Re:Balance -- Jim Peterson

The Weekend Press: "Billion-dollar Lawsuit Could Destroy Top Accountancy Firms"

The Finance section of this Sunday's edition of the London Telegraph carried a piece by Sean Farrell, under the evocative and self-explanatory headline, "Billion-Dollar Lawsuit Could Destroy Top Accountancy Firms."

It can happen. Attention should be paid.

Farrell captures the essence of the structural weakness of the current model for the delivery of audit services to the world's large global companies, as demonstrated by the speed with which the Andersen firm disintegrated in 2002 under the stress of the Enron debacle:

"Andersen's collapse highlighted the fragility of a global accountancy partnership. As soon as the extent of the fraud was made public, Andersen's international divisions and partners not involved in the scandal detached themselves from the firm, making it impossible for Andersen to survive. The nightmare scenario for the big four – PwC, KPMG, Deloitte and Ernst & Young – is to be caught out by the next Enron." 

I talked at length with Farrell last week, while his story was in preparation -- and was gratified to see his uptake on the under-appreciated research done on the limited financial capacity of the Big Four to resist or withstand large-scale litigation claims, because as private partnerships they lack access to the outside investor capital available to public-company corporate structures:

"A London Economics study for the European Commission three years ago calculated that the biggest claim a London arm of a big firm could bear after the exhaustion of insurance was €540m (£474m). The report says: 'As firms have practically no assets of their own which could be mobilised, the partners of the firm would in such a case bear the cost of the adjustment. At issue is the size of the financial burden that partners would be willing to bear before the firm collapses'."

I've written on this subject before. See here and here for calculations of the "tipping point" numbers on the Big Four's exposure to litigation in the US -- where the largest threats are lurking -- numbers that should be eye-opening because they are miniscule compared to the firms' exposures. 

Farrell quotes me:

"(A)ccountants already face pressures from incoherent international accounting standards, huge potential litigation liabilities and their own failure to meet the standards expected of them. He says on top of these recurring problems firms now face mounting litigation connected with Madoff.

"Peterson says: 'What is not generally appreciated is that most accounting firms work with a level of capitalisation supplied by their partners that is woefully thin... There is no big four firm that could survive a judgment as high as $2bn'.

"He argues the fall of one more big four firm could cause the system to collapse because rules on conflicts and the big four's patchy geographic strength would prevent the remaining firms from mopping up the business as happened after Andersen's blow-up."

Critics of the accounting profession will have their say, as they well should. But no discussion agenda on the future of the large-company audit franchise is either complete or credible unless it includes the unsustainable nature of the current regulatory and legal structure, within which the business model of the Big Four firms is at mortal risk.

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Forecasting the Survival of the Big Four: Does a Black Box Model Hold the Answer?

If the global tumult of the last two years has taught us nothing else, it’s that reliable forecasts on complex issues are damnably hard to come by.

So where can wisdom be found today, on the vexed and pressing question of the survivability of the Big Four accounting firms and their franchise to audit the world’s large companies? Arrayed in an existential threat are the aggregated forces of unachievable performance expectations, unrelenting regulatory hostility and devastating litigation exposure – against which, what are their chances?

The question about the presumptively available but failed sources of advice and prognostication is not whether the recent performance of model-builders and risk managers has failed to provide actionable guidance – plainly it has not, as credit markets seized up and venerable institutions toppled -- but how extensive were their own contribution and culpability.

A possible source came on the screen last week. Clive Thompson’s article in the New York Times magazine for August 16, “Can Game Theory Predict When Iran Will Get the Bomb?” features the “black box” prediction methodology of a New York University professor and Hoover Institution fellow. Bruce Buena de Mesquita’s forecasts on the complex interactions of variously influential parties are applied in contexts ranging from the business strategies of large companies to geopolitical hot spots for the Central Intelligence Agency.

Bruce’s method starts with identification of those with interests – whether the conflicting constituencies in the ever-shifting landscape of Iranian politics, or the negotiating partners in a potential corporate merger. He assigns values to their respective goals, commitments and capacity for influence – numeric inputs which are then processed by his proprietary (and opaque) computer model in an iterative series of scenarios, eventually leading to a conclusion as to the outcome.

Here’s the thought: an identifiable set of inter-locking antagonists are now in mutually-reinforcing paralysis on the fate of the large accounting firms – each with deeply committed self-interests being served, and all suffering limitations of vision and authority:

That roster includes -- along with the issuers of financial information and their auditors themselves -- the banks, investors and other users; the professional standard-setters, regulators and politicians; and the several-faceted machinery of law enforcement including prosecutors, judges and lawyers – as well as, probably for completeness, the communities of academics, critics and other observers.

