The Auditors And Financial Regulatory Reform: That Dog Don’t HuntBy Francine • May 31st, 2010 • Category: Food for Thought, Latest, Pure Content
It’s not every day that a regular girl from Chicago has a chance to talk with a sitting US Senator about the subject most important to her.
No… I’m not talking about Rosie, my Rottweiler.
I’m talking about the auditors’ role in the financial crisis and their place in the regulatory reform bills now being considered. Through a series of wonderful and kind acts, namely the efforts of one particular journalist, I was invited to talk with Delaware Senator Ted Kaufman (D) and his staff about accounting industry reform.
The conversation was wide ranging and opinions expressed off-the-record. The meeting happened on the same day as Representative Barney Frank’s speech to the Compliance Week conference and we talked about his remarks. I expressed my disappointment with several things especially Rep. Frank’s capitulation on a Sarbanes-Oxley exception for smaller companies and his rambling response to the question about a Department of Justice implied “too few to fail” policy.
The Kaufman team is led with mucho gusto by the Senator. It was great to have a chance to meet them, but I realize it’s probably too late to get anything that addresses audit industry reform in this bill. There’s a lot of compromise going on with what’s already there.
Health care reform took some of the fight out of more than a few on both sides of the aisle and in both legislative bodies. Rep. Frank mentioned it a few times during his speech. He described advantages and disadvantages from a legislative perspective of the pure focus on financial regulatory reform now that health care is “a done deal.” It makes it both easier for media to spotlight an individual politician’s positions without the clutter of other major legislation and harder for that politician to hide behind multiple major initiatives when it comes to supporting or voting for controversial or dramatic change.
I came to the meeting with a few points to make. I think I did that but, as usual, a discussion of the issues facing the audit industry can get a little depressing, even for me.
However, this meeting, as well as the ones at the PCAOB, made me realize the time has come to make proposals and suggestions for industry change instead of just pointing out the issues, problems and need for change.
Most regulators and legislators avoid talking about wholesale change to the structure of the accounting/audit industry. It seems too big a task and untenable. The refrain I hear most often both when attending conferences and events and on this site is, “We can’t get rid of the audit opinion. It’s required.” I’ve also written about the strong and steady political contributions the accounting industry makes, party-agnostic, dictated primarily by the politician’s position and influence over the audit firms’ interests.
Lack of vision and loads of cash. These are the fundamental obstacles to serving investors and other stakeholders with financial reporting that can be trusted.
But it’s also true that Big Oil has spent years deluding itself and others into thinking that this kind of spill was impossible and that preparing for one wasn’t necessary. Indeed, BP once called a blowout disaster “inconceivable.” Certainly, if you can’t conceive of a disaster, you’ll become more and more lax, more and more reckless, until one happens. You’ll cut corners on backup systems and testing. And you certainly won’t pre-build and pre-position any relevant equipment for staunching the flow. Since a disaster can’t happen, you and your allies in Congress will block all serious safeguards and demagogue all efforts to oversee the industry as “Big Government interference in the marketplace that will raise the price of gasoline for average Americans.”
This quote comes from Salon and refers to the oil spill disaster. But it could have just as easily been said about the litigation threats against the largest global accounting firms and doubts about their viability and credibility post-financial crisis. If legislators and regulators can’t imagine a world without the audit firms and the audit report in their current form, then they can’t work towards something better for investors and the capitalist system.
The firms are broken and their basic product is worthless. The auditors were completely impotent to warn investors of over-leverage and risky business models, to prevent erroneous and potentially fraudulent financial reporting and to mitigate the impact on everyone of these errors, misstatements, obfuscations and subterfuge by executives of the failed, bailed out and nationalized financial institutions.
It wasn’t such an intellectual leap for media, regulators and legislators to see the inherent conflicts in the ratings agencies’ business model post-crisis and to essentially, with the stroke of a pen, destroy that business model.
New York Times, The Caucus Blog, May 13, 2010: One amendment, sponsored by Senators George LeMieux, Republican of Florida and Maria Cantwell, Democrat of Washington, would remove references to the credit agencies in major financial services laws, including the Securities Exchange Act of 1934, the Investment Company Act of 1940 and the Federal Deposit Insurance Act. It was approved by a vote of 61 to 38.
Additional reform legislation sponsored by Senator Al Franken – I kid you not – puts the government in the middle between ratings agencies and the securities issuers. The ideas is to take the “pleaser” part out of how the credit raters make their living.
The Atlantic, May 13, 2010: “The new legislation calls for every new ABS bond issue to have a rating by one agency assigned by a new board, instead of being chosen by the investment bank creating the security. The board will consist of mostly investors along with a few other industry participants. Although the underwriter can solicit additional ratings, it cannot escape the verdict of the assigned agency, so it cannot shop around for whichever agency has the most favorable view.”
