Re:Balance -- Jim Peterson

BDO's Liability for the Bankest Verdict Against Seidman: Whose Side to Take?

Ham-and-eggs for breakfast? To the hen, the choice is a matter of interest. To the pig, it’s life or death.

On the complexities of auditor liability and accounting firm survival, a reader last week had a subtle question. It concerned the Miami state court outcome in the Bankest litigation – where the BDO international firm was held not liable for any part of the $521 million jury verdict imposed in June 2007 against its US component, the Seidman accounting firm.

For the American partners of Seidman, the dispute now moves to its penultimate phases of appeal and possible enforcement of ruinous damages -- $170 million plus an additional punitive assessment of $351 million -- with this question:

As interested spectators of the trial just ended, which sought to hold BDO liable along with the Seidman firm, which side would they have been rooting for?

That is, facing financial devastation (for the calculations, see the Note below) – would they have preferred that their international brethren be put under judicial fiat to share their pain? Or are they better off standing alone – facing ruin, and hoping to rely on the strength of their network and the readiness of their colleagues to provide succor on the basis only of network agreements and business solidarity?

And in the end, will it matter? 

Those whose work is with the assessment and management of disputes look with envy on their counterparts who deal with allocating good and positive economic outcomes. Business lawyers, for example, thrive on the deals and contracts that include mutually shared profits, repeat business with counter-parties and the nurturing of on-going relationships.

The supporting literature of game theory and decision strategy offers exquisite exercises in dividing the results of negotiations -- heavily biased toward optimistic scenarios. Case studies on shared outcomes focus on happy conditions: the division between two strangers who find a wallet full of money, or how and whether to share the pay-off of a winning lottery ticket received as a gift.

The outcomes under dispute scenarios go the other way: typically they are zero-sum between one-time antagonists; lawsuits involve wasting assets and the steady bleeding of costs, legal fees and business pressures.

And the impositions of shared punishments or detriments are not the subject of useful scrutiny: litigation lawyers suffer the scholars who default to the platitudes of “re-framing for a ‘win-win’,” or “finding a way to ‘yes’.”

The real world doesn’t work that way. In the Bankest case, the impending next steps include the plaintiff’s pursuit of finality and collection of a half-billion dollars, the challenged viability of BDO as an international enterprise and the careers of its several thousand professionals, and – considering that Bankest is only a smaller version of the much bigger cases hanging over the Big Four – a clarion warning on the survivability of privately provided, large-company audit services.

Either way – whether BDO was formally held liable or not -- the final chapter for Seidman and BDO is ominous. The collapse of the Andersen network in 2002, within weeks of the indictment of its US firm – through the flight of clients, partners, personnel and the international entities – showed the fragility of the wealthiest and most cohesive of the large accounting structures.

Just as Andersen’s ex-US practices voted their local interests with their feet, it remains to be seen how the business and integrity of the BDO network could withstand the drain needed to sustain its vital US member firm.

And whether a Miami court judgment might affect BDO’s strategic choice between its own disintegration and collapse, and massive sacrifice for the sake of its US member firm, will be a matter not of legal enforceability but of corporate behavioral psychology at the highest level.

The graduate students in my MBA class on risk management and decision-making are always in need of good assignments. As the Seidman/BDO dynamic plays along, it will provide a rich if depressing study.

Please let me know – for whom would you have cheered, and why?  

Note: A model to calculate how big a “litigation hit” would disintegrate a large accounting firm was done by a UK consultancy for EU Markets Commissioner Charlie McCreevy – here. I have applied it to the Big Four’s American and global practices – here and here. The topic is anathema to the large firms, but they have not voiced public disagreement with either the approach or the frighteningly small numbers.

Based on Seidman’s reported 2008 revenue of $ 659 million and the BDO networks’ global figure of $ 5,145 million, the model indicates breakup thresholds of around $ 100 million for the US firm of Seidman on its own, and perhaps $ 750 million for the BDO network as a whole. Look on the Bankest verdict at $521 million – and despair.

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Re-Post: The Supreme Court Targets the PCAOB: If Things Could Hardly Be Worse, Might They Perhaps Get Better?

For reasons known only to Mercury, the god of communications, this post from Thursday was not fed to most subscribers. So this re-posting, with apologies to anyone finding or receiving it a second time.

When I went to make breakfast on Tuesday, I found a tempest swirling in my teapot: the report that the United States Supreme Court is to resolve a constitutional challenge to the law establishing the Public Company Accounting Oversight Board – created by the post-Enron legislative spasm of the Sarbanes/Oxley law of 2002.

This is an abstruse squabble over the scope of the presidential authority to appoint government employees classified, without any apparent irony, as “inferior officials.”

Paying almost no attention, the mainstream American media have their priorities right, putting their focus instead on the Court’s agreement the same day to review the criminal conviction of corporate kleptocrat Conrad Black.

The news-consuming public, in other words, understandably has less interest in whether a bunch of rascals are to be thrown out, than if one should be thrown in.

I’m not generally one for wagering, for reasons I’ve spelled out – here – life already being sufficiently full of risks and hazards. But the easiest signal of the high court’s acceptance of the PCAOB’s legitimacy would have been to leave standing the lower courts’ orders. So it is a decent prediction that some time in next year’s term, the axe will fall.

And then?

And then will come the kind of grandstanding that Washington does so well. Led in the Senate by Chris Dodd (D-Conn.), chairman of the Banking Committee, and in the House by Barney Frank (D-Mass.), chairman of the Committee on Financial Services, the elected mob – of whom humorist Will Rogers sagely observed that “no man’s purse is safe while the legislature is in session” – will serve up a new kind of bail-out.

Which is, they will resuscitate the old agency in a new guise, only this time arrayed in bells and whistles reflecting their politicized reaction to the economic turmoil lately inflicted on us all.

And where will the vitally-interested accounting profession figure?

Historically, the high point of their influence lay in securing the franchise of privately supplied assurance, under the audit requirements of the securities laws of 1933 and 1934. In the following three-quarter century, sadly, the degree of attention and respect given to the auditors in the shaping of their regulatory fate has been like that in the research into shark feeding, as given to the food.

Because the Democrats control both houses of Congress and have their rock-star in the White House, the “appointment authority” issue will be repaired with the legislative equivalent of a piece of duct tape or a whack with a wrench. Making it a total non-event, the fix-up will include a wholesale re-adoption and ratification of everything wrought by the then-defunct PCAOB, so the transition will be seamless and invisible – turning the entire affair into little more than an ego exercise for those angling to get their names into the law case reports.

It’s necessary to remember that the Supreme Court’s power runs only to the narrow questions offered. It will not do a qualitative assessment of all the mischief since Sarbox was enacted – not answering, for example, the question that could be reasonably asked by, say, the battered investors in Bear or Lehman or Merrill or Citi or AIG: “Over the last seven years, has the PCAOB made the world of financial reporting and assurance a better place?”

Which means there is nothing to be served by trying to pick a winning side in this punch-up: there isn’t one, in any way that matters.

If adult perspective prevails, the accounting profession will resist the lure of friend-of-court advocacy, saving itself both large legal fees and whatever amity it might salvage for the lawmakers’ debate to come.

For there is now a window, of perhaps six to nine months, in which a blueprint might be developed for the successor agency to be enabled when the Supremes pull the PCAOB’s plug.

Avoiding the post-Enron stampede that flattened all before it in the rush to Sarbox – footnote below -- the accountants along with whatever friends they can muster have the chance to organize in support of a coherent and achievable structure – here.

Namely: federal-level chartering of auditors of US public companies could be combined holistically with standard-setting, oversight, inspection and discipline -- along with investor protection including insurance that would be industry-funded but government-backed, to relieve the firms’ current “survivability” issue – namely, the deadly overhang of life-threatening litigation exposure.

