The UK accounting firms’ response to the “pressure” on their industry post-crisis has been sharp, quick, and on message.
But the “pressure” itself feels like a strategy orchestrated by the audit firms to force legislators to grant their wishes under the mistaken assumption they’re “regulating” the industry.
Let me break it down for you.
There’s been much more noise made by legislators and regulators in the UK regarding the auditors’ role in the financial crisis than in the US. Banks failed there, too. The government bailed them out, although it looked more like nationalization. The difference is they’re not afraid to admit it.
Mainstream media publications such as the Financial Times and the Guardian have been full of stories about the auditors and what they did, and did not do, to warn of the crisis or mitigate the impact to investors.
The UK regulators have gone through the motions, wringing their hands. The angst has even spread to the European Union, where Michel Barnier has voiced overall displeasure with the audit firms and threatened new laws and regulations.
But the firms’ master plan hit a speedbump at end of November. The leaders of the largest audit firms – Ian Powell, chairman of PwC UK, John Connolly, Senior Partner and Chief Executive of Deloitte’s UK firm and Global MD of its international firm, John Griffith-Jones, Chairman of KPMG’s Europe, Middle East and Africa region and Chairman of KPMG UK, and Scott Halliday, UK & Ireland Managing Partner for Ernst & Young – appeared before the House of Lord’s Economic Affairs Committee and let their cat out of the bag.
The auditors admitted they did not issue “going concern” warnings for any of the large banks that were eventually nationalized because they were assured during private, confidential meetings with government officials – Lord Myners in particular – that the government would bail out the banks if needed.
The admission was “astonishing” said one member of the Committee, Lord Lawson.
Accountancy Age, November 23, 2010: Debate focused on the use of “going concern” guidance, issued by auditors if they believe a company will survive the next year. Auditors said they did not change their going concern guidance because they were told the government would bail out the banks.
“Going concern [means] that a business can pay its debts as they fall due. You meant something thing quite different, you meant that the government would dip into its pockets and give the company money and then it can pay it debts and you gave an unqualified report on that basis,” Lipsey said.
Lord Lawson said there was a “threat to solvency” for UK banks which was not reflected in the auditors’ reports.
“I find that absolutely astonishing, absolutely astonishing. It seems to me that you are saying that you noticed they were on very thin ice but you were completely relaxed about it because you knew there would be support, in other words, the taxpayer would support them,” he said.
I found the admission to be quite astonishing myself. I reprinted it on my site, based here in the United States, and some in the US also found it rather astonishing.
But the revelation was never reported or explored further here in the US by any other journalists. Last week, Lord Myners refuted the auditors’ version of their meetings with him during the crisis.
Reuters London, January 18, 2011: “It was not my task to give them comfort,” Myners told the economic affairs committee of Britain’s upper house of parliament.
After that meeting the auditors gave unqualified endorsement to the accounts of UK banks as going concerns even though the government had to support the sector, sparking public anger.
Auditors surprised the parliamentary committee last November by saying they had been reassured at the meeting with Myners that there would be government help for banks in trouble.
Myners said he had only repeated statements made by the government that it was committed to taking whatever action it regarded as necessary to maintain financial stability.
He ended the meeting by stressing the need for “clear, fair and honest” annual reports for 2008 and had not “given some all embracing guarantee that, come what may, that bank shareholders” would be protected.
“I did not want them to go away thinking the weight of responsibility has gone away, we can rely on the minister,” the former UK financial services minister and top fund manager said.
It was up to a bank’s directors and the auditors whether annual reports needed qualifying comments about going concerns.
On Monday this week, the Financial Times reported that Big 4 audit firms responded to a European Commission white paper from October on possible market reform by expressing their, “willingness to work on contingency plans with regulators – albeit at national or regional member firm level, rather than for their global networks.”
Ah yes… I think the fiction of the “global network” model was #7 on my Top Ten Things Lawyers Should Know About Auditors.
7. You know what Global Network means? It means shifting blame. The audit industry is a profitable $100 billion revenue global business, employing hundreds of thousands of people. The “Global Network” is the legal vehicle the audit industry uses to drive liability around, in the Big 4 version of ”Catch Me If You Can.”
The Financial Times describes the PwC solution to the failure of an audit firm network member somewhere in the world that threatens to take down an entire firm, a la Arthur Andersen. Their solution: Create a clean shell firm for the good clients and team and discard bad clients, partners, and staff in a throw-away firm.