Bruce’s techniques of inputting stakeholder interviews into a multi-scenario decision algorithm yield predictions that are valued and used at the level of global intelligence agencies, regarding issues on the scale of nuclear deterrence policy or the evolving role of the BRIC economies. So he should find it a piece of cake to crank up a view on a question as straightforward as whether the Big Four and their one-page auditors’ report have a viable future.

Considering that the present models underlying the use of Value-at-Risk, dynamic hedging and complex derivatives valuations have been shown no more robust than old-fashioned consultations with the oracle at Delphi or the entrail-reading of a Roman haruspex – or for that matter, turning over today’s desk-top 8-Ball -- Bruce’s approach might well be of great value.

Or at least, shouldn’t somebody think it an undertaking worthy to be engaged and widely shared?

Let me know if you think so.

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How Valuable is Today's Audit Report? Military History's Metaphor for "Expensive, Obsolete and Irrelevant"

The dog days of summer. I’d rather be under a beach umbrella, doing teaching outlines for the fall semester with the facilitating aid of something cold and rum-based. Instead I am in deep dialog on tough issues with one of the world’s thoughtful accountancy regulators.

A very small group, that. “Thoughtful accountancy regulator” being as oxymoronic as “Italian justice system” or “effective Belgian government,” their entire convocation could be booked in a telephone booth with room to spare.

On our table was one of my persistent themes, under the rubric of the threatened survivability of the Big Four and their nearly exclusive franchise to audit large global companies – only one major shock away from disintegration, which once started will be unstoppable not least because of the limited vision and authority of the political and regulatory classes.

Namely, there is no real chance to get ahead of this destructive tidal wave without explicit confrontation of the obsolete and anachronistic nature of the audit report in its current form.

To this proposition, my correspondent suggests there is at least some chance of traction under cover of the legislative debates on the question why auditors did not do more in relation to the credit and banking crisis of the last two years.

Possibly. But because the lawmakers’ limited attention span is focused elsewhere – on executive pay schemes and bank survival subsidies and constraints on short sales and flash trading -- I doubt it.

Our exchange calls to mind a recent holiday, and the moving experience of touring one of the surviving fortresses of the Maginot Line – the defensive installations named for France’s Minister of Defense, built in the 1930’s and left largely unscathed when the invading Germans simply and speedily flew their planes and drove their tanks over and around.

Dug deep into the Alsatian hills, these brutal piles of 1920’s military technology – built for 3 billion francs and among the largest public projects in France since the construction of the Gothic cathedrals – are derided by history as a strategic failure, because they were rendered irrelevant by the German circumvention.

Yet consider the success -- in terms, the Line did its job. It was evaded, rather than destroyed by direct attack; surrendered largely whole, rather than bombarded; and only thereafter abandoned by government to the effects of rust, decay and amateur tourism.

It’s much the same for the modern-era audit report: Conceived in an earlier and simpler time, oriented to the avoidance of problems no longer meaningful, and now ignored by aggressors with superior tools in their armory. Consuming vast sums of defensive budgets, engaging battalions of trained and expensive manpower in an endeavor of questionable value, and achieving no obvious deterrence against threats on a scale of systemic corporate collapse.

Life for the French garrisons would have been misery: cramped underground in caves of steel and concrete; enclosed by machinery, ducts and wiring; ventilators struggling with the confluent mixture of petrol, dangerous explosives and close human quarters. Happily, except for times of drills and alerts, they were often able to emerge into the French forests, to hunt the birds and rabbits that relieved their military rations. 

Contrast the modern audit engagement team – inflicting vast costs on their clients for a marginal purpose, toiling away to tick the boxes required by Sarbanes/Oxley and its equivalents, facing a hostile world through the narrow visor of inflexible reporting requirements and a crude and outmoded arsenal of opinion language, and exposed to being out-flanked or over-run without warning by antagonists of superior mobility and strategic imagination.

Just as the Maginot Line proved its worth as a sublimely ironic success against invasion that never came, the current audit report stands as a bulwark effective only against the kind of assaults about which no one cares.

Instead, just as the hapless French troops were obliged to surrender without a struggle when overtaken from the rear, the modern system of assurance has been revealed as dug in and powerless against such invasive forces as the exotic financial derivatives of the credit crisis or the guerrilla tactics of a Bernie Madoff or an Alan Stanford.

