Re:Balance -- Jim Peterson

Hazards in the UK Audit Market – A Parable for the Holidays

Bidding farewell to this dismal year, it’s my long experience with the holiday season in the United Kingdom that a significant matter open on the solstice will not receive attention through Christmas, Boxing Day and the New Years celebration, until after the arrival of the Three Kings.

So today’s news is welcome, that Boris Johnson’s beleaguered government actually has a candidate -- the seasoned Jan du Plessis, late of BT and Rio Tinto -- to chair the Financial Reporting Council. But the post requires parliamentary committee approval to head the audit regulator, an agency itself hostage to the absence of legislation to relieve its “ramshackle” condition. Further official delays and inaction look inevitable, well into 2022, in untangling the complexities contained in the depressing question, “Where were the auditors?”

While the prospects are slight that the arrival of du Plessis will herald a secular epiphany, there is at least a learning opportunity in the recent reporting that HSBC’s approaching obligation to put its audit out for tender may well attract no proposals save from incumbent PwC. 

That is, the needless distractions over auditor tenure –- under UK and EU rules that have been in place long enough to demonstrate the absence of discernible effect on either audit quality or competition and choice -- are relevant to the still-pending possibility that the UK government’s long-delayed action on its consultation of March 18, 2021, will include either “managed shared audits” for FTSE 350 companies, with the forced participation of the smaller firms, or attempts to impose “caps” on the Big Four firms’ market share.

Namely, with the indicated lack of enthusiasm among PwC’s three large brethren,  the unlikelihood of change at HSBC is further confirmed, according to the Financial Times, as “senior auditors at two challengers said mid-tier firms would not pitch to audit the entire HSBC group because of its size and the associated regulatory risk.”

No surprise at all. HSBC is the largest bank in the FTSE 100. PwC’s audit and related fees of $ 130 million last year are, as the FT put it, “more than the entire UK audit revenues of any challenger other than BDO and Grant Thornton.”

Which said, the story in the numbers is not the only way to consider the structural inability of the smaller firms to expand their large-company market share. For a perspective on such an attempt, here follows a first-hand experience, with implications if a “challenger” firm actually tried –- that is, had the chutzpah or the reckless courage -– to propose.  

It was a long time ago, in a galaxy far away –- so far in the past that all statutes of limitations on the telling are long since expired. A small-city office of a then-Big Eight firm wrenched the audit of a complex financial institution away from its main local competitor -- to be the successful aggressor’s only local client in the sector.

With abundant confidence and complete good faith, the newly-arriving firm cobbled together an engagement team headed by the office’s senior audit partner –- experienced and respected in the local community, known for his probity and his leadership, although with a blank slate of specific industry experience. His supporting lead manager’s briefing into the new role was to attend the firm’s internal industry training classes.

The first two years went smoothly enough, save for the weight on the engagement of the expected and greater than normal resort to the national office.

In year three, however, the client pushed into a major new product line, an ambition burdened by start-up operational glitches and accounting complexities beyond the experience and resources of its own CFO and staff.

As for the audit team, this new business went observed but unremarked. Hindsight was later to reveal that they failed to grasp or even recognize the risks and complexities of a business environment they had no way ever to have seen before. 

The finger pointing and blame attribution between client and auditor were intense and unpleasant. The inevitable rupture of the relationship was nasty, including extended litigation and ample unpleasant gossip in the city’s civic venues and country clubs.

Developments in behavioral psychology and economics provide the framework for this parable. At play is the Dunning-Kruger effect -– the cognitive bias under which catastrophically erroneous risk-related decisions are made, where the actors are ignorant of the scope of their own ignorance.

“Not knowing what they didn’t know,” in other words, both the client and the audit team were exposed to fatal defects in their decision-making capability.

Dunning-Kruger is wonderfully powerful as a means for better decisions, but only if recognized in the specific context:

• Applications start with the simple and entertaining -- if told to draw a picture of a giraffe, you have no chance if you’ve never seen one before.
• Scaling up the example to a multi-million-dollar business challenge -- even a highly-skilled professional, unless specifically trained and experienced, cannot conceive, much less carry out, the judgments involved, eg., in fixing and accounting for a realization reserve on the assumption of a portfolio of exotic financial instruments.

In the hypothetical future world of “managed shared audits” or capped market share, the engagement partner of a mid-tier audit firm with big-table aspirations would hang from a limb of uncertain length and weakness. The questions “who can I call?” and “where is my help?” would come back unanswered. 

The various versions of the clichéd doom that awaits those who forget history have even greater force for those never learning in the first place. For future problems of newly-presented scope and complexity, the consequences will be no prettier than they were in my old case a generation ago.   

