These disclosures were a result of pressure brought to bear by Congresswoman Maxine Waters and several other congressional members who sent a letter to the OCC and the Fed on October 28. This letter expressed the legislators’ displeasure with the way the OCC and the Federal Reserve Bank had so far run the “independent” foreclosure review process that is intended to overhaul mortgage-servicing processes and controls and to compensate borrowers harmed financially by wrongdoing or negligence.

Congresswoman Waters cited my October 6 column for American Banker in this letter to the OCC and Fed when demanding that the regulators manage conflicts of interest in the foreclosure review process as well as make a full disclosure of vendors and their engagement letters with the banks.

On December 6, I wrote again in American Banker after I reviewed the engagement letters that were posted by the OCC. I had several concerns. Congresswoman Waters did, too.

“[The OCC] issued a report on the actions of a dozen national bank and federal savings association mortgage servicers aimed at complying with the consent orders issued in April 2011 to correct deficient and unsafe or unsound foreclosure practices. (The two remaining consent order recipients — GMAC/Ally and SunTrust — have not yet finalized their terms with vendors and as a result their overseers, Fed Chairman Bernanke and the Federal Reserve Bank, have not yet responded to the request for full disclosure, according to the Water’s office.)

Waters was less than impressed with what she saw and so am I.  She told me, “My letters specifically asked for information on conflicts of interest between the banks and the consultants — which is precisely what the OCC redacted in the information they released last week. A cursory look into the banks and their consultants indicates that in some cases, there are substantial pre-existing relationships between the firms.”

Redacted is an understatement.

Here’s what was redacted, according to OCC spokesman Bryan Hubbard:

Limited proprietary and personal information has been redacted from the engagement letters including, but not limited to:

• Names,titles and biographies of individuals;
• Proprietary systems information;
• References to specific bank policy;
• Fees and costs associated with the engagement;
• Specific descriptions of past work performed by the independent consultants.

So what’s left? It’s interesting enough, as a start, to look at which consultants and law firms were selected by which servicers. It’s also interesting to look at the scope of services to be performed and the time and volume estimates for project activities where they were not redacted.

From my December 6 American Banker column:

The disclosure of the consultant engagement letters for each servicer has already had a huge impact. The Financial Times reports that the New York Attorney General “launched an investigation into possibly unlawful foreclosureson the mortgages of active-duty members of the US military.” The foreclosure review engagement letters posted by the OCC included estimates prepared by the banks and their consultants suggesting, according to the Financial Times, that 10 leading lenders may have seized the homes of about 5,000 service members in violation of the Servicemembers Civil Relief Act, which restricts foreclosures on the homes of active duty members of the U.S. armed forces.

There’s also the issue of attorney-client privilege:

Some of the engagement letters invoke attorney-client privilege and attorney work product privilege over the whole process and confidential treatment of engagement letter itself. It appears all the servicers used their general counsel’s office to engage the consultants and outside counsel and some name their general counsel as project lead. Some servicers engaged additional outside legal counsel for the review directly rather than through the primary consultant.

OCC spokesperson Hubbard says, “although some of the engagement letters make claims of attorney-client privilege, these claims are by statute inapplicable to the OCC and FRB, which have complete access to all documents produced by the independent consultants and servicers as part of the independent foreclosure reviews required by the Consent Orders.

I certainly hope so.

I was the first to report on December 6 the irony of Deloitte having been selected by, of all banks, JP Morgan Chase. The high likelihood of a conflict between the bank and the audit firm, and possibly the individual Deloitte partners assigned to the JP Morgan Chase review, should have been obvious to anyone at the OCC. I said on December 6 that it would be great if we could see the names of the partners and staff assigned to the engagements and check their credentials and prior client work for conflicts.

It would be enlightening, for example, to see whether any of the Deloitte partners proposed as consultants as part of the foreclosure solution at JP Morgan/EMC, were previously part of the mortgage origination/securitization problems as auditors at Bear Stearns or Washington Mutual.

Bear and Washington Mutual, both former Deloitte audit clients, are now part of JP Morgan Chase, and Deloitte is defending lawsuits over alleged audit failures at those firms.

