Re:Balance -- Jim Peterson

Market Concentration of the Big Four Audit Firms: The Feasibility of a Suggested Trade -- Divestiture for Liability Limitations

“No such thing as a failed experiment …. only experiments with unexpected outcomes.”-- American engineer-architect R. Buckminster Fuller

 Is the Big Four’s concentrated control of large company audits a real problem? Persistent voices of concern and attention extend back at least to the 2006 study for the Financial Reporting Counsel (here), recently joined by global leadership of BDO and Grants (here and here).

If so, is there a credible case to incentivize their exchange of market dominance for liability limitations?

Those issues were addressed this month in a paper from the American Antitrust Institute – here. In an all-too-rare burst of clarity, the AAI forthrightly recognizes that:

With pending claims totaling billions of dollars, the Big 4 audit firms face serious threats to their survival…. (L)iability exposure substantially exceeds the combined partner capital of the Big 4 firms… (They) contend that liability limits are necessary to prevent the loss of another Big 4 firm, which would throw the global financial system into chaos. (footnotes omitted)   

The AAI’s suggestion would be a legislated trade-off: “government incentives to break up the Big 4 into smaller, more competitive firms” – namely, a liability cap conditioned on a firm divesting itself of, say, 20% of its domestic revenue and the personnel serving the surrendered clients.

Can’t work – because of the many problems with the underlying but unachievable assumptions. 

But before getting there -- the AAI deserves credit at least for recognizing the completeness of the Big Four’s market dominance – auditing “nearly all of the world’s public companies with annual sales over $250 million” (emphasis in original) – with even tighter limitations on auditor choice in such industries as metals and mining, energy, air transportation and financial services.

Start with the political unacceptability of liability capping at a level that can assure Big Four survival. I have spelled out before (here) the financial limits of the large firms’ private partnership structure and their membrane-thin working capital, under which they cannot withstand litigation shocks above the $1 - $2 billion range – a tiny fraction (by either amount or percentage) of the exposures in their pending lawsuit inventory.

As the AAI paper summarizes, critics of liability protection point to the firms’ average litigation payouts, as a percentage of revenues and as compared to the far larger total of alleged damages. They fail to recognize – as do the arguments for capping from the profession itself -- that averages are meaningless when the “outlier” of a single verdict, falling outside the misleading comfort zone of a bell-curve model, could and would be devastating.   

So: because American politics offers no cover for protection at those levels, that side of the proposed AAI bargain is no solution. What of the other side -- the plausibility of large-scale competitors emerging from the suggested divestiture program? The facts dictate otherwise.

First, an abundance of small practices already exist. Why they have not coalesced into global-scale practices is a long-familiar story of limited geographic scope, expertise, risk appetite and readiness to invest.

Second, the smaller sector does not inspire confidence in its strength or capacity for quality growth to global scale. Of the largest, BDO’s Seidman firm in the US is on a deathwatch, facing the post-appeal enforceability of its $521 million jury verdict in Miami. Grant Thornton – not yet fully disengaged from the Refco matter in which lawyer Joe Collins just received a seven-year prison sentence – now faces the fall-out of being fired by Koss, its public but family-dominated Milwaukee client, whose CFO managed for years to steal amounts in excess of the company’s total net revenue (on which, to read Francine McKenna in unusually high dudgeon, see Re:The Auditors.)

Third, as a practical matter, how would global-scale competition emerge? If a Big Four firm were to hive off a small geography-based practice, that newcomer would suffer handicaps of capacity and expertise no different that those of the current smaller firms.  If a large firm were to shed an entire industry practice, no new competition is added to serve that industry. And if instead, it were to divide a viable large-scale practice, then each of the two sub-practices would be burdened with shortages of expertise, personnel and the capital strength necessary to build to scale and withstand their risks.

In summary, the AAI’s aspirations fall victim yet again to the Nirvana Fallacy – the defect in logic I described (here) in the comparison of a failing situation against an idealized state, without recognizing that the assumed achievement is impossible under real-world limits, flaws and constraints.

The large firms grew that way for service-based reasons. And dreams of expanding the population of pygmies do not, sadly, increase the likelihood of evolving a giant.

At bottom, the AAI’s most seriously under-examined assumption is that the “catastrophic” disintegration of another Big Four firm “would throw the global financial system into chaos.”

Why so? To the contrary, if the now-standard auditors’ report were suddenly not to be obtainable from any source, who would miss it?