  

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Brian Kelly Leaves Notre Dame: The Oxymoron of “College Football Ethics”

What lessons from Notre Dame football coach Brian Kelly’s abrupt departure for LSU last month? As so often, where you stand depends on where you sit.

Kelly took up the chance to elevate the Tigers’ 2021 dreary record -- 6-6 overall and anchoring the SEC at 3-5 -- enticed by a ten-year contract for $ 95 million plus multiple incentives. In the Southeastern Conference’s multi-billion dollar program to feed well-muscled young beef into the professional meat-grinder -- business as usual.

Back in South Bend, however, Kelly piled insult on injury:

• Using a Twitter message to inform the players he had recruited and led to the threshold (ultimately frustrated) of the College Football Playoff.
• Taking the phone call that iced his new deal as a distraction from a family dinner with a star recruit, with no disclosure during the homey sales pitch.
• Holding an abbreviated no-questions team meeting at 7.00 the next morning, ahead of his flight by private jet flight to Baton Rouge.

At both schools, the follow-on effects were immediate. Notre Dame filled the vacancy in four days. First-year defensive coordinator Marcus Freeman was promoted on an outpouring of affection, support and lobbying by the team itself, after its sullen reaction to Kelly’s superficial messaging.

Meanwhile in Louisiana, Kelly’s performative introduction was derided as a bogus attempt to transmute his New England origins and Midwestern history into an adopted southern accent. More pointedly, both the Tigers’ starting quarterback and his top-prospect high school brother, Max and Jake Johnson, promptly declared themselves unwilling to be part of a Kelly regime.

Time will tell whether the youthful Freeman will grow to be the Fighting Irish’s next Knute Rockne or Ara Parseghian; in the eyes and hearts of the faithful, he will definitely not be the next Kelly.     

For myself, I hold no brief for the massive industry of college sport. It comes hard, to endorse the inducement of young athletes with transient weekend glory and the prospect of an abbreviated professional career all too likely to end with life-shortening brain damage. Or, where even a fraction of the resources that build athletic palaces and pay the massive salaries of sweat-suited coaches could be deployed to libraries and research facilities and academic scholarships and the scholars to whom we entrust the education of our best and brightest. 

Which said, I forswear negativity or cynicism in the broader purpose of this inquiry. At the law school where I teach in a Masters program in Ethics and Governance, syllabus demands leave limited space for guiding themes and principles. So I look for opportunities to ask about some basics: What impels our human need for laws and codes of conduct in the first place? What different choices do societies make in the balance between incentives and coercion? With the fallibility of humans prone to deviant or non-compliant behavior, should we look to minimize the harm done by wrong-doers, or focus energy on leading by positive example?

The American economy and culture have two major sources for their metaphors –- the military, and sports.

• A corporate raider launches a blitz against its target. Companies competing for workers fight the war for talent.
• A successful mentor is the team captain. Career success brings recognition as an All-Star, or election to a Hall of Fame.

One of the finest trial lawyers with whom I was privileged to work, the late and great Peter Fleming (RIP 2009), drew upon his son’s experience as a D-1 football coach, to illustrate the personnel dilemma of a corporate leader:

“You work your butt off all week, to train and prepare them. On Saturday afternoon they take all that onto the field. And you’re stuck on the sidelines, watching while they surprise you –- for better or worse. Just the same with young employees.” 

It could be said that Kelly’s be-clouded departure was predictable. The broader signals of a tattered ethical fabric were there from the start:

• The 2010 death on a practice field of student photographer Declan Sullivan, sent 39 feet up a scissor lift despite winds gusting to 53 miles per hour.
• The suicide the same year of a sister-school freshman whose report of sexual assault by a Notre Dame football player received minimal attention and no school or law enforcement consequences for the player.
• The vacating by the NCAA of Notre Dame’s 21 wins over the 2012 and 2013 seasons for violations of the rules of academic integrity.

More immediately, not only had Kelly bolted his prior position at Cincinnati before the 2009 bowl games, with the Bearcats on their way to the Sugar Bowl -- he had done the very same in 2006, leaving behind his staff at Central Michigan to coach that team in the Iron City Bowl.

As it’s said, “Karma never loses your address.” Administrators at LSU might consider themselves forewarned by Kelly’s trifecta of premature evacuation. Post-season, before future years’ bowl games, they’d be advised to take away his phone and clamp him in an ankle monitor.

