Re:Balance -- Jim Peterson

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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Ratings Agency Liability -- The Aussies Turn the World Upside Down

The litigation exposure of the Big Four accounting firms has not been made easier. 

The global networks should take no satisfaction from the field-leveling decision of Judge Jayne Jagot of the Federal Court of Australia, who on November 5 found ratings agency Standard & Poor’s (S&P) negligently liable to the purchasers of “grotesquely complicated” derivatives, designed and sold by ABN Amro. 

Schadenfreude would be wrong – and not just because it’s too hard to spell.

Consider the cries for accountability, during the recent years of financial calamity, by the auditors and the ratings agencies (e.g., here and here) – both of them, depending on one’s perspective, either vital gate-keepers to the markets, or aiders and abettors of the malefactors.

When their roles are compared, the guilty shiver of pleasure at another’s troubles would under-estimate the potential spreading of exposure. Consider the similarities: 

• Both have come to be viewed as essential functions in the world’s capital raising – chiefly by their regulatory authorities, to whom self-preservation and continuing existence are their own primary raison d’être.   

• Both are engaged and paid by their clients, upon which direct financial relationship they construct an elaborate edifice in illusory support of the intellectually unsatisfactory concept of an “appearance of independence.”

• Both seek to advance credible arguments that there is legitimate competition in their sector, despite effective barriers to entry that maintain their pass-the-parcel hegemony and an ever-tightening dominance by their respective global cartels.

• Their core products – the standard audit report and the three-letter rating – are delivered to users in prescribed and commoditized language – of which the source is a matter of consumer indifference and authorship would not be obvious absent a letterhead. 

• And finally, both couch their language in the qualified language of “opinions” and “judgment. ”

As to the last, however, the critical survivability difference emerges.

Namely, while S&P and its brethren have succeeded in wrapping themselves in the fuzzy if heretofore liability-proof blanket of the First Amendment’s free-speech protection, the auditors have long skirted disaster at the hands of a hindsight jurisprudence that threatens damages far beyond the limits of their financial tolerance or capacity. 

For the detail geeks, ABN Amro’s eye-crossingly complex derivatives, code-named “Rembrandt,” and the model-gaming involved in the rating process are laid out in overwhelming detail in the summary of Judge Jagot’s massive decision, and are thoroughly and colorfully discussed elsewhere – here and here.

The result threatens to turn topsy-turvy the ratings agencies’ comfortably protected world. Her Antipodean perspective is that S&P’s triple-A ratings were “misleading and deceptive,” involved “publication of information or statements false in material particulars,” and could not have been given by “a reasonably competent ratings agency.

For the ratings agencies themselves, the threat of worldwide contagion after the Rembrandt decision may be mitigated by both the availability of continuing scorched-earth defense strategies and the likely expiration of statutes of limitations to shield them from crisis-era claims.

For the auditors, who as noted are already far more exposed, it may be otherwise. Because -- taking cautionary note that the Rembrandt investor plaintiffs were supported by a publicly-listed company whose business is the funding and financing of large-scale class action securities litigation (here) – the investor-protection bar is a ruthlessly effective learning organism – to which the Judge’s liability language will operate like a blood-soaked invitation into a shark tank.

Even if not in the already-fraught American litigation market, should her process of hindsight negligence analysis gain traction in the courtrooms of Europe and elsewhere, the large accounting firms will find no ready firewall against the spreading conflagration.

 

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