And to what end? The metaphor can be pressed one step further. By surrendering the Maginot Line’s indefensible position, the French cut losses that would otherwise have been catastrophic, and survived to be joined by their allies in a strategic re-grouping.

As with supplanting the dimly mis-guided André Maginot, can the regulators find in their weary ranks the likes of a Churchill or Roosevelt or DeGaulle?

Cometh the hour, cometh the man? The future of the profession can only hope.  

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The Indian Government's Reaction to Satyam -- Marching Backwards to the Future

In what is still the global-scale financial scandal of the year -- India’s Satyam Computer Services -- the search for villainy continues to diversify.

•    Blogger Francine McKenna leads the charge (Re:The Auditors) against what she sees as a corrupting business relationship of services provided alongside PricewaterhouseCoopers, whose Indian firm did Satyam’s audits.

•    Indian regulators are publicizing their cooperation with the US SEC (here), and suggesting the imminent end to their investigations (here).

•    And the amount of impartiality expected from the Indian system of criminal justice was signaled in the July 9 statement of Corporate Affairs Minister Salman Khurshid, that “All the concerned persons have been arrested except one and prosecution has begun against the guilty" (here, and the anxious emphasis is mine).

I was recently berated by a reader for saying back in February (here), that the Indian approach of incarcerating suspects even before charges were brought did not accord with basic notions of fairness and due process. The gist of his barb was that I was being “holier than thou,” because in his view the US government bail-out of its financial institutions was the “crime of the century,” whereby the “biggest crooks in our society” have stolen $ 700 billion of taxpayer money with no benefit to “the people who have landed on the streets due to foreclosure.”

My deeply insulted critic is entitled to his position. But he is trying to pick a fight on the wrong ground. I have lived and worked outside the US long enough to recognize the risk of presumptive cross-border judgments. And history, not he or I, will judge the leadership of President Obama, Treasury Secretary Geithner and Federal Reserve Chairman Bernanke. It’s not an “either/or” proposition.

Rather, it remains that, save for those like Alan Stanford who present flight risk, and where even the now-jailed Bernard Madoff enjoyed the liberty of his apartment until the day of his guilty plea, it offends mature notions of justice to imprison white-collar accused ahead of an adjudication of their guilt.

Pass this as a quibble. It is of more importance to the evolution of the Indian environment, that the degree of insight and perception shown by Minister Khurshid ominously suggests two reasons why the only impact of Satyam on that country’s governance and regulation will be from the “law of unintended consequences.”

The first issue is attitudinal. Satyam represents India’s “Black Swan” moment, in the phrase made popular by Nassim Nicholas Taleb’s best-seller (reviewed here). It was an unexpected and highly disruptive event – about which Khurshid commits the familiar error of misperception and flawed analysis, stating that “the Satyam scam is an aberration and the events are specific to the company in question. No other scam of this nature has come to notice since then” (here).

Now that Satyam has brought it forcefully home that large-scale corporate fraud is a reality in India (and in fact was completely predictable all along, despite official denial and evasion), it is equally certain that other similar situations are gestating even now, undiscovered but waiting their own moments to emerge.

So rationalizing Satyam as unique will be to miss the inevitable crises of the future. Yet, Khurshid’s remarks indicate a simple-minded determination to replicate the ineffective reactions of his counterparts in countries elsewhere.

That is, his view that a package of new legislation and an “elaborate regulatory framework” will address “all issues” involving forgery and computer manipulations, disclosures to stakeholders and discipline of public accountants and corporate secretaries (here) simply lacks the credibility of a track record of success.

Did Sarbanes/Oxley impede the credit market implosion? Or slow down Bernard Madoff? Measured against efforts at prevention, in jurisdictions suffering decades of corporate malfeasance and failing consistently to stop the periodic eruption of fresh cycles of wrongdoing, the Indian view that effective prevention can be learned and implemented from a one-off experience is dangerously naïve.

Secondly, even less likely to act as a deterrent is Khurshid’s proposal to include the concept of shareholder class actions in a new Companies Bill (here).

Events may well outrun the Indian legislators. As announced (here), the opportunistically-named Midas Touch Investment Association seeks to launch a class action in India on behalf of 300,000 shareholders, seeking over $ 1 billion from Satyam’s directors, auditors and promoters. At the very least, this promises a two-ring circus as veteran plaintiffs’ lawyers in the already-pending US actions will eagerly protect their access to an expected honeypot of legal fees.

