When Auditors Get Mixed Up In M&A, Smaller Clients Get Hurt
Over at Medium.com I’ve written about a new academic study, Shared Auditors in Mergers and Acquisitions, to be published soon in the Journal of Accounting and Economics that documents an interesting, rarely commented on auditor conflict of interest. The data suggests that when an acquiring company and its target share the same auditor, the audit firms favor acquirers at the expense of the smaller target audit clients. The researchers are also more bold than I have ever seen in an academic study in alleging that auditors prioritize their own self-interest and larger clients by using confidential information about the smaller clients to benefit the big ones.
From the study:
“Results suggest that auditors frequently violate their duty to put the interests of their clients ahead of their own in what appears to be a failure to protect confidential client information within their practice offices.”
There are plenty of studies that talk about shared advisors in M&A like investment banks and lawyers. (There is also a study cited in the above paper and also to be published soon in the Journal of Accounting and Economics that focuses solely on the finance impact of this shared auditor scenario, Cai, Kim, Park and White (2014)) Banks and lawyers are well known to favor the larger clients. But companies choose those advisors for the deals and, I assume, do so willingly and knowing that conflicts must be managed.
From the study:
We anticipate that shared auditors may favor acquisitive clients over targets for at least two reasons. First, an auditor’s long-term incentives (even within an auditor’s practice office) are more closely aligned with those of their acquisitive clients. Our intuition follows that applied to shared investment bank advisors who are more likely to favor acquiring firms when representing both a target and an acquirer in the same deal (Agrawal et al., 2013).
And…
We do not incorporate selection into our main analysis as selection issues with shared auditors in M&A appear to be less of a concern as compared to shared advisors in M&A deals (Agrawal et al., 2013). This is because both an acquirer and a target make the explicit choice to have a shared investment bank advise each of them for a specific transaction. In contrast, a shared auditor is a result of both a target and acquirer independently contracting with an audit firm to receive audit services prior to a bid being announced.
Recently the New York State Department of Financial Services (NYSDFS) fined and sanctioned Deloitte and PricewaterhouseCoopers for sacrificing independence, integrity and objectivity while providing consulting services to Standard Chartered and Bank of Tokyo-Mitsubishi, respectively, that were mandated by regulatory sanctions against the banks. These regulatory actions go beyond a typical focus by the SEC and PCAOB on the audit relationships of public accounting firms only.
From my article at Medium:
All of the largest public accounting firms provide advisory services that fall between the cracks of what the US Securities and Exchange Commission — which regulates public companies and their audits — and the PCAOB — which regulates auditors of public companies in a post-SOx environment — think they are supposed to monitor.
If you still think auditors would never risk the reputational damage of getting caught sharing confidential information to benefit one client over another, just look at what NYDFS says Deloitte did for Standard Chartered.
From a report I wrote for Forbes at the time:
[The NYDFS] fined the firm $10 million this week and banned Deloitte from accepting new consulting engagements at financial institutions regulated by Lawsky. Deloitte’s violations took place while standing in the shoes of the regulator as a “monitor” at Standard Chartered. The original Deloitte engagement was the result of a 2004 joint written agreement between Standard Chartered and the New York State Banking Department – a DFS predecessor agency – and the Federal Reserve Bank of New York which identified several compliance and risk management deficiencies in the anti-money laundering and Bank Secrecy Act controls at Standard Chartered’s New York branch.The order addresses Deloitte’s “misconduct, violations of law, and lack of autonomy during its consulting work” at Standard Chartered Bank on those anti-money laundering (AML) issues.
From a press release from New York Governor Cuomo’s office:
DFS’s investigation into the conduct of firm professionals during its consulting work at Standard Chartered found that Deloitte:
Did not demonstrate the necessary autonomy required of consultants performing regulatory work. Based primarily on Standard Chartered’s objection, Deloitte removed a recommendation aimed at rooting out money laundering from its written final report on the matter to the Department. The recommendation discussed how wire messages or “cover payments” on transactions could be manipulated by banks to evade money laundering controls on U.S. dollar clearing activities.
Violated New York Banking Law § 36.10 by disclosing confidential information of other Deloitte clients to Standard Chartered. A senior Deloitte employee sent emails to Standard Chartered employees containing two reports on anti-money laundering issues at other Deloitte client banks. Both reports contained confidential supervisory information, which Deloitte FAS was legally barred by New York Banking Law § 36.10 from disclosing to third parties.
All of the Big Four have corporate finance, broker-dealer subs that are hungry for M&A work. The Big Four also go down market and pitch smaller public companies as audit clients by pricing below cost, sucking them in at the pre-IPO stage and spouting aspirational crap.
Now we know just what they are up to. You, smaller private company, are paying a premium for the prestige of a Big Four auditor but you’re just chum for larger acquisitive shark audit clients. You may think that getting acquired is not such a bad thing. This study, however, says there is strong evidence you will be betrayed and cheated before you’re swallowed whole.
Main page photo courtesy FineArtAmerica.com and the artist Joan Pollack.