Wouldn’t it be funny if the audit firms took advantage of the credit ratings agencies’ weakness and swooped in to do that business? After all, the auditors have the trust and integrity thing down pat. But there’s no way the audit firms would have the nerve to even float that idea post-EY/Lehman…
Nobody disagrees when I remind them that audit firms have the same inherent conflict of interest as ratings agencies. The audit firms have a business relationship with Audit Committees who are selected by the corporations’ executives. Audit partners are “pleasers.” The audit fees for the largest financial institutions are in the $100,000,000 annually range but it’s been a challenge to grow that business in the current economic environment. The Sarbanes-Oxley gravy train has pretty much derailed.
Is it such a stretch to think about taking the control over appointment and renewal of auditors away from the corporations – the corporate executives are the true corrupting influence on the poor, innocent auditors – and give it to the SEC or PCAOB? Corporations could be required to pay the auditor regardless of the audit opinion or how many exceptions are found or hard the auditor has to push back on aggressive accounting. All this can happen under the watchful eye of their regulator who can put the firms on a “good list” and can effect limited or general “debarment” type actions if an audit firm or audit partner rolls over and plays dead too often.
I also ran my idea of a Service Corp for Accountability and Transparency by the Kaufman team but I admit it’s a big move. My basic argument is this:
“Why are the same audit firms who presided over the failure of clients like like AIG, Lehman, Bear Stearns, Citigroup, Freddie Mac, GM, WaMu, and Wachovia still collecting fees from the survivors owned substantially by the taxpayer? They’re also getting paid by the US government to audit and monitor the bailout programs as well as to audit the agencies themselves such as Treasury. We need to take the audit firms off the taxpayer dole and demand performance.”
Fraud happened and the auditors haven’t even testified before a Congressional Committee.
I went a little further and reminded them that immediate Congressional action will be necessary if the PCAOB is declared unconstitutional by the US Supreme Court. The decision will be made by the end of the month. I hope Senator Kaufman is prepared to help develop new legislation that will reestablish the PCAOB or a comparable regulatory authority within the SEC to continue the independent regulation of the audit firms.
If an emergency bill needs to be passed, let’s take the time to plug not only the gaps cited by a Supreme Court decision regarding Presidential authority but also to fix some other critical holes in the original legislation.
My recommendations for a new PCAOB will be discussed in a separate piece. Although I am a strong supporter of Sarbanes-Oxley, the law and the PCAOB have been vulnerable to criticism and challenge because of the hasty way the legislation, patterned after regulation of broker/dealers, was enacted. Given the chance, let’s plug these holes and give the PCAOB the teeth it needs to do its job for investors.
We talked a bit about the litigation facing the firms. I think the audit firms do a great job hiding the big picture of crushing litigation from everyone, including their own partners. Suffice to say, I could pick any one of the largest four firms – Deloitte, PwC, KPMG or EY – and make the case that litigation is threatening their viability and their ability to do quality work. Any one of the several billion dollar cases against the largest four global firms may either result in a judgement they can’t pay or require bigger and bigger settlements over and over again in order to avoid public disclosure of their flaws and weaknesses.
The scope of the current audit product – requiring an opinion on the financial statements taken as a whole – means that none of the next tier firms can step up and deliver audit opinions to the global multinationals. They’re just not ready for prime time. The depth and breadth of their experience is nowhere near what it needs to be to do that kind of engagement.
What the regulators and legislators must avoid is being distracted by the Arthur Andrsen scenario. The Department of Justice (DOJ) handed KPMG a “Get Out of Jail Free” card after their tax shelter transgressions. Then they implemented, literally and figuratively, a policy to never again indict an audit firm. What they don’t seem to see is that “too few to fail” is harming investors as much as “too big to fail”.
Moral hazard is moral hazard.
As one of the Compliance Week speakers blurted, “We know now the collateral damage from putting one of these audit firms out of business and no one wants to see that repeat…”
Rep. Frank thinks some version of the Specter bill repealing Stoneridge will make it back into the legislation. I don’t think the Kaufman team agrees. I told them I was in favor of such a repeal since, under PSLRA, judges are letting negligent and corrupt auditors off the hook far too often. It’s easy to bring a suit against the auditors but very hard for plaintiffs to survive a a motion to dismiss, especially when fraud is alleged. Almost every suit for auditor malpractice or professional negligence settles. Notable exceptions are BDO Seidman’s loss in the Bankest verdict and PwC’s loss in the Ambassador Insurance case.
It must be confusing when I say the viability of the audit firms is threatened by existing litigation – whether they go to trial or not, settlements and the cost of defense is now suffocating the firms – but I also advocate the repeal of Stoneridge, making the firms potentially even more vulnerable to a catastrophic judgement.
Aren’t liability caps the answer?
No. That preserves the status quo.
I am advocating we reject the status quo. The government-sanctioned, oligopolistically priced product – an opinion on the financial statements taken as a whole – should be thrown out and new forms of insuring the integrity of financial reporting imagined.