Ambitious – yes, surely. But Dodd and Frank will have their law-drafting pencils sharpened anyway. The opportunity to write on a blank page is too good for the profession to waste.

Note: As I wrote back in July 2002 about the Senate’s passage of Sarbox, “any legislation receiving the bipartisan margin of 97-0 is bound to be fundamentally defective.” You’ll have to trust me, though; as the International Herald Tribune for whom I was then writing in Paris moves closer to full absorption by its parent, the New York Times, its archive has somehow disappeared from internet accessibility – here.

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Which Large Accounting Firm Will Be "Next to Fail"? It's the Wrong Question

When was there ever so concentrated a burst of public speculation on “which Big 4 audit firm is the next to fail”?

Within a single week, Accountancy Age predicted it would be Ernst & Young; in the blogosphere, Francine McKenna’s wager with Dennis Howlett fingered her ex-employer and bête noire, PwC; and ProPublica reached into the remains of the second tier to round on McGladrey and BDO.

All for very serious reasons, ample to cause sleepless nights among the profession’s leaders. But the voyeuristic speculation as to “which one” is a pointless and mis-directed exercise, because each of these firms – but also Deloitte and KPMG, and Grants too, for good measure – faces multiple overhanging threats on a mortal scale.

All the chambers are loaded in this losers’ game of Russian roulette. So it is an unanswerable question, where the weapon may be pointing when the hammer falls next. It’s also an irrelevant query, too – because it depends entirely on the judges’ docket management on Parmalat, Satyam, New Century, AIG, Bankest, Refco, Sentinel, the Madoff feeders and all the other ticking time bombs.

Instead, the real question should be, “What next?”

On this, for grown-up dialog to occur, two fundamental misconceptions – both lurking in the Accountancy Age article – have to be killed off, once-for-all:

The first is that the large firms’ survival will somehow be assured by government, on the assertion that global-scale companies “will invariably have a legal requirement for an audit.”

If there is any logic here, it is seriously inverted. The regulators long ago conceded that they would be powerless to stop the disintegration of a large firm that reached a tipping point – here and here. Further, when that next step takes down the other three, and unravels the entire suppliers’ market, legislative mandates that there be audits would be as futile as a requirement that all trains be hauled by steam locomotives. No more suppliers: no delivery. Period.

The second fallacy, conspicuous even in an article that displays a truly stunning lack of comprehension of the profession’s structural issues, is that a Big Three would survive the loss of a fourth.

Won’t happen. The uneven concentrations of industry expertise around the world’s large economies, the politically-imposed constraints on auditor choice, and the post-Andersen fragility of the international networks are alone sufficient to show that the Big Four are already down to an irreducible tipping point. One more, and they all go.

While no insider will say so in public, senior risk managers acknowledge that in the coming turmoil of another Big Four failure, the prospect that three survivors would stay in today’s business by accepting further concentration of exposure and liability will be untenable.

That a fundamental re-structuring of the profession will occur is beyond debate – and is nothing new – although answers will only lie in the readiness of all interested parties to get past the posturing to offer constructive, achievable solutions.

Trouble is, none of the critics have either the vision or the authority to lead. There is no available government intervention, to “save” a privately-capitalized Big Four partnership once slipped into a death spiral – here. Nor can the large firms’ collective survival be enabled by statutory requirements that there be audits; if a firm goes down and takes the others, it is as futile as King Canute’s attempt to order the tides, to require delivery of an audit report when the providers are all out of business.

The only alternative to a highly-disruptive disintegration of the large firm networks – and a long shot wager indeed, requiring the most wild optimism to imagine – would be the emergence of Big Four leadership prepared to engage, for the sake of their future, in the “creative destruction” brought forward in 1942 by economist Joseph Schumpeter:

•    To forswear the currently outmoded auditors’ report, which provides no value to the market and is toxic to the sustainability of the firms’ business model.

•    To cut to the heart of the critics’ animosity, by the deep finesse of voluntarily turning the task of issuing low-value “compliance assurance” over to nationalized agencies.

•    To allow the capital and investor markets to ascribe to “compliance audits,” performed by huge cadres of conscripted civil servants, the nominal value they would deserve.

•    To empower the surviving firms to invent, sell and deliver new forms of assurance that companies will buy, and the markets will pay for, under sustainable limits on liability and free of the life-threatening legal exposures as wielded by the class action plaintiffs.

•    To break the antiquated shackles of the compliance-driven limitations of “independence,” so as to build or acquire whatever professional services capabilities may be congruent with the new forms of assurance – whether in systems or technology consulting, finance, law or otherwise.

Starting down such a road would require envisioning an entirely new set of directions for the profession – beginning with the acknowledgment that the current race is going around a one-way track to a dead end. 

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Survival of the Large Accounting Firms -- You Wanna Bet?

How confident are you in what you think you know? How certain that the facts underlying your belief are fixed and unchanging?

A renowned food writer was dining on the bouillabaisse in a storied Marseilles restaurant. In a dazzling flash of cutlery at tableside, the server expertly beheaded, skinned and de-boned the platter of cooked fish for addition to the classic soup.

In response to the writer’s extravagant praise for her display of elegance and precision, the server was understated. “Madam, I’ve been doing this for thirty years,” she said. “Every night, the bones are in the same place.”

Not so, elsewhere. I was recently challenged to a non-trivial wager, by a highly placed member of senior management of a Big Four accounting firm. He is prepared to take the other side of this proposition, that the Big Four’s days are numbered:

“Within five years -- by March of 2014 --  one (or more) of the Big Four will have incurred an event because of which its network will be unable to provide a single report on the consolidated financial statements of a significant number of its large global clients.

“This event could be a civil litigation impact, prosecution or other law enforcement action, professional regulatory sanction, voluntary or strategic withdrawal in one or more key countries, or some other event the identity of which cannot be known today.”

A lot is certain to happen in the next five years. Not least, we should both hope to be around for the reckoning. And my side of the bet should be seen as a modest hedge against my firm belief that – whatever its problems and shortcomings (see here and here) – a worthy profession and those relying on it deserve a better fate than its disintegration into ignominy or irrelevance.

Still, we are at a legitimate standoff. He views me as academic and naïve, detached from the “reality” of the capacity for change in the market for professional services. I in turn view him as operating under several types of bias, of the type I explore in my MBA students’ Risk Management course.

With access to both a classroom and this platform, I have the advocate’s advantage:

First, with his optimism about the stability of the Big Four’s audit franchise that I only wish I could share, my friend shows the “proximity” bias of a handsome compensation package and regular paychecks that are, for the moment, accepted at financial institutions worldwide.

Second, he has the common “induction” bias that over-values what he knows, minimizing the credible likelihood of a disruptive unknown. He reasons that because it hasn’t happened before – that large-company assurance has become unavailable – therefore it won’t happen in the foreseeable future.

Third and closely related, he rationalizes as proof of the Big Four’s stability that it has survived the last decade’s close calls and danger signals. His conclusions of strength -- despite the 5-to-4 shrinkage after Andersen’s collapse, KPMG’s avoiding a tax-shelter indictment, and PwC’s near-death experience in Japan -- resemble the tragically optimistic rationalizations of NASA management, that the Challenger and Columbia shuttles were safe to fly, despite the prior evidence of O-ring burn-through or insulation impact damage.

Fourth, a typical “hindsight” bias in any projection is to minimize conditions changed for the worse. In evaluating the Big Four’s ability to survive, past experience should in fairness be adjusted for the steady escalation in claim and settlement amounts, the collapse all around of major institutions once thought invincible (all involving Big Four clients, incidentally), and an atmosphere of public hostility to both corporate malefactors and their proximate watch-dogs.

