What litigation cost would kill a Big Four accounting firm? Since this column first appeared, the responses have been remarkably quiet on two aspects: neither any disagreement with the shockingly small numbers, nor any credible claim that a political or regulatory solution is achievable.
The Impact of Unheard Bullets
Originally published in the International Herald Tribune on December 16, 2006
Business vocabulary borrows freely from the military: control battles, hostile raids, road warriors, chain of command.
Today's example is this axiom of warfare: "You never hear the bullet that kills you."
Last week I was with a retired partner of a Big Four accounting firm who has plenty of reason to be on full alert for silent killers: His pension is contingent on the doubtful durability of the large firms' cartel to audit the world's large companies.
The discussion of possible changes in the regulatory regimes for corporate financial reporting is rapidly expanding. It includes a full menu of ideas proposed in Brussels, London and Washington. But the reactions to any proposal for serious adjustment to the American auditor liability regime range all the way from lukewarm to downright hostile.
Those antagonistic views are based on the disbelief that there will be another collapse. That, in turn, is based on the persistently erroneous view that the disintegration of Arthur Andersen in 2002 was caused by its Enron-related indictment.
Hear this now: The unheard deadly bullet was Andersen's litigation exposure. And that has grave implications for the remaining Big Four.
How likely is it that another big- firm implosion could happen? As with Andersen, it would involve an emotion-driven breakdown in confidence — the simultaneous outflow of clients, collapse of an international network and flight of partners.
Although client flight will be severely constrained the next time around, with the lack of auditor choice available when the current Big Four drops to three, the other two factors can be quantified. And it's not a matter of exposure to prosecution.
While we await a promised talking paper from Charlie McCreevy, the European Union commissioner for internal markets and services (now available -- see here) , a supporting report prepared for him on Oct. 4 by London Economics, a consulting firm (here) , has calculated the size of the litigation hit that would disintegrate a large European linchpin accounting practice.
The report's assumptions, extended to the more threatened U.S. litigation environment, are truly scary in that they demonstrate the fragility of the large accounting firms' franchise.
To set the stage, recall that there are three reasons why the large accounting networks are forced to finance their large litigation settlements out of their partners' future profits:
First, by local codes they are barred from access to public shareholders or other equity investment.
Second, the partners' personally invested capital is on demand for working purposes.
Third, the insurance market no longer provides real risk transfer, but instead is at most a source of time- shifting finance.
The key to survival, then, lies in the willingness of the partners to stay committed and at their desks — something that the Andersen partners did not possess, as proved by the two- week period in 2002 during which they bailed out en masse and thus smashed the firm beyond recovery.
The study done for McCreevy calculates that the partners of a European firm would bolt, in numbers large enough to be destabilizing, rather than be forced to finance a litigation payment that extracted a profit reduction of 15 percent to 20 percent spread over three to four years.
Applying those assumptions to the Big Four's latest reported U.S. revenues of $4.7 billion to $8.7 billion (write me if you want to hear the numbers crunch), the dispiriting result is that the U.S. firms will confront partner flight and possible failure at liability levels as small as $450 million and up to $1.8 billion.
Those amounts are modest to the point of insignificance against the size of this decade's financial debacles — examples ranging from the $20 billion hole in the balance sheet of Parmalat to Enron's own $67 billion bankruptcy. Little wonder there is no public support for liability caps in the auditors' favor at levels low enough to protect them from collapse.
These assumptions also make plain that the Enron-inflicted blow on Andersen was mortal. The firm's 2001 worldwide revenue was $9.3 billion. It confronted plaintiffs' lawyers claiming that the case would be the first against accountants to reach $1 billion. The crippled firm was already dealing with claims involving Baptist Hospital, Waste Management and Sunbeam, and it was about to receive the incoming bombardment of WorldCom and Qwest, among others.
So to blame Andersen's death on the Enron indictment misses the point. The firm was like a terminal patient on late-stage life support who happened to succumb to a fast-moving staph infection: Its demise was imminent, and inevitable.
The report this month (here) to the U.S. Treasury secretary, Henry Paulson Jr., on a broad-ranging set of proposals for regulatory change, notes that the Big Four's litigation inventory in the United States includes 22 actions, each with damage claims exceeding $1 billion — and that's without contemplating their lesser but not trivial cases, or the new matters that will inevitably arise in the months to come.
All of these will eventually be settled; witness the announcement last week that Deloitte will settle the shareholder piece of its Adelphia litigation for $210 million. Managements are too risk-averse to risk a life-threatening jury result at trial.
The Big Four might each survive one such impact from this barrage of lawsuits — although even that is a big if. But a second direct hit on any of them would be the last explosion they ever heard.