HP-Autonomy: A Red-Ink Bath for Everyone

       “Either nobody in this deal understood the Company’s business, or someone was committing a fraud.”

-- Big Firm audit manager’s file note

Such language doubtless lurks in the working papers of the Big Four accounting firms, concerning this Thanksgiving’s biggest corporate turkey – HP’s announcement on November 20 of the whopping write-off of  $ 8.8 billion of the $ 11.1 billion paid a year earlier to acquire the UK’s FTSE 100 Autonomy.

How the blame-mongering cost of this fiasco will be allocated will depend, since each member of the large-firm tetrapoly touched the deal – Deloitte as Autonomy’s independent auditor, E&Y in the same role for HP, KPMG as part of HP’s huge buyer-side due diligence team, and finally PwC, brought in to pick over the forensic wreckage.

The quoted memo itself goes back a generation, to an investigation into sketchy high-tech revenue accounting – where it figured prominently in the investor litigation and the company’s SEC consent decree, an exhibit to the hazards of recording ideas that were both prescient and dangerous.     

That’s context for these thoughts responding to my investment banker friend and regular reader, “waiting for commentary on the Hewlett-Packard news and how it will affect Deloitte.”

Happily for the global supply of bandwidth, this story broke in a holiday week, absorbing in turkey, shopping and football the perfervid reactions of the most strident critics and their demonizing of the audit franchise as systemically venal and corrupt (e.g., here and here).

It is pointless now – time enough as the process evolves – to judge the predictable protestations of virtue of ex-CEO Mike Lynch, or Deloitte’s statement that it “categorically denies that it had any knowledge of any accounting misrepresentations….”

The Autonomy claims involve aggressions as old as IBM’s practices under the Watsons in the 1950’s – long stale and banal, and at best only interesting as an undergraduate classroom exercise in the endlessly elastic opportunities for revenue manipulation.

HP’s allegations do not, so far at least, involve such classics as the empty boxes at Miniscribe (1989) or Crazy Eddie (1987), nor yet the bogus contracts of Lernhout & Hauspie (2000) or Satyam (2009), but only the dreary familiarity of channel-stuffing and phantom contract dates – activities perpetually inviting to companies creatively striving for sweetened earnings, and elusively beyond the persistent efforts of standard-setters, regulators or law enforcement. 

More to the point, given the long-running criticism of Autonomy’s reporting by hedge funds and short sellers, is that it defies acceptable practice for HP CEO Meg Whitman to attempt the lay-off, that “the board relied on audited financials – audited by Deloitte – not Brand X accounting firm but Deloitte.”

Sorry, Meg. Not for a generation has an effective due diligence team done any more with a standard audit report than throw it onto the compost heap at the back of the document repository.

The HP team, said to comprise three hundred people from KPMG, bankers Perella Weinberg and Barclays and a quintet of law firms, surely had ample experience to sniff out any issues deemed significant. Why it did not will abide further finger-pointing.

But collective memories should not have been so short as to miss the red alert flag that the Autonomy deal was being flogged by Qatalyst Partners in the person of Frank Quattrone.

Whose earlier heady days in Silicon Valley had ended with one hung jury, a conviction reversed on appeal and a deferred prosecution agreement. So to say as did Reuters that Quattrone “specializes in tech deals” is like saying that Typhoid Mary was just going about innocently looking for work.  

Surer proof that HP will fail to spin its Autonomy debacle as an Enron-scale accounting fraud, is its assessment by Lynn Turner, who in 1998 was levitated to the post of Chief Accountant at the SEC from his position in a since-disappeared high tech company, after two decades at Coopers & Lybrand where he had emerged as national leader of its High Technology Practice.

Turner – whose background would presumably recognize dubious practices in the sector –- resisted the chance to pile on his erstwhile large-firm brethren --  for whom he forsook any affection upon his extraction from their ranks, his animosity more typically achieving the zeal of the mad monk in The DaVinci Code. Asking how the Autonomy policies “translate into a $ 5 billion write-off?” he demurred, that “the big issue isn’t the fraud they’re talking about. The big issue is that HP has made acquisitions that have turned out to be a disaster.”    

And so to my friend’s question, who might ultimately be liable to whom? The news is unhappy for HP’s long-suffering shareholders, whose claims -- either as a class (immediately launched) or on behalf of the company – under either British or American jurisprudence will offer little recourse, against HP or its management, Autonomy’s sellers or Deloitte.

Direct HP litigation against Deloitte would seem unlikely, given their existing ten-year consulting relationship as global alliance partners. Nor could Meg Whitman relish hostile courtroom scrutiny of the acquisition decision of her predecessor, Leo Apotheker, given – on her watch -- the year of pre-disclosure operating experience HP had with Autonomy, its string of prior write-offs including the $ 9.2 billion charge related to EDS, and the skeptics’ suspicion that HP’s write-off is a “big bath” overstatement of Autonomy’s illness to the forward benefit of HP’s balance sheet.   

If the impact on Deloitte and the other gate-keepers is likely “not much at all,” it is also likely not zero -- depending on where the “smoking gun” memos of the quoted variety might reside and be discovered – since a multi-billion dollar claim is beyond the Big Four firms’ financial capacity or risk tolerance to take to trial (here) – however enthusiastic their press-office protestations of innocence and scorched-earth defenses. 

What this latest dreary escapade does portend is several years of uncontrolled legal and litigation costs, and a flurry of inconclusive regulatory and oversight investigations – the end results of which will be inconsequential.

And finally, a wager is offered here, that Meg Whitman will not survive in place at HP to see it through.

 

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Comments

[James]

Thank you for your thoughts, they have served as an interesting and topical distraction to revising for my auditing exam!

On this subject of auditors' liability, if HP come at Deloitte I would imagine Deloitte may first use the Caparo defence in terms of its 'duty of care' (i.e. lack thereof to HP).

Assuming that avenue is blocked off, HP or regulators may point to Deloitte's duty to detect material misstatement under ISA240 (auditors responsibilities relating to fraud).

Deloitte have stated that they were not aware of any 'accounting misrepresentations' by HP. In my opinion by stating this they are leaving themselves wide open if such misrepresentations did occur and they signed off on the accounts. Perhaps I am naive but that is unlikely for such an experienced and distinguished firm. (JRP Note: sorry, sadly, it would not be the first time.)

It is hard for anyone to know what has went on here but you could conclude therefore that the problem lies more with HP's running of Autonomy post acquisition.

[Andrew]

Kudos to you James! You uncovered far better information than I have seen anywhere else combined (FT, WSJ, TC, etc).

These guys have some share of blame, but how would you rank them based on responsibility? How would you order in terms of legal liability?

1. Former Autonomy Management (Mike Lynch included)
2. HP Management & Board (Apotheker included)
3. Qatalyst (Quattrone)
4. Deloitte
5. E&Y
6. KPMG
7. PwC
8. Sell-side attorneys
9. Buy-side attorneys

[David Merkel]

Meg Whitman could have just paid the ~$100 million breakup fee at the beginning of her time as CEO. She is partly to blame here.

[zaubern]

Thank you, I have been looking for details about this subject matter for ages and yours is the best I have discovered so far.