I am in this dialog wrongly charged as being the pessimist whose dour predictions, over enough time, will be proved right.

Like the server in the restaurant, I demur – not saying that Big Four collapse must necessarily happen, but that the prospects that it may are likely enough that deliberate, explicit attention and consideration are required.    

To my MBA students, this will be a stimulating if academic exercise. Out in the profession itself, under managements’ real obligations of stewardship to safeguard four enterprises that together employ 600,000 people and have worldwide revenue exceeding $100 billion, wishful thinking is not an option.

Nor is “hope for the best” a strategy.

It is, instead, a bet I will be sad to collect.

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Where Else Does Size Matter? Audit Firms, and the Experience in India

Suppose a law that limited the height of professional basketball players to six feet. Or that forbade the performance of Beethoven’s symphonies by groups of musicians larger than a trio.

However able the players, the performance quality would be inferior. Discerning customers would flee in multitudes, for venues freely offering the unrestricted alternatives.

Independent audit has evolved a great deal since the winter of 1850, when sole practitioner William Welch Deloitte delivered his first opinion on the financial statements of the Great Western Railway.

Today the surviving Big Four – Mr. Deloitte’s namesake, along with Ernst & Young, KPMG and PricewaterhouseCoopers – collectively comprise some 593,000 personnel, and have worldwide annual turnover of $103 billion. The foursome together have a lock on engagements for global-scale companies in the developed economies – doing the audits, for example, of all but a handful of the S&P 500 in the United States, all of the FTSE 100 in the United Kingdom, and (with the involvement of some smaller firms as joint auditors) all of the CAC 40 in France.

Ample justifications are offered – scale, technical expertise, cross-border client demands, and uniformity of standardized practices being the usual rationales. On the other side, careful risk managers at the smaller networks are ready to concede this high-risk territory to their larger brethren, competing at levels where complexity and exposure are, optimistically, more manageable.

There being no cogent case that the smaller audit firms deliver better quality than the larger, an argument in favor of scale lies in the recent disasters: critics of the still-emerging schemes of Bernard Madoff and Allan Stanford are quick to point out that each employed tiny audit firms, lacking visible signs of personnel or qualifications, or indeed even appropriate licensing compliance.

Still, vestiges of the Victorian era of Mr. Deloitte’s start-up do survive in the profession’s structure and attitudes. The visible current example is in India, where the governing rhetoric is dominated by the small firms’ unexcepted hostility to the Big Four – even ahead of this winter’s demonization of PwC over the $1 billion debacle at Satyam Computer Services Ltd.

As a legacy of an earlier and simpler provincial time, audit firms in India have been capped at no more than 20 partners, each allowed to sign no more than 30 reports. All very well, for an economy comprising thousands of store-front enterprises – served in India by as many as 45,000 little accounting practices. But hardly does this suit the demands of global-scale enterprises, where even the members of the so-called “second tier” continue to lose market share to the largest networks.

Overseers of the profession, including the Institute of Chartered Accountants in India and the Ministry of Public Affairs – with the combination of bombast and naïveté that is characteristic of officials extended beyond their vision or their competence – have responded to Satyam with a variety of retrograde proposals, including mandatory rotation of audit firms and a blacklist for firms under investigation -- see here, here and here – also scrutinizing such superficialities as the firms’ policies on paid leave and Institute seminars.

The first of these is already discredited by the example in Italy – the only developed country with experience. There, mandatory rotation only increased the Big Four’s market concentration, and the consequent division of responsibility between Grants and Deloitte arguably contributed to the on-going misbehavior at Parmalat.

And if the punishment of a blacklist were applied ahead of the conclusion and final judgment of appropriate enforcement proceedings, it would only perpetuate the lack of due process manifest in the continued imprisonment of the still-uncharged and presumably innocent Satyam engagement partners from Price Waterhouse.

As well observed in the natural sciences, evolution is a force that will not be stopped. It can only be diverted or stalled temporarily – through artificial means, political resistance or subsidies and expediencies.

Still, the trend to large-company auditor concentration has been inexorable for decades elsewhere, and is already well on display in India: at last available count, of the 300 largest corporate enterprises not under Indian state control, 178 were audited by a Big Four firm (of which 24 included a smaller firm along for the ride as joint auditor).

The lessons of Madoff and Stanford speak loudly to the credibility of small-shop audits for large-scale situations. “Small is beautiful” cannot be established by the claim that sometimes “large may be ugly.” Those positioned to shape the future of the profession in India will eventually be obliged to take heed.

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Prisoners of Satyam: Price Waterhouse Auditors Still Under Arrest

An eye for an eye and a tooth for a tooth.
The system seems fair
But is really quite ruthless.
For in time all involved
Become eyeless & toothless.  

The succinct wisdom of the late poet and trenchant social critic Jodie Hansen frames the dust-up started by my criticism of the extended jailing of the Indian audit partners of Price Waterhouse responsible for that firm’s work on Satyam Computers Services – here. That mis-treatment began with their arrest over the January 24-25 weekend and continues, bail applications having failed, apparently at least to late this month.

The PwC organization and its people have their hands amply full in defense, both in India and in the shareholder cases promptly filed in the US, and it is not my point, nor for anyone at this stage, to pre-judge the outcome.

Rather, it is right to scrutinize the means and quality of government response. One American reader, known to me as a wise counselor and teacher, wrote that:

“The Rule of Law has protected us (in America) from the get-go. Here we believe that not only must the result be in accord with law, we give equal importance to the process.”

The contrasting view of a reader in India was that my views were “totally objectionable,” on two grounds.

First, Mr. Ramakrishna asserts, “the Indian legal procedures and systems are far more stable and consistent than their counterparts in the US where far more fraudsters have gone scot-free.”

This is subject to test. Checking the recent roster of the post-Enron convicted and incarcerated – Messrs. Ebbers, Skilling, Fastow, Kozlowski, Black and Rigas come to mind, and adding Weiss and Lerach to boot – the wheels of justice seem to have ground along.

What would be fair grounds for criticism, though, to anyone evaluating the tax-payer impact of the world’s various bail-out packages or checking a retirement fund statement, is whether any of these machinations have wrought the least deterrent effect – either in the US or anywhere else in the world.

Mr. Ramakrishna goes on that “it is a good thing that the Government of India superseded the (Satyam) board and imprisoned the fraudsters – including the auditors.” His basis is evidently the long logical leap that audit quality is to be achieved by mandatory rotational appointment of auditors for a fixed term, and public posting to a website of all audit notes and working papers.

Global-level discussion has long since explored and declined to act on a roster of impractical and unachievable solutions to the persistent issues of audit quality – here. The only country to experiment with mandatory rotation is Italy, with conspicuous lack of success: There, required rotation led to an increase in concentration of large-company work by the large firms, while the 2003 exposure of a € 20 billion hole in the balance sheet of dairy products giant Parmalat exposed the gaping question of any positive impact on corporate reporting and governance.

This Indian reader also cited the critical observations about PwC of my estimable colleague Francine McKenna – Re:TheAuditors – whose characteristic umbrage at the behavior of the large firms was equally directed to me:

“I am a bit surprised you chose to spend so much precious space worrying about the poor PwC partners in custody…. It may be unusual by our standards. In fact it’s downright rare. But at this stage, I’m sure you’ll find lots of folks in the US wishing a few more CEOs, CFOs and auditors were sitting behind bars, examining their consciences.”

Sorry, but even appreciating the natural instinct for punishment and vindication, I will worry.