Regulators and politicians would have convulsions, to be sure. But as the financial crisis itself has shown, that is daily practice for office-holders in the hermetic confines of Washington and London and Brussels.  

Should the stock exchanges be closed, if a Big Four failure meant that one-quarter of the large listed companies lacked an audit report? Could those companies’ securities be barred from trading? Unthinkable. Out where capital really flows and trade is actually engaged, the world’s markets would shrug, start the process of designing new forms of assurance from a blank page, and move on.

And the splintered pieces of the former Big Four would provide ample building blocks for a new assurance structure – without, pace the AAI, any need or use for the unintended and unpredictable hazards of another failed experiment.

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Previewing 2010 -- And a Note of Thanks

As the old year winds down to the winter solstice and all those rituals by which we mark the holiday season, a brief look ahead.

Depending on reckoning, the New Year will either end an old decade or begin the next one. Whichever, here are a few events that will feature in 2010 among the on-going challenges to the global structure of large-company assurance:

• The Supreme Court in the US may well declare the PCAOB to have been illegally constituted (here or here). If so, predictable spasms of re-enactment and ratification by the SEC cannot successfully encompass such issues as the viability of pending investigations, the legitimacy of past inspection reports, or the need to re-register all the foreign accounting firms.

In the context of those issues of contention, the legislative mischief to be wrought by a Congress offered a blank page on which to re-debate the Sarbanes/Oxley law can scarcely be imagined.

• The fits and starts of accounting standards convergence will have no more traction than a pig on roller skates. The announced retirement of Sir David Tweedie as head of the IASB (here) will take one prickly personality off-stage, but will not solve the antagonisms among competing country and industry level interests. And as the scope of complexity and judgments within both GAAP and IFRS figure to be as significant as those between reporting systems, the achievability of comparability and comprehension will remain as elusive as ever. 

• Attempts to impose liability on the large accounting firms’ international structures will continue apace. The success of BDO International in confining the Bankest verdict in Miami to the Seidman firm alone (here) means that if that $521 million exposure becomes enforceable, BDO may need to find a new US member firm – a tactic painful enough for that organization but which none of the Big Four could achieve under like conditions.

Flashpoints for structural threats will include the Madoff-related feeder funds litigations, concentrated in the US but also spread around the world, and PwC’s exposure on Satyam.  And with PwC’s Indian partners on Satyam about to observe their first full year of local imprisonment, that network's attempts to extract itself from class action exposure in the American court system (here) raise the interesting question whether submission to Indian justice is really a preferred strategy.

• Tempting as it might be to be lured into the speculation about identifying which of the Big Four firm is most likely to disintegrate under the combined pressures of litigation and government threat, in 2010 or otherwise (here), I will decline – since the determining factor is the unpredictable timing of the cases themselves. Specify the judges’ scheduled trial dates for the 25 biggest cases hanging in Damoclean fashion over the large firms – and only then would I be able to offer a view.

• More broadly, strategic decision makers in the world of financial information will continue to confront the volatility of government conduct – an under-recognized factor in their overall risk assessment methodologies.
  

The reactive nature of public officials has been marked in recent years by an ad hoc cascade of unpredictable and unintended consequences – ranging in scope and scale from the back-of-envelope bank bail-out schemes to the bonus supertax in the United Kingdom to the first-ever invention in Dubai of a default-driven debt reorganization scheme of uncertain application or reliability.

So life in the forthcoming year will not be boring. 

Meanwhile, in this space, Re:Balance observes its second birthday. Launched in January 2008, this venture was the evolution from “Balance Sheet,” the column I had the six-year privilege and good fortune to write for the International Herald Tribune.

The challenges have been fascinating, starting with the anxiety-inducing migration from old-style print. No less than the accounting firms, the IHT itself -- like the other newspapers -- pursues its fading struggle in search of a sustainable niche business model. While in the world of rapidly mutating media platforms, the near-term impact of the likes of Twitter, Facebook and Kindle will continue at a dizzying pace to re-define the information landscape.  

It has been most gratifying over these two years, both to participate in community with an expanding group of smart and incisive commentators, and to experience steady growth in readership and especially in subscribers.

For these opportunities, I thank you all for your interest, your insights and your inputs.

Merry Christmas -- best holiday wishes -- and a healthy, peaceful and prosperous New Year to all. 

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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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