Lo and behold, partner Ann Kenyon of Deloitte, who testified at a December 13th Senate hearing on the issue, said under oath that she is the engagement partner on the JP Morgan Chase foreclosure review. An internet search revealed a conference biography that suggests that amongst Kenyon’s representative clients was Washington Mutual, now owned by JP Morgan Chase and a significant part of the review. This would be a clear conflict with her role as engagement partner for the review.

Ms. Kenyon [who leads Deloitte's Securitization Advisory practice] works with issuers, comprised of both attest and non-attest clients, who have encountered difficulties in accounting for and reporting on their securitizations.

At the 126:20 mark of the archived webcast of the Senate hearing Kenyon describes the organizational structure, level of experience and source of professionals for the Deloitte JP Morgan Chase review team. (She says it’s all Deloitte staff.) She also says that a large team of Deloitte partners who are subject matter experts report to her and are leading each team.

Someone should check their conflicts, too.

Two of the other three Big Four audit firms were selected for multiple review assignments. KPMG, auditor of Citigroup, New Century, Countrywide, Wells Fargo, and Wachovia, is conspicuously but thankfully absent from the list of consultants.

Examples of firms involved in multiple reviews include Ernst & Young (involved in three reviews as both a primary consultant and subcontractor), PricewaterhouseCoopers (involved in two reviews as a primary consultant), and Promontory Financial Group (involved in three reviews as primary consultant). Law firm Gibson Dunn is legal counsel for three reviews (retained by the consultant in two cases and by the bank directly in one).

For example, one firm could be charging different rates to different banks for what is supposed to be a consistent review across servicers. That not only indicates banks can leverage their influence with vendors to get the review they want (and the monetary exposure estimate) at the price they want to pay, but that we may not get consistent results for borrowers that were harmed by multiple servicers.

Some of the concerns I mentioned in my December 6 column were pursued by Senators at the December 13 Senate Committee on Banking, Housing, and Urban Affairs hearing: Helping Homeowners Harmed by Foreclosures: Ensuring Accountability and Transparency in Foreclosure Reviews.

Some additional interesting interchanges during the hearing:

At the 45:30 mark of the archived webcast, Senator Reed asks the OCC’s Julie Williams why the OCC and Fed could not select and contract with the consultants directly. Williams says that would have been difficult because it would have necessitated the regulators to use a “procurement process” that included consistent “standards” for selection.

That sounds to me like a Request for Proposal process and a vendor selection process that is in place  - for many of these same vendors already – as a result of the finical crisis. Instead the OCC and Federal Reserve bank abdicated the vendor selection process to the services and, therefore, will reap the numerous potential conflicts they have sown.

At the 49:00 mark, Senator Reed asks a critical question, perhaps thinking about the Deloitte/Bear Stearns-EMC/Washington Mutual issue with regard to a JP Morgan Chase review. If a consultant runs across a set of transactions that the firm or those consultants had direct involvement in is the consultant obligated to report that conflict to the regulator?  Williams says that they would expect to hear about such a conflict.

Reed presses to ask if there is an “obligation” versus an “expectation”.  Williams sounds evasive in her answer, implying that this specific obligation is not explicit in the engagement letters.  I sure didn’t see it.

My December 6 column, in particular the parts regarding the Deloitte conflict and the attorney-client privilege issue were mentioned in the written and oral testimony by Alys Cohen, Staff Attorney  at the National Consumer Law Center.

With regard to the attorney-client privilege potential issue, the OCC and the Federal Reserve Bank should make sure all legal counsel that is intended to be part of the foreclosure review team should be retained by the consultant not the bank.  Otherwise, I see an assertion of attorney-client privilege by the outside legal counsel for the reviews as inevitable.

Some additional areas where strong monitoring by Congress and the OCC/Fed might be helpful going forward include:

• Checking consistency of level of effort estimates across project plans for each consultant’s proposal. Estimated hours for each task may vary based on the size and complexity of servicer, difficulty of obtaining information, and level of cooperation in resolving issues. But consultants will bill on a “time and materials” basis and variations in length of time estimated, for example, for each initial loan review and the quality assurance process could make millions of dollars of difference in fees given the tens of thousands of documents to be reviewed.