For what’s the rush? The careers of the PwC partners are in shreds, no matter what. They will never again put pen to a professional opinion, even if their firm does survive – which is far from sure.

The measure of a society’s civility is in how it treats its least – the poor, sick and hungry; the minorities and the disadvantaged. And, importantly, the accused. And those rights extend no less to a professional auditor than to a slumdog – else they dependably protect neither one.

Popular confidence essential for stable democratic institutions rests on trust in the agencies of government. Which requires that the exercise of power by those with the authority to use it be done not in a hasty rush to punitive judgment, but with the restraint and good process that engender credibility.

Robert Bolt’s 1966 play, “A Man for All Seasons,” made the case for the law’s restraint:

Sir Thomas More: What would you do? Cut a great road through the law to get to the Devil?
Roper: Yes. I’d cut down every law in England to do that!
More: Oh? And when the last law was down, and the Devil turned ‘round on you, where would you hide, Roper, the laws all being flat? …. Do you really think you could stand upright in the winds that would blow then? Yes, I’d give the Devil benefit of the law, for my own safety’s sake!

The alternatives are the tyranny of petty officialdom, red tape and corruption; pervasive short-term opportunism by those exploiting the cozy roles of insiders; and, not least, a citizenry both cynical and fearful.

Those choices are made at the local country level. It’s their resolution that determines whether a polity – Indian or otherwise -- deserves full and equal participation in a mature globalized economy.

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Satyam's Auditors from PwC Remain in Custody -- A Prisoners' Dilemma for "Indian Justice"

Even as I said last month that the Indian government’s reaction to the billion-dollar fraud confessed by Ramalinga Raju, the CEO of Satyam Computer Services, would be protracted, disruptive and expensive – here – one manifestation both expected and unpleasant was an excess of prosecutorial zeal.

The Satyam saga has a long and ugly ways to go. But for PricewaterhouseCoopers, auditors of Satyam from 2000 until recently sacked, it is unjust and offensive that its Indian engagement partners – S Gopalakrishnan and Talluri Srinivas -- should be in confinement for what is now almost two weeks and counting.

PwC and its people will eventually have a lot to answer for – the extent is presently unknown, and an impossible topic for uninformed speculation. In a best case, the two individuals are already professionally ruined; the firm’s Indian practice will take a serious reputational hit, even if it survives; and the eventual settlement cost of the flurry of shareholder suits will be painful.

That’s the best case. At worst, although the leadership of the profession could never be heard to admit it aloud, Satyam could be the fatal bullet in the global game of Russian roulette that the Big Four are playing with their survival.

No position is taken here on the defensibility of PwC’s work for Satyam – that’s entirely premature, until a credible legal process works its way. Nor, as regular readers know, am I an apologist for the large firms – neither for the persistence of their inability to learn from and surmount their recurring performance short-comings, nor for their mismanagement of the public dialogue in fruitless pursuit of impractical and politically unachievable “reforms.”

But – to be held without bail or lawyers, much less the consultation with their colleagues and their papers by which to answer charges and mount a defense, PwC’s personnel are suffering their fate in a country whose system of oversight and enforcement is immature, unpredictable and therefore extremely dangerous.

Due process of law should be expected in the official reaction to financial frauds, not the Alice-In-Wonderland policy of “sentence first – verdict afterwards.”  

Put otherwise, measured by comparison to systems evolved in their handling of corporate malfeasance, the operation of the “Indian justice system” is revealed to be as oxymoronic as the maligned Dark Ages version of the “Holy Roman Empire.”

Starkly showing the impotence of the large firms in the face of localized over-reaction, not even global PwC managing partner Sam DiPiazza’s short-cutting the World Economic Conference in Davos in favor of a hasty charm-offensive tour around the ministries of Mumbai has been able to spring the locks for his partners. 

When the dust settles and the prisoners from PwC are eventually released back to liberty, the global firms must re-assess their business model: They are over-exposed to the potential for employee hazard and business catastrophe, by the tri-fold interaction of their own uneven performance across international borders, clumsy enforcement agencies having dubious and disproportionate impacts, and porous leakage into the big-country legal systems where litigation exposures already threaten their ruin.

One potential solution, which would redound on the small-firm practitioners whose voices of hostility and criticism dominate the Indian accountancy regulator – and whose capacity to step in and carry out the challenges of a large multi-national audit engagement is precisely nil – would be to simply declare the Big Four’s services unavailable for use by local companies in the capital markets and securities exchanges of the more developed countries.

Under such a showing that “enough is enough,” the Big Four would -- both in India and other candidate countries coming readily to mind – continue with both their purely local clients and their inward referrals on local operations of global enterprises. What they would not do, however, is voluntarily expose their continued global existence to the vagaries of oversight by agencies lacking either competence or experience at that level.

The large accounting firms serve their clients, after all, as free-standing private enterprises. They are neither the nationalized minions of small-bore bureaucrats nor obliged to practice in a form of coerced servitude to hostile and chauvinistic government agencies.

They have the opportunity – as expected by their people who should deservedly be able to work without daily fear of being hauled off to indefinite imprisonment – to declare their entitlement to fair, measured and even-handed justice.

So far in India, that standard is not met.       

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Autos and Auditors -- Could the Big Four Learn from the Big Three?

I've been thinking this week of the impending fate of the large accounting firms -- after watching the CEO’s of GM, Ford and Chrysler, who slouched home empty-handed from Washington after flying in separate corporate jets to plead for rescue from the industry’s history of mismanagement and reality-avoidance.

There are plenty of similarities. Come this winter, after Barack Obama takes office amid another couple months of disruptions in the financial markets, attention is going to turn back to the perilous condition and doubtful viability of the Big Four and their franchise to audit the world’s large companies.

I’ve suggested before that in this environment nobody really cares – here – at least enough to act.

But if we could mark up the carmakers’ talking points – what might the auditors learn to re-frame their so-far unsuccessful case?

They have this in common: just as failure of one of the auto companies would quickly envelop the others, so too the collapse of another large accounting firm will unravel the remaining international networks, leaving large companies with no available source for their obligatory audit reports.

The carmakers argue the ripple effect of their impending failures: not only their own workers, but the galaxy of suppliers and dealers and peripheral blue-collar workers country-wide.  

No such argument for the auditors. Professional and support staff in their people-driven business would be dislocated by the tens of thousands, to be sure, but nobody else’s jobs are at risk. And most of the casualties would re-locate, to fill the needs of industry or to re-build the new niche firms that would emerge from the wreckage.

The Big Three also have the alternative of Chapter 11 reorganization, as familiarly done by the airlines. No similar plan is feasible for the Big Four, whose very structures would evaporate with the mobility of their highly-trained and migratory partners and staff.

Given the bankruptcy chance to do a real re-engineering, the Big Three might actually bring cars to market that would be models of technology and efficiency. Again, no such opportunity for the auditors, who under their present model are locked into obsolete reporting and assurance – the standard auditors’ report – in part through their own failure to escape the leaden hand of regulation and compliance.

Tellingly, perhaps, the carmakers’ rescue balloon deflates with the reality of excess capacity: those dinosaur companies have lost their edge to the lower cost and superior quality of their more agile foreign competitors, who can make profits by winning the battle for consumer loyalty right on US soil.

By contrast, the auditors’ clients have nowhere else to go. Failure of the Big Four audit franchise confronts a stark proposition: unlike the migration to other auto brands, with the sales and jobs and peripheral economic benefits, it would require a complete post-collapse re-tooling to replace the present but out-dated assurance model.

The auditors do have a miserable record of bringing their message of peril to the public – partly lacking the clout of a unionized labor force, but also because the public at large has difficulty developing the passion for audited financial statements that it has about the family car, truck or SUV.