In the first act of Shakespeare’s Scottish play, the action is animated by the off-stage execution of the treacherous Cawdor. An otherwise minor plot device will echo to color Macbeth’s own fate: the traitor is credited with the morality of his final confession and his deep repentance -- “Nothing in his life became him like the leaving it.”

Subject to history’s possible revision, it may be said of Brian Kelly’s graceless flight from South Bend:

“Nothing besmirched his legacy at Notre Dame like the leaving it.”

 

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Chinese Companies in the US: The SEC Should Be Making American Foreign Policy?

Nearly a year into the Biden presidency, the breaks with his predecessor are stark and wide-ranging: the Paris climate accord, Iran, NATO, infrastructure –- and of course, the question whether success against COVID-19 should rely on the science of vaccinations or veterinary medicines for equine heartworms.

In that context, it bears wondering why America’s top securities regulator, Gary Gensler, chairman of the Securities and Exchange Commission, has with enthusiasm embraced one of the prior administration’s least coherent ideas.

By rules finalized on November 5 and December 2, Gensler committed his agency and the US audit regulator, the Public Company Accounting Oversight Board, to the Holding Foreign Companies Accountable Act, passed in May 2020, under which foreign companies would be punished for their auditors’ failure to allow oversight agency inspection and production of their working papers.

Aimed directly at the recalcitrant Chinese, who have refused, since passage of the Sarbanes/Oxley law in 2002, to submit to the enforcement processes of the PCAOB, the HFCAA perches Chairman Gensler on the pointed horns of a dilemma: What shall he do now? 

That’s because it is well enough, at the level of the cheer-leading rhetoric of Washington bureau-speak -- as Gensler’s latest press release put it, “the final rule furthers the mandate that Congress laid out and gets to the heart of the SEC’s mission to protect investors … to ensure that the auditors of foreign companies accessing U.S. capital markets play by our rules.”

Left un-addressed, however, are implications for international policy, well above the pay grade of a securities regulator. At the heart of the matter: is official Washington prepared either to de-register the uninspected Chinese member firms of the large international accounting networks, or to enact stock trading prohibitions and ultimate de-listing of non-compliant Chinese companies?

There are multiple issues:

• To start, application of the HFCAA could not please the bankers and other participants in the American-based portion of the world’s capital markets, putting at risk of exclusion an estimated 250 companies with market capitalization above $ 2.1 trillion and headed by such as Alibaba, Tencent and JD.com.

• The self-interest of the bankers would align with ex-China investors in preserving not only simple trading mechanics, but also the availability of information about Chinese companies, as required under the American regimes, incomplete as may be. There is no indication, for example, that an audit regulator in Hong Kong would be any more successful in achieving inspections and document production than its American counterpart.

• Consistency of approach should also drive attention to the unavailability of auditor information on the enormous China-based operations of the array of giant corporations based or listed in the US –- a simple example being Apple, which steadily generates about one-quarter of its revenue in China although the local Chinese firm of EY’s global network has never made available its personnel or its papers.

• China’s own policy intentions and desires are in play. It may indeed suit that country’s leadership to reel in the listings of its country favorites, bringing them home to the proximate bourses of Hong Kong or Shanghai. That step would be congruent with the evident arm-twisting wrought on the fallen darling, ride-share company Didi, which announced on December 3, in timing most likely coincidental, that it has repented of its US initial public offering and will take steps to de-list in favor of Hong Kong –- a move of scant comfort to the investors who saw Didi’s share price lift from its initial offering price of $ 14 to a high of $ 18.01, only to crash back last week to a range around $ 7.

Finally, the entire recent exercise –- passage of the HFCAA and the ponderous rule-creation process of the SEC and the PCAOB –- is redundant and duplicative of pre-existing authority and tools under Sarbanes/Oxley itself.

That is, as outlined here last May, since the time that law was passed in 2002, its framework has required that both domestic and foreign auditors of US-listed companies submit to the PCAOB; that sanctions for non-compliance would include a firm’s de-registration; that audit reports of a de-registered firm were not permissible for SEC filing; and that the consequences for a company would include trading prohibitions and de-listing.

That authority has gone unexercised for almost twenty years. Now, with the HFCAA lurching into place, its rules contemplate a three-year timetable before sanctions would fall on either a non-compliant company or its auditor. That is, commencement of meaningful enforcement consequences would not start before 2024.

Chairman Gensler having inherited a poisoned chalice of mutually conflicting policy goals and potential unintended consequences of uncertain geo-political scope, he stands before a wide-open opportunity window. There, a prediction may be made with confidence, that political exigencies will yet oblige him to hurl that chalice through the window and as far down the road as possible.  

 

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