• The complaints process, managed as a coordinated approach for all servicers by Rust Consulting, needs to be synchronized with each servicer’s plan for their reviews. Although the OCC strongly influenced the design and implementation of the “coordinated” process, Rust Consulting signed a contract each servicer, risking the possibility of some servicers skimping on the effort or being unprepared based on their lack of progress in other dependent activities.

To his credit, Judge Kaplan does leave one important allegation for Ernst & Young to defend:

Ernst & Young had reason to know that Lehman’s 2Q 2008 financial statements could be materially misstated because of the extensive use of Repo 105 transactions.

John McDermott of FT Alphaville does a good job explaining why:

Kaplan dismisses the majority of the specific allegations against the auditors but writes that one particular incident means that the case against them cannot be thrown out [when] he stops to ask another question on Repo 105:

In other words, have plaintiffs sufficiently alleged that E&Y knew enough about Lehman’s use of Repo 105s to “window-dress” its period-end balance sheets to permit a finding that E&Y had no reasonable basis for believing that those balance sheets fairly presented the financial condition of Lehman?

The answer: yes, in one case.

Plaintiffs rely for this purpose on precisely the same alleged red flags discussed previously in connection with E&Y’s GAAS opinion – the “true sale” opinion, the netting grid, and the Lee interview. The first two are no stronger in this context than in that. The Lee interview, however, is a different matter.

The “Lee interview” pertains to warnings allegedly made by Matthew Lee, Lehman’s SVP for Global Balance Sheet and Legal Entity Accounting, that Ernst & Young were told of a $50bn repo 105 move in June 2008 but did not pass on the full information to Lehman’s board. Thus, it failed to fulfill GAAP requirements as part of its Q2 2008 auditing.

I’ve been saying for a while that there’s too much deflective focus on the accounting for Repo 105 and not enough on the disclosure.

Now they’ve got a public airing of some dirty laundry by the PCAOB.

From Compliance Week:

The Public Company Accounting Oversight Board has barred the now-former E&Y partner, Peter O’Toole, from associating with a PCAOB-registered firm for three years and fined him $50,000. The board barred the now former senior manager, Darrin G. Estella, from associating with a PCAOB-registered firm for two years. Both auditors can petition the board for reinstatement at the end of their penalty periods. In December, the PCOAB issued an earlier action against Jacqueline Higgins, an E&Y manager, in connection with the same incident.

The PCAOB says the three auditors created, backdated, and added documentation to an audit file when they learned it would soon be inspected by the board. The disciplinary orders say O’Toole was the engagement partner for an audit of an unnamed public company with a Sept. 30, 2009, year-end. The firm gave the company a clean audit opinion on Nov. 23, 2009, then learned the audit would be inspected in April 2010, with inspectors planning to study “securities valuation.”

Ernst & Young spokesman Charlie Perkins tells The Financial Times, “no harm, no foul,” as far as the firm is concerned.

“Our firm’s policy explicitly prohibits persons from supplementing or changing audit workpapers in circumstances like those present here,” said Charles Perkins, a spokesman for Ernst & Young, in a statement.

“When we determined that firm policy had been violated, we subsequently separated the partner and senior manager from the firm. We have co-operated fully with the PCAOB throughout its investigation of this matter. The conduct described in the order had no impact on our audit conclusions or on the client’s financial statements.”

Unless there are sanctions, we won’t know if more of this kind of thing is happening at U.S. firms. That’s becasue that part of the PCAOB inspection report is private.

We do know it’s happening at Ernst & Young in the U.K. Repeatedly.

From my post at Forbes.com, “By Any Means Possible: Auditors Try To Meet Standards By Faking It”:

The latest inspection report for Ernst & Young in the U.K., the same global firm that the PCAOB recently disciplined, cited specific deficiencies: (The AIU inspected thirteen engagements of a total of 295 eligible.)

Signing and dating of audit reports:

On two audits the auditor’s report was signed prior to the completion or evidencing of all necessary review procedures.