Still, although seven-figure per-partner compensation may have eroded their tradition of eye-shaded modesty, the accountants are not known to travel by private jet, and look positively threadbare compared to the bankers and hedge fund managers paraded this fall through the halls of Congress.

Finally, there’s the contrasting economics of government support. Nobody really believes that $25 billion will rescue the Big Three, who would only be jetting back to Washington next spring for another re-fuelling of their empty fiscal tanks.

By contrast the auditors don’t need and aren’t asking for money. Here is their message – and it needn’t cost the public purse a single dollar:

    “As calculated – here – we just don’t have the money. To survive, we’ll have to give up public company auditing.

    “Or else, there has to be a de-coupling of our survival as firms from the threat to our existence from the PCAOB, the SEC and especially claim for shareholder protection by way of class action lawsuits.

    “This won’t be easy, and it’s definitely not the same as the “litigation reform” of liability caps previously touted. But models are available – here. And we’re prepared to do our part.”

Unlike the Big Three carmakers, who won’t live to get new models off their drawing boards that anybody wants to buy, the Big Four have re-tooling potential. It’s not about rescue money – but only the vision, cooperation and leadership needed to get there.

One last thing. When the Big Four auditors go to see their Congressmen – take the bus. 

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Disintegration of the Big Four -- Where is the Tipping Point Today?

Time for an update: how large is the litigation hit that would devastate one of the Big Four accounting firms?

The answer is a number that is shockingly small, in light of the large firms’ aggregate estimated litigation exposure of up to $140 billion and their individual confrontation of multiple claims ranging up to and well above $10 billion.

But it cannot be avoided. Reckonings are coming, when the debate on the survivability of privately provided audit services is revived – which will be some time after the U.S. elections and the dust-settling around the world’s banking bail-outs.

Quantification of the impact that would trigger the disintegration of the global networks -- leaving the world’s large companies unable to procure the audit reports necessary for listing and regulatory compliance – was a subject last visited two years ago.

A study done in September 2006 for European Union markets commissioner Charlie McCreevy (here) did that calculation for the large U.K. firms. I applied its model to the Big Four’s American firms that December (re-published here) – and attracted no substantive disagreement, but instead grudging if off-the-record concurrence from those positioned to know.

A revision is now possible, and the news is no less grave.

The recent report of the U.S. Treasury’s Advisory Committee on the Audit Profession (here), for all its insipid unwillingness either to acknowledge the gravity of the audit survival risk or to propose an achievable course of action toward real solutions, did provide updated financial data from the large firms.

Those figures can be run through the prior model, after a quick recap of its basic assumptions: 

•    Not having access to outside investors, under regulatory limitations, and impelled by tax laws to distribute their profits, the accounting firms operate on the thin but vital base of their partners’ personally invested capital.

•    The insurance industry’s readiness to contribute to the firms’ litigation outcomes is insignificant compared to the size of pending claims; comes – if at all – only on top of large and growing deductions and retentions; and in any event takes primarily the form of time-shifting finance.

•    As a result, large litigation settlements must be funded out of future partner profits, which depend on the ability of the firms to retain both clients and personnel.

The original London study assumed that, in a highly-charged crisis environment dominated by the pressure and publicity of a massive adverse litigation result, critical numbers of partners would defect, so as to put a firm into a death spiral, if faced with a profit reduction of from 15 to 20 percent and extending over three or four years.

Based on the profits calculable on the Big Four firm’s U.S. revenues of between $5.3 and $9.8 billion, as provided to the Treasury Committee, the bust-up figures would be as small as $560 million, up to just over $2 billion. (Those wanting a walk through the model are invited to write me.)

Could such death-blow amounts be inflicted? On top of the firms’ recent hefty payments to settle many (but not all) of the wave of post-Enron litigations, the outstanding jury verdict of $521 million against the Seidman firm in Florida (see here) starkly demonstrates the possibility. And the obligation of plaintiffs’ lawyers to represent their clients’ antagonistic interests weighs against any lingering unwillingness they would have to kill the gaggle of golden geese.

Would the Big Four firms’ international networks step up? Although by all measures the most cohesive and financially robust of the firms, Arthur Andersen collapsed in 2002 with a speed that suggests otherwise: that firm’s ability to call on either foreign resources or partner commitment proved ephemeral.

Keep in mind that loss of another Big Four firm will throw the entire system into chaos – for lack of auditor choice and readiness among the survivors to stay in an untenable business. So the stability of the entire fragile structure includes the continuing survival of the weakest of them. 

That in turn exposes the hopeless state of the public debate. When corporate bankruptcies have shot far beyond the $100 billion mark, it’s a dead certainty that investor advocates can kill at birth any proposal to limit auditor liability at a level low enough to include the tipping points.

Nothing less is required, then, to enable the survival of large-company audits under the current model, than a de-coupling of the machinery of investor protection and auditor oversight and enforcement from the Big Four firms’ fragile capital structures.

Until that point is recognized and on the table – even if not agreed—the debate goes nowhere. While the risk of catastrophic failure only grows.

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If the Banks are Nationalized -- Why not the Auditors?

I’ve been in a lively exchange with Francine McKenna (Re: The Auditors) – she of the stiletto heels and equally sharp tongue – especially about her tart message last week to Senate banking committee chairman Christopher Dodd (D-Conn.):

“Demand PwC be fired as AIG’s auditors, and get rid of Fannie Mae and Freddie Mac auditors (Deloitte and PWC, respectively). Have the PCAOB audit them directly.”

Take Francine’s position (elaborated here) for discussion, without necessarily agreeing, that the Big Four should be stripped of their engagements for the large financial institutions subject to government rescue or take-over. At the heart of the concern: with all the Big Four carrying death-penalty litigation into the current mess, and all being targets of new mega-claims, there are no available private alternatives.

Her interesting view is that with Fannie and Freddie taken over – and with the government’s controlling interest in AIG and about to invest in nine of the country’s largest banks -- its interests and those of taxpayers are best looked after by a government-run audit function as well.

Expand the PCAOB’s current remit, she says, or create a new form of inspector general.

Despite a skeptical first reaction, this may be the plausible path to the re-engineering of the model of private assurance -- which I’ve been arguing (for example, here) is inevitable with a litigation-driven collapse of the Big Four themselves.

Here’s why:

First, Francine sees no problem in building a federal audit agency. Currently the PCAOB has 500 staff. To build a remotely credible capability, it would have to grow by orders of magnitude, at all experience levels and in world-wide locations. But personnel will be available: The wave of bank failures, bail-outs and mergers is drastically reducing the population of surviving institutions, so the net loss of clients among the Big Four is about to put small armies of bean-counters on the streets.

While it is depressing to think of the creation of yet another vast bureaucracy, the civil service manpower needed through the years of the trillion-dollar bailout reduces opposition to a quibble. It does require noting, however, that the hiring will be of those unable to migrate their stature and compensation in the private sector – namely, the superannuated and the second-rate – not exactly a recipe for staying ahead of a sector of mind-bending complexity.

It bears asking, also, how the concepts of independence and avoidance of conflicts could be squared with the appearance of one agency auditing another. But since the intellectually sound argument for “independence in fact” gave way decades ago with the rationalized acceptability of “client pays,” it would be an easy step to condone a cross-Washington audit function.

As for the questionable value in the market place of an report both by and for the government, the current one-page “pass-fail” audit report is already a no-value anachronism (see here), useful only for statutory compliance but of no useful purpose to investors. So it could as well be done by a collection of civil servants, with the diminished level of attention and respect it would deserve.

