line of defense, and they are hired by and report to the independent Audit Committee of the Board of Directors.
And yet the same audit firms that stood by and watched Bear Stearns and Lehman Brothers fail – Deloitte and Ernst &Young – are recipients of lucrative government contracts to audit or monitor the taxpayers’ investment in the bailed out firms. Deloitte, the Bear Stearns and Merrill Lynch auditor, works for the US Federal Reserve system. Ernst & Young, Lehman’s auditor, is working for the US Treasury on the original $700 billion TARP program and with the Fed on the AIG bailout.
Who are we kidding?
America’s auditors serve themselves. Focused on “client service” not shareholder advocacy, they’ve remained above the financial crisis finger-pointing fray. Call it skillful lobbying or targeted political contributions… Either way, regulators and legislators have been afraid of getting on the auditors’ bad side.
Investment banks, mortgage originators, commercial banks, and ratings agencies have all been questioned about their role in the crisis. And the Big 4 public accounting firms work for all of them.
But when accused of negligence, malpractice or complicity, the audit firms frequently claim to have been duped. Do you believe them? The industry is an oligopoly. That’s a $10 word for what happens when a market or industry is dominated by a small number of sellers who discuss their strategies in order to achieve common objectives.
The Sarbanes Oxley Act of 2002 (SOx) was enacted after the Enron debacle to restore confidence in the audit profession. Instead, accounting firms reaped huge financial rewards while enforcing SOx, until the tremendous cost to America’s businesses forced regulators to lighten up and the auditors to stand down.
But SOx had another insidious byproduct: the misplaced belief that after Arthur Andersen’s implosion, the remaining four global public accounting firms were too important, and too few, to fail.
This fear of auditor failure precludes any regulatory or legislative actions that might precipitate the loss of another large accounting firm. What do you get when there’s no timely or significant regulatory consequence to repeated auditor malpractice and incompetence? Moral hazard. “Too few to fail” has been as detrimental to capital markets as the notion that some financial institutions are too big to fail. Shareholders are harmed and investors lose confidence.
Every one of the audit firms is a defendant in lawsuits for institutions that failed, were taken over, or bailed out, in addition to several $1 billion plus malpractice, fraud and Madoff-related lawsuits. Any one of these “catastrophic” matters could threaten their viability. However, regulators and the worldwide business community are ignoring this threat or, worse yet, promoting liability caps. Limiting liability only exacerbates moral hazard.
Can a crisis caused by “catastrophic” disruption in audit service delivery be any worse than the one they never warned us about? Why not face fears head on and start re-writing the audit blank check – ineffective audit opinions – before the plaintiffs’ bar does it for us?