PwC has floated the idea of developing a process that would allow “untainted” staff from a stricken member firm to transfer to a new entity under fresh management, possibly under the supervision of a trustee.
This, it said, could stop problems at one member firm from bringing down a whole network, as happened with Andersen.
PwC has a lot of experience with this “good-bank/bad bank” solution. They did it in Japan after the Kenebo scandal. They’re doing it in India post-Satyam. PwC global leadership swooped in almost immediately and took control. They pruned the Indian firm of the unwashed, diseased members by design – terminations – and by default – defections. They converted the most promising consulting business – outsourcing – to a joint venture between the US, UK and Austrailia, essentially eliminating the influence of the Indian partners since they “couldn’t handle the potential of the business.”
Deloitte’s solution is to cut off the gangrenous member firm arm immediately to stop the spread of the disease. Continuing, from the Financial Times:
Similarly, KPMG envisages a “resolution regime” to license a replacement firm while Deloitte is talking of a “reboot” facility. Stuart Diack, a Deloitte associate partner who has been working on its proposal, said the goal would be to cut out compromised parts of the affected firm in order to avoid a “disorderly run to the hills” by clients and the rest of its staff.
But while such an approach could stop the audit profession shrinking from four to three dominant firms, he acknowledged that there would be complications, including the difficulty of rapidly establishing which employees were involved in any wrong-doing.
That’s a familiar scenario for Deloitte. Deloitte stood by and watched as Grant Thornton abandoned their Milan member firm as a result of the Parmalat fraud litigation. That fraud cost Deloitte hundreds of millions in settlements, including an unprecedented contribution by their international firm towards closing the books on that disaster.
Unfortunately, the Parmalat door is open again for Grant Thornton. An Appeals Court reversed a decision by New York’s Judge Kaplan. Seems Judge Kaplan may have overstepped his authority in resolving that case in New York rather than in Chicago.
KPMG knows that being under the thumb of a federally mandated monitor in the event of a near-death by litigation is the lesser of two evils. Their leadership decided quickly who was at fault in their tax shelter scandal, threw their own partners under the bus – and withheld funds for their defense – then cut a deal with the Department of Justice. They’ve survived to thrive.
Continuing, from the Financial Times:
John Griffith-Jones, joint chairman of KPMG’s main European firm, suggested that regulators might need to compel clients to stay with a stricken auditor temporarily.
He also argued that the risk to markets posed by the Big Four was less severe than banks because they did not lend to each other.
Well, the firms can take care of retaining clients – and staff – in the event one of them is stricken. They’ve done it before – made agreements amongst themselves, I’ve heard, to refrain from poaching clients or staff when the KPMG tax shelter crisis hit. More recently their idea of calming the storm when Ernst & Young was skewered in the Lehman Bankruptcy Examiner report was to agree together not to approach their clients. But those are gentlemen’s agreements. Or, rather, pinkie-swear honor amongst thieves.
Tentative at best.
And then the Financial Times reported the pièce de résistance:
Each of the Big Four said the risks run by auditors were sufficient to warrant liability caps, however.
It’s not news that the firms want liability caps.
They want them bad.
From The Times of London Online in April 2009:
Leading accountants will meet the Government this week to plead for protection as they prepare for a surge in litigation from investors trying to recover their losses from big company failures.
The Big Four — Deloitte, Ernst & Young, KPMG and PricewaterhouseCoopers (PwC) — are braced for an increase in legal action from investors and liquidators as the economic crisis continues.
The [US] SEC fears that directors and auditors could cut secret deals under which auditors are given proportionate liability in return for glossing over the company’s accounts.
Some of the cases I mentioned in the post that used this quote in April of 2009 have been settled. But, since then, there have been new ones, in particular the cases against Ernst & Young for the Lehman failure. As soon as the auditors settle one or two, more pop up like a very expensive and time consuming game of whack-a-mole they can’t win given their current strategy.
Limits on liability – liability caps – are the solution auditors want to the problem – audit failure – that they themselves create. It’s what they want more than anything. They’ve humbly gone along with legislators foaming at the mouth long enough to turn it around to their favor.
It’s eerily familiar to what happened after Enron. In spite of the fact that the auditors, Arthur Andersen in that case, were clearly part of the problem not the solution, the audit firms reaped the huge benefits of the fix.
Liability caps are a pretzel logic moral hazard that legislators in the UK, and probably in the US, will soon beg the audit firms to accept.