Government assumption of audit responsibility opens this tempting door:

Even under state ownership, the huge and complex financial institutions will have undiminished future needs for sophisticated and specialized assurance – in such areas as financial product design and evaluation, process execution and operational soundness – which the Big Four should be both able and enthusiastic to design and deliver.

Freed from delivery of low-value but litigation-laden audits, they should in reason be evolving their services -- only under contractual terms unburdened by the threat of investor claims.

To be sure, for the sake of transparency and accountability of public funds, the banks themselves might well choose to offer to the outside world the reports they would obtain from the Big Four (or the niche providers who would no doubt arise by spin-off or new growth) – but this would be under strict limitations of warranty and liability. 

Tasting both the potential stream of new revenue and the liability relief offered under such a model could be heady for the Big Four, who might well see the potential to extend the model across the entire spectrum of public companies.

In practice, they could tender to a new audit agency the keys to their now-outmoded franchise – thereby finally unshackling themselves from its unsustainable burden. By evolving into sources of real user value, they would escape the looming fate of catastrophic collapse.

Senator Dodd has not given Francine the courtesy of a response – which seems a little ungracious, for a politician savvy enough about the new media to run his own blog and subscribe to an instant message platform.

Especially when she has lit the fuse on an issue ripe for political leadership. By taking up this opportunity, under Dodd’s sponsorship, the large firms could be enabled to survive --- to re-design their assurance products, to re-discover relationships with their clients, and to restore their purpose. 

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The Accounting Professors Ask: Are the Audit Firms Sustainable?

Spending a week in August at a convention of three thousand accounting professors would not be just everyone’s idea of a good time.

But as the 2008 meeting of the American Accounting Association winds down in Anaheim, California, the phrase “where fun goes to die” would be more than a little harsh.

To some, the mind-numbing acronymic jargon of IFRS and ERM and XBRL might yield to the near-by temptation of Disneyland or the division-leading Angels playing baseball just down the road. But the topic and speaker quality has been high, and the attendance both loyal and durable.

A high point for me was the opportunity to be part of a panel that took up the compelling question, “Is the Current Business Model of the Audit Firms Sustainable?”

The quality of the public dialog has left open to question the seriousness of the lip service being paid to the audit profession, and the ostensible importance of large-firm assurance to the world’s capital markets. Tom Selling has been sharp-edged and perceptive in The Accounting Onion – here – in his criticism of the SEC’s Committee on Improvements to Financial Reporting. I’ve raised my own issues over the flaccid performance of the US Treasury’s Advisory Committee on the Audit Profession -- some both here and here.

Credit for convening the AAA panel goes to Gary Previts, historian and professor of accounting at Case Western University and, probably not coincidentally, a member of the Treasury Committee. Wearing a third hat as president of the AAA, Previts reasoned correctly that the accounting academics have their own “skin in the game” on the sustainability issue.

That’s for at least two reasons: First, the universities are called upon to provide the intellectual horsepower, research platforms and ivory-tower resources that support the profession’s capacity and relevance in a complex global society. Second, it’s these professors’ students who are the very feedstock into the gaping pipeline of personnel needs of the large and small firms, industry and government.   

Despite being assigned the death slot on the meeting’s 150-page schedule -- after lunch on the last day of the program -- turn-out for the session was robust and energized.

On the table were the academics’ reasons why the current reporting and assurance structure requires evolution – ranging from the impact of information handling technology on the firms’ partner:staff leverage, to doubts about audit methods to verify intangible assets, to skepticism that audit risk models can deliver quality results because they are ill-suited to assess either management’s major areas of judgment or the deliberate acts of fraud or manipulation.

Bolstering these professorial perceptions were the observations from “the street” – the hazards and risks that must be part of any serious sustainability discussion:

•    Litigation with claims exceeding $100 billion loom over the large firms, with the immediate potential to overwhelm the modest level of their partners’ capital.

•    There are no achievable survival strategies, either singly or in combination – whether liability caps, insurance, new competition, ownership changes or outside capital.

•    The players in the public discussion, all acting in presumed good faith but with antagonisms and limitations of vision, include the firms themselves, with the weakness of their focus on improvements when their performance remains subject to criticism, and the issuers and the regulators with their own interests being served by the preservation of the status quo.

•    The next large-firm collapse will take the system down, not from four firms to three, but all the way to zero, for reasons of overwhelming concentration, inability to absorb the work demand, and predictable risk avoidance in a dysfunctional system.

•    Finally, the reporting and assurance model coming down from the 19th century is obsolete and unsatisfactory in a modern context -- but cannot evolve, under the existing legal and regulatory constraints, into new forms of assurance that the capital markets would value and be prepared to pay for.

What the AAA session could only touch on – and what remains as the next step – is a serious and comprehensive effort to do the “blank page” design work for an assurance model responsive to the needs of the 21st century.

That delivery model will evolve, for certain, because change cannot be stopped. The only question is whether it will occur before or after the collapse of the current system, with the attendant market cost and disruption and the dispersion of the large firms’ personnel, reputation and financial and intellectual resources.

So here’s a message from academia, to the regulators, politicians, think-tank leaders and the large firm managements alike – all sitting there, heads down in denial, confusion or resistance:

There is a lot of hard but rewarding work that has to be done to avert a catastrophe. Is anybody listening?

Audit Firm Survival -- Is Government-Backed Insurance at the Cutting Edge?

Considering the vacuity of the debate on the survivability of the Big Four audit firms and the delivery of audits to large public companies, especially at official levels – see here – there should be full exploration of all ideas that at least pass a laugh test.

So I was tantalized by Tom Selling’s suggestion last month (The Accounting Onion) to reincarnate a “Big Eight”, if “the government could offer to share the litigation exposure from each of the Big Four’s prior audit engagements in exchange for [their] splitting up into two completely separate firms.”

Well, maybe. But anyone thinking that large-company audits would be helped by hacking up the large firms should consider this tool: the razor named for 14th century English friar and logician, William of Occam, whose rule of succinctness states that all things being equal, the simplest solution is the best.

Beyond the purely political issue that auditor liability reform is an officially toxic topic in Washington, and the absence of any legal foundation for such slicing and dicing, there are some practical issues:

First, unless the Big Four bifurcate their industry teams, no new competition would emerge. That is, if a current Big Four health care or insurance practice spun off as a whole into one new firm, while its technology or energy practice stayed intact but went to another, the range of auditor choice within an industry would not be expanded.

And the glacial and ineffective pace of change within the profession itself makes it unlikely that senior experienced audit personnel would have the incentive or take the initiative to re-tool their expertise from one industry over to another.

On the other hand, however the Big Four firms might be broken up, it would not reduce the complexity or resources needed to audit a large global company. For example, each half of a firm’s split-up banking industry practice would still require a full-bore set of technical and regulatory expertise. With the loss of economies of scale, duplicating such competence would reduce efficiency and increase rather than reduce the cost of large-client engagements.

Relatedly, on the issue of performance quality, Selling suggests that the Big Four may have grown “too decentralized to control.” But to serve global companies, Big Four practices riven in two would still need a serious presence in all the countries where their clients require service. That challenge of scope, scale and resources is not solved today by the Big Four’s smaller brethren – and would present an immediate quality challenge to any Big Four offspring.

Which asks the question whether division would be desirable beyond the US, in countries deemed to be low risk. Are there any candidates? Significant litigation now originates in engagements or companies as far-flung as Italy, the Netherlands, Russia and South Korea. So countries attractive for firm mitosis may be few indeed. And with one or two of the Big Four typically dominant in the larger non-Anglo countries, division of the firms only in the US might well have perverse effects on concentration elsewhere.

