The harder they fall: Will the Big Four survive the credit crunch?
Ever since Arthur Andersen left the market after its scandalous role in the fall of Enron, people have been asking how long it will be before another big firm follows suit. The (UK) Financial Reporting Council (FRC) has been trying ever since to make sure that the Big Four will be protected if found guilty of similar negligence. The introduction of limited liability should help, but given the accelerating meltdown of the global financial system, will it be enough?
As always, and as was the case with Arthur Andersen, it will be events in America that determine the fate of the Big Four. This summer the U.S. Treasury's Advisory Committee of the Auditing Profession met in Washington and heard that between them the six largest firms had 27 outstanding litigation proceedings against them with damage exposure above $1 billion, seven of which exceed $10 billion. It is impossible to buy insurance that will cover such catastrophic liability and any one of them, if successful, could prove a fatal blow.
That U.S. Treasury committee met again last week to discuss the viability of limited liability for auditors in the U.S., but the 21-strong panel decided against it. With that, the hope of some silver bullet solution to the Big Four's problems expired. Committee member Lynn Turner, formerly a chief accountant to the Securities and Exchange Commission (SEC), was plainly baffled such an idea had even been seriously suggested.
"Do you believe that an auditor found to have been aware of financial reporting problems but never reporting them to the public should be the subject of liability caps or some type of litigation reform protecting them?" he asked. Turner summed the situation up nicely when he described the big accounting firms as a "federally mandated and authorized cartel" which was "too big to [be allowed to] fail".
When Arthur Andersen went down six years ago, Turner had never been quite able to believe that the firm's bad behavior had really been all that anomalous. "It's beyond Andersen," he told CBS Frontline that same year, "it's something that's embedded in the system at this time. This notion that everything is fine in the system just because you can't see it is totally off-base."
The credibility of the markets
Looking at recent economic events, Turner's suspicions that the credibility of the markets were at stake has plainly proved prescient. So too may his belief that unethical accounting was not so much a case of a few bad apples, but a bad barrel.
Consider some of the recent and outstanding claims against the biggest six firms. In Miami last August a jury ordered BDO Seidman to pay $521 million in damages for its negligence in a Portuguese bank audit; almost as much as the firm's estimated revenue for that year. In the U.S., banks and the shareholders of banks are perfectly prepared to go after auditors, and when they win they tend to win big. Note than when Her Majesty's Treasury hired the BDO's valuation partner Andrew Caldwell for the controversial Northern Rock valuation, they hired the man and not the firm. The firms are already worried enough about litigation.
KPMG provides a clear example of how the credit crunch might cull the Big Four. The firm was already looking vulnerable before it hit: there was the 2005 'deferred prosecution' agreement with the New York Attorney's Office, the damning German probe into the Siemens bribery scandal, a lawsuit from superconductor company Vitesse for 'audit failures,' and a minor fine from the UK's Joint Disciplinary Scheme (JDS) for allowing fraud to occur at Independent Insurance (it may only have been half a million, but it was the JDS's biggest fine to date). But when the subprime problems of U.S. lender New Century enter the picture, the damages involved escalate drastically.
An independent report commissioned by the U.S. Justice Department has already concluded that KPMG either helped perpetrate the fraud at the mortgager or deliberately ignored it. Class-action lawsuits are already pending. Only weeks before the report was published the U.S. Supreme Court's Stone Ridge ruling immunized third party advisers like accountants and bankers from the disgruntled shareholders of other entities, but that may be not much of a shield. Of course, New Century might not be KPMG's biggest problem. That's probably the Federal National Mortgage Association, or Fannie Mae.
Fannie Mae initiated litigation way back in 2006, and is trying to reclaim more than $2 billion from its old auditors (the lender has already agreed to pay the SEC $400 million). KPMG's defense so far has been one of complete innocence, asserting that Fannie Mae successfully hid all evidence of anything untoward. Now that the FBI is investigating the mortgage lender, such a position will have to be abandoned if incriminating evidence turns up. Ostensibly, the Federal investigation relates to Fannie Mae's relationship with ratings agencies, but you never know what will fall out of the closet.
So KPMG is in a spot of bother, but it's not alone. Ernst and Young will almost inevitably see itself in court over the demise of its audit client Lehman Brothers. Similarly, PricewaterhouseCoopers is surely going to feel some heat for its auditing of what was once the world's largest insurance company, AIG, assuming the Northern Rock Shareholders Group doesn't take a pop at it first.
"It's not that the Big Four are 'too big to fail'," as International Herald Tribune columnist Jim Petersen put it. "They can fail, and there is nothing on the table to save them."
But never mind the Big Four. Some, like Richard Murphy of Tax Research UK or Anthony Hilton of the Evening Standard, have questioned whether audit itself can survive. When our anxieties over the financial markets have eased, it won't just be the experts wondering how useless these statements are. When the Big Four finally shrinks, there will be collateral damage.