Lest I attract further vitriol from those taking positions on either end of the advocacy spectrum – as to whether class actions are either a vital and essential weapon for defrauded investors, or a tool of extortion and destruction held over corporate management and a menace to the entire capitalist system -- a middle course:

Decades of American experience with securities class actions would suggest caution, before introducing such a jurisprudential tool into the kit of Indian governance and enforcement. At least, the empirical observation of developed economies and markets in Europe, which have thrived without the common resort to shareholder class actions, might at least indicate that steering the Indian system in the direction of the American would invite the re-invention of a set of less than desirable problems.

An available lesson from Taleb’s “Black Swan” is the all-too-human tendency to resist learning from failure. A special version – characteristic of the political classes and fully displayed by Minister Khurshid – is the hubris of the uninformed, who in their refusal to study the lessons of history are incapable of appreciating the boundaries of their ignorance.  

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A Scandal Erupts in Islamic Finance: The Algosaibi / Saad Dispute -- And is Anyone Surprised?

An exchange of lawsuits escalated late last month between Saudi Arabia’s Algosaibi family companies and the Saad group’s Maan al-Sanea.

Misappropriations rising to $10 billion are claimed, based on an alleged series of foreign exchange transactions in a workers’ remittance unit, by which riyal-for-dollars deals were rolled over and diverted through the use of forged documents and phony confirmations (here).

At the end of last week, a court in the Cayman Islands even presumed to order a worldwide asset freeze against al-Sanea (here) – an exercise of jurisprudential hubris worthy of the Grand Duchy of Fenwick in Peter Seller’s 1959 “Mouse That Roared.”

So another prediction promptly comes good: my call on June 8 – here – that “accounting scams pose risks to Sharia finance.”

From allegations in a New York court filing, the basics of my predictions are confirmed:

•    With lawsuits proliferating in the US and the UK, by bankers exposed on the debt securities of both sides of the Saudi feud, another multi-national financial scandal spreads across a borderless world of disputes.

•    The securities of both the Saad group and the Algosaibis – “sukuk” in the Sharia-compliant terminology – are trading at default levels, despite the demand for compliance with Islamic law, that repayment be assured by way of especially-designated collateral.

•    And so, as the spiritual basis for Islamic finance is overcome by the victims’ drive for secular accountability, the illusory pretense that “we’re different” and “it’s not done that way here” give way again, in the Gulf as it has elsewhere throughout history, when the veils of naïveté and denial are torn away.

One aspect yet to emerge from the Islamic dust-up is the finger-pointing at the gatekeepers. With aggressive advocates now driving claims that the string of unfulfilled financial commitments extended over four years, it is to be expected that the questions will be pursued: “Where were the lawyers?” and “Where were the auditors?”

Which will make for ominous times among the professionals.

The July 11 criminal conviction of Chicago lawyer Joseph Collins, for his role in the transactions by which now-jailed Refco chief Philip Bennett fleeced his shareholders and investors, puts a darkened color to the on-going civil litigation exposure of both lawyers Mayer Brown and accountants Grant Thornton.

And it appears that David Friehling, held out as Bernie Madoff’s long-time auditor, is in negotiations for a criminal plea deal – although in context of the 150-year sentence dealt out to Madoff himself, a deal would seem unlikely unless it spares Friehling the greater part of the maximum 105 years he faces.

For an informative if unsurprisingly defensive apologia for Mr. Collins, from a fellow lawyer, see here.

The Collins conviction may signal a new era of exposure for the bar, considering that their brethren among the accountants have been unsuccessful for years in selling the “pure heart – empty head” defense. The lawyers have long relied on their client privilege and a jealousy-guarded “duty of advocacy” behind which to manufacture and supply the tools of felonious monkey business. But if the duties and accountability of the two professions are seeming to converge, as the Friehling negotiations and the Collins verdict would suggest, the lawyers’ pain will be palpable.

Meanwhile -- from Refco to Madoff to Saad/Algosaibi, commodities options to Ponzi-style fictions to Sharia-based forex -- the repetitive pattern of window-dressed accounts that serve to conceal the predations of the principals -- facilitated or over-looked by those chargeable with detection and prevention oversight – continues to roll around the globe.

And only one thing is knowable for certain: the latest Saudi mis-adventure – immediate proof that Islamic finance is no more virtuous or scandal-proof than its Western equivalents – will not be the last.

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