As for the economics of a bail-out, leave aside the political improbability that government would assume a litigation exposure currently estimated to exceed $100 billion. True, the cost of a rescue would be chump change compared with the taxpayer burden looming over the impending rescues of Fannie Mae and Freddie Mac – but public passions are far less aroused for auditor salvation than for the country’s dominant home mortgage institutions.

The idea is a non-starter for other reasons, starting with the impracticality of doing a “one-off.” That’s because protecting the Big Four from today’s catastrophic litigation threats does nothing for the future. Any new mini-firm would, post-split, still be exposed to the next generation of cases that – based on four decades of experience – will inevitably arise.

And it would not bode well that smaller, capital-challenged new firms would have only half the financial resources they do now, when they are already facing litigation-driven extinction.

There is one positive glimmer in the heart of Selling’s idea – a stand-alone government assumption of the large firms’ catastrophic exposures.

Today the Big Four are forced to settle their biggest cases. They lack either insurance or partners’ capital robust enough to take the non-trivial risk of going to trial and incurring a punishing adverse outcome.

It cannot be imagined that politicians would create a $100 billion honey pot for the investor plaintiffs and their lawyers to dive into. But there could indeed be created a federally underwritten catastrophic re-insurance mechanism or “litigation trust” – which as a form of contingency capital would enable the firms to litigate their cases without fear of a death-blow verdict.

If such a lifeline were available, it would obviate the viability threat. So simplified, the very reasons for the otherwise impractical Big Four split-up go away. The firms in their current form could then address their twin goals of quality and relevance, without the distractions of imminent overhanging bankruptcy proceedings.

Using Occam’s Razor to pare away the parts that fail to benefit audit delivery effectiveness, the Selling proposal suggests a financial buffer worthy of consideration.  That idea would logically be housed in the proposal I outlined on June 10 – here -- for a government-sponsored structure of charters for firms doing audits of publicly-traded companies.

So let the discussion continue.

Federal Charters for Accounting Firms -- A Blank Page Approach

Six years on from the disintegration of the Arthur Andersen firm, the fragility of the last Big Four and their franchise to provide large-company audits attracts a discussion that is steadily louder – but not more productive.

The latest example of a collection of the wise, talking past each other, was the June 3 meeting of the US Treasury’s Advisory Committee on the Audit Profession, summarized on Edith Orenstein’s blog – here – and webcast here.

A reason the discourse is so barren is the circularity of the blame-mongering. Rather than recognize the interlocking web of entanglements, the focus is on the problems of “the other guys.” The list includes:

•    Issuers’ incentives to manipulate their results
•    Overly complex accounting standards
•    Persistently inadequate audit performance by a too-small oligopoly
•    Regulators with over-lapping but parochial interests
•    Liability standards that lack precision in practice or predictability in outcomes, and
•    The overhang of catastrophe-level litigation that would overwhelm the audit firms’ fragile capital structures.

If there is ever to be a comprehensive, holistic solution, a blank-page approach is essential. There is such a framework at hand – although it would require a clean, robust and full-blown debate and a fresh legislative mandate. What is lacking, but essential in the organizational and legislative discussion, is the broad buy-in and ready participation that might actually replace today’s antagonistic finger-pointing.

Namely, national-level “charters” or “public company audit licenses” – the naming is less important than the concept – could authorize and regulate newly organized and re-structured firms -- that would do the audits of all public companies.

Applied in the United States – a jurisdiction necessary for any worldwide solution -- a new system would be administered by the Securities and Exchange Commission and the Public Company Accounting Oversight Board, having as analogies the government oversight of American stock exchanges, credit rating agencies and broker-dealers.

Newly organized “public company audit licensees” could be in corporate form. They could be owned by existing accounting networks or other new market entrants. Their resources – personnel, methodologies and technology – could be internal, or out-sourced from the existing Big Four or from emergent niche competitors.

For quality and enforcement purposes, audit engagement personnel would be individually licensed along with their employers, in coordination between federal authorities and existing state regulations over education, examination and training.  

Minimum capital requirements could be set, geared to the firms’ turnover or the capitalization of their client list. Governance structures could include independent outside directors, and accountability of management to agency oversight – measures not presently achievable under the constraints of state regulation and the laws of partnership and bankruptcy.

Collateral benefits to federal “chartering” abound:

Because these SEC licensees would be “audit only” enterprises, the multiple overlapping restrictions on scope of services would be finessed, and the endless debate over independence and permissible ancillary services could at last be ended.

Associated non-audit entities – whether parent or affiliate companies – would be freed from independence and compliance requirements, able to evolve beyond the one-page statutory report that now looks so obsolete. Targeted assurance reports could be designed that users in the capital markets would actually value and pay for. Immediate examples ripe for attention would have been Shell’s petroleum reserving, the internal trading controls regime at Société Générale, and the black hole of inter-company money transfers at Parmalat.

In aide of enhanced competition and expanded auditor choice, segments of the public company market could be specifically identified to encourage new entrants – such as high-risk or technically specialized sectors (IPO’s, troubled companies and financial services come to mind) – whose audits could be segregated, underwritten and priced as now done with high-risk insureds.

Under the aegis of the licensees’ regulators, a privileged forum could be organized to scrutinize cases of accounting and audit insufficiency for lessons and areas for improvement – drawing for experience on the airline, engineering and medical models for the successful study of failure.

As to liability -- the elephant in the room – and taking at their word the investor advocates who would prefer improved information over the capricious and low-return litigation lottery: the investigation and prosecution of all auditor claims based on public company financial statements would be pre-empted into the hands of the supervising agency. A specialized tribunal of expert jurists would hear all cases, levying fines and sanctions against convicted wrongdoers, both firms and individuals.

Compensation for legitimately damaged investors would be determined through the agency process rather than the caprice of juries and settlements, and be funded through a system of fee schedules rather than the hazards of limited firm capital.

Modifications of existing regimes would include elimination of the tax code’s incentives to maximize distribution of current revenues, and a cut-off above which audit firms would not audit their own owner/investors.

And with firewalls of corporate organization and bankruptcy infrastructure in place to limit liability, the conditions for insurability could be brought once more into alignment with manageable litigation and enforcement risk.

With this array of stabilizing governance changes in place, the new structures could at last be attractive to outside capital, which would be needed by offerors of new services in order to fund the necessary research, personnel and technology.

Given the dead-end nature of the debate these last years, the bare bones of this proposal should include something to excite or insult nearly everyone – which could be a signal that it is broad enough to be worthy of pursuit.

Ernst & Young Consolidates -- And History Asks: Who Cares?

This one comes straight from the heart.

First, I salute the plan announced in early May by Ernst & Young, to merge its practices in 87 countries in Europe, the Middle East, India and Africa. Sharing of management, strategy and costs will create the most integrated accountancy structure since the disintegration of Arthur Andersen in 2002.

It’s a bold move, in a terrifying environment, both worthy and full of challenges to execute and deliver.

But, to say with reluctance, it compares with the poor cabin boys re-arranging the deck chairs on the Titanic.

I was first an outside counsel, and later an employee, of the late Andersen firm. I was then privileged to be one of its worldwide partners – and personally fortunate to have retired before the wrenching events of its failure.

So the discouraging phrase – “been there, done that” – hangs over E&Y’s initiative. Its necessary evolution will address the complex demands for quality services to global companies. But that is insufficient – nay, irrelevant – to shorten the list of life-threatening issues facing the Big Four.

E&Y is not operating in virgin territory. Andersen’s worldwide partners shared both economic risks and benefits. We supported start-up practices in new countries, and lagging economies in others. And we reaped unequalled revenue and profitability from the effective deployment of shared technologies, methodologies and personnel.