Completion of audit disclosure checklists:

…On two of the files that we reviewed it was unclear from the audit file whether the team had re‐performed the completion of the financial statements disclosure checklist.

Audit finalisation:

We found weaknesses in connection with audit finalisation procedures on seven of the audits we reviewed. The majority of these weaknesses related to undetected clerical drafting errors in the accounts including, in one case, an error in the disclosed audit fee.

Thank goodness for the plaintiffs’ bar and class action lawsuits.

And state attorneys general.

Without them, there’d be very little justice yet – or compensation – for any of the mortgage-related fraud perpetrated during the recent real estate bubble.

Chad Johnson, a partner in the litigation practice at Bernstein Litowitz Berger & Grossmann LLP, posted in the Harvard Law School Corporate Governance and Financial Regulation Forum (on behalf of colleague Ross Shikowitz who wrote the article) that private litigants, in spite of some significant impediments, are picking up the slack for the SEC and Department of Justice.

Now, more than ever, private lawsuits are needed to supplement the existing regulatory structure, both to ensure that shareholders are adequately compensated for their losses and to send a strong message that fraudulent conduct will not be tolerated. Indeed, institutional investors continue to vigorously prosecute suits against the companies and executives at the heart of the mortgage crisis, well after the SEC and DOJ have shuttered their civil and criminal investigations.

While it remains to be seen whether government regulators will eventually force Wall Street executives to answer for their improprieties, it is clear that sophisticated public pension funds will continue to play an essential role in obtaining compensation for injured investors and deterring future wrongdoing by corporate executives.

Even when institutional investors like pension funds try to work within the system, using their significant, long-term shareholder standing to exert influence on corporate boards, they have been turned back. The banks and financial institutions won’t own up to their mistakes and their executives to their culpability willingly.

Eliot Spitzer explains the phenomenon in his recent broadside, “Government’s Place In The Market,” published by Boston Review Books and MIT Press.

“Only government can ensure integrity, transparency, and fair dealing…even though private companies compete, only government can ensure that there is competition. Everyone wants to be a monopolist.”

In January, my column, Accounting Watchdog, described the potential impact on bank stocks of a letter sent to Bank of America, Citigroup, JP Morgan Chase, and Wells Fargo by New York City Comptroller John Liu. This letter, sent on behalf of a coalition of seven major public pension systems, called on the banks’ Audit Committees to launch independent examinations of their loan modification, foreclosure, and securitization policies and procedures.

Liu had proposed these reviews, initially on behalf of the New York City pension plans, back in November. The banks were cold to these proposals, as well as the one in January by the larger coalition. The pension funds called for immediate action.

Time passed with no willingness by the banks’ boards, in particular their Audit Committees, to conduct independent reviews in the normal course of business. So, the coalition submitted shareholder proposals for the banks’ annual meetings. Throughout this period, the boards of the four banks were generally unresponsive to the coalition’s requests to discuss and meet on the proposals. Audit Committee members would not meet with them at all.

It’s a sign of the banks’ unwillingness to own up to the problems we know so much more about now that the only way for these institutional, long-term investors to be heard was to submit an advisory-only  shareholder proposal viewed as antagonistic by the banks’ boards.

“The banks and financial institutions won’t own up to their mistakes and their executives to their culpability willingly.” Chad Johnson

I said at the time that the letter didn’t go far enough. The reviews should also have demanded an accounting of the reserves for loan losses and for litigation. These numbers have been slow to come and, when they did, hard to decipher.

Gretchen Morgenson in the New York Times on January 8: While it is unfortunate that the Bank of America deal won’t recoup much for taxpayers, the resolution could have one important benefit. It might just open the door to a much-needed reckoning of the liabilities created by questionable mortgage practices at the nation’s largest banks. These institutions have not yet made a full and realistic accounting of their liabilities.

I agree.

On September 30, 2010, before the SEC issued its letter to bank CFOs reminding them to follow the standards and book adequate reserves, I wrote that Bank of America had admitted it had “repurchased, during 2009, $13.1 billion of loans from first lien securitization trusts as a result of modifications, loan delinquencies or optional clean-up calls.”

I couldn’t easily see what the actual