But while Andersen’s unique cohesiveness drove an almighty profit machine in times of prosperity, it proved weak and fragile under stress – shattering into local fragments within days of the US firm’s Enron-related criminal indictment.

Unifying E&Y’s practices will be a big deal for its partners – but much less important to its employees – and a matter of indifference to issuers and the consumers of its audit reports. As an inward-facing matter of management strategy, it does not change the commodity nature of the standard audit report, whose value in the capital markets is so diminished as to be serving no purpose beyond regulatory compliance.

The report is instead an unevolved and obsolete barrier to the required re-engineering of the corporate financial reporting model, and a litigation ticket to oblivion as much for a re-designed E&Y as for the other firms.

E&Y’s consolidation may have a quality impact on its cross-border work. All concerned should hope so. But just as Parmalat in Italy and Lernout & Hauspie in Korea showed that major litigation inheres in cross-border work, there is also deadly peril from purely local jobs – examples run from the Houston-based impact of Enron on Andersen to the pending exposure of BDO International to litigation damages for the Miami work of Seidman, its US firm (here).

Giving E&Y the benefit of the doubt, a single regional partnership may – with massive investment of resources and personnel – mitigate its cross-border divisions. These are driven by differences in culture, language, corporate governance, professional standards and education. But those issues deeply persisted in Andersen’s regional operations, despite decades of effort -- making E&Y’s reprise an incremental step at best.       

At the same time, as Andersen showed, a unified structure that suffers a knockout blow in a critical country does not survive. And it need not be an American issue.

A look at France is instructive. The latest report from its market regulator on auditor/client relations among the CAC 40 – here -- shows the depth of E&Y’s blue-chip client list: of the 37 companies for which data are available, E&Y is principal or secondary auditor of 22.

Included are global companies that are hardly risk-free – among those with media notoriety are EADS, Société Générale and Vivendi. Any on E&Y’s global roster could inflict on its French practice a blow that would be fatal to its EMEIA structure. For in a globalized world, a firm that cannot practice in all economies on the scale of the G-8 countries cannot viably provide comprehensive service to large companies in any of them.

All these examples show that mega-threat litigation remains the uninvited elephant crashing E&Y’s party. EMEIA and Far East mergers may not actually raise the EY network’s collective exposure – firewalls and careful agreements may have some slight effect.

But again, the Andersen experience shows the irrelevance of structure to the outside world. Quality issues and the assertion of cross-border jurisdiction both track the actual performance of cross-border, risk-laden audit work. And it makes not a bit of difference to investors’ lawyers whether multi-country engagement teams are led by fellow partners or franchisees using only a common name.

The partners of Arthur Andersen, who designed and ran its unified global practice, banked their fortunes under the impression that they were riding a gravy train, resistant to external shocks or self-inflicted mis-management.

The history of their downfall suggests that while we should wish the best for the vision of E&Y’s leaders, the warning lights on its track to the future are blinking brightly.

The Future of Auditors as Gate-Keepers -- A Glossary of The Non-Solutions

Do investors get real value from their gate-keepers? It was a main question at a conference of international investment managers where I spoke last week.

This group -- who sit over funds across the spectrum from public employee and union pensions to hedge funds and private equity – had common concerns: corporate governance, ethics, compensation and performance, and the quality and reliability of the third-parties – the analysts, rating agencies and outside auditors.

On the subject of the auditors, I had a brief opportunity to offer this three-fold view – familiar enough to regular readers here, but beyond orthodoxy to many in the audience (and with thanks to Mark Cobley at Financial News Online for the uptake):

•    That the traditional form of auditor’s report is obsolete and provides no investor value, especially compared to the possible forms of assurance that are impossible under the current model -- here;

•    That the overwhelming pressures on the Big Four firms render their current business model unsustainable, and their litigation-based exposure makes disintegration inevitable, absent a radical and comprehensive re-engineering – here;

•    That the current dialog on achievable solutions is vapid and sterile, due to denial, blame-shifting and the limited vision of all of the interested constituencies -- here and here.

In the ensuing barrage of panelists’ skepticism, audience questions and post-session follow-up, I was challenged to answer in single sentences to all the standard one-dimensional “solutions” to the fragility of the current Big Four structure.

Bringing those exchanges together here, with links to their more extensive treatment elsewhere, seems worthwhile – even if only in sound-bite form: 

•    Q: Why isn’t the litigation threat to the Big Four well handled by insurance?

A: Having learned from the savings & loans in the 1980’s the expensive lesson that auditor liability fails the basic criteria for insurability – diversification, predictability and quantification – the insurance industry has voted with its feet -- here.  

•    Q: If lack of auditor choice is the issue, how about creating competitors by splitting up the Big Four?

A: For starters there’s no workable legal theory. Either industry and geographic expertise would stay concentrated, in which case nothing is achieved, or they would be so split up that today’s talent level would be severely diluted.

•    Q: Can’t the issue of Big Four concentration be solved by built-up competition from the smaller firms?

A: The size gap is just too large to bridge – see here – and the smaller firms are if anything even more at litigation risk – see here. Anyway, smart risk managers in those firms would avoid global-scale engagements for which they lack either the skills or the risk appetite.

•    Q: If the rules on audit firm ownership were relaxed, wouldn’t outside capital both strengthen the Big Four firms and support new competitors?

A: The Big Four don’t want or need extra capital to run as they do – here. And the bankers have shown they are smart enough not to sacrifice new money that would only fuel the litigation fires.

•    Q: How about improving audit quality by requiring the rotation of auditors?

A: Italy being the only large country to mandate changes in auditors, experience provides a one-word rebuttal: “Parmalat.”

•    Q: Doesn’t a system of joint or dual audit promote higher quality of performance?

A: Proponents in France, which has almost no history of auditor liability litigation, would quickly change their tune when joint auditors became subject to 100% joint and several liability in the courts of other countries.

•    Q: Isn’t the problem of impaired audit independence the fact that it’s the clients who pay the bills?

A: Consider the alternative: funding audits through an agency or regulator amounts to nationalization – and no one makes the case for audits by government civil servants. 

•    Q: How about caps on litigation liability – either money limits or percentage allocation of fault?

A: Because the size of claims arising out of large corporate failures so completely dwarfs the limited financial capability of the Big Four – here – the political process cannot set a survival bar so low as to ensure the stability of a large firm under serious litigation threat.  

•    Q: Wouldn’t performance standards based on principles rather than rules recognize the judgmental nature of auditing?

A: Standard-setters cannot reduce the liability threat, so long as it is courts and juries who assess auditor fault and liability, unless there is the readiness – so far unseen – to enact “safe harbors” to protect the auditors’ judgments.  

•    Q: If another Big Four firm were failing, couldn’t regulators waive the scope of service limitations so that another firm could step in?

A: Even if the large firms weren’t so ostracized already that this solution is politically untenable, they are already fully-stretched and without resource capacity, so that when another firm crashes, the three survivors could not possibly pick up the pieces out of the wreckage. 

•    Q: If another firm is threatened with disintegration, how about replacing its tainted management with a credible outsider?

Q: As shown by the failure of Arthur Andersen despite Paul Volcker’s well-meaning initiative, the speed and complexity of a disintegration would out-strip any outsider’s powers or resources – see here.   

•    Q: In the end, won’t the regulators act to prevent the collapse of another global audit firm?

A: There is no more candid response than the concession of William McDonough as he neared the end of his term as chairman of the Public Company Accounting Oversight Board: as to what the regulators would do about another disintegration threat, “they don’t have a clue.”

These are sound-bites only, as I said, and I may have missed a point or two. Either way this compilation should be a good reference point. Please don’t hesitate to write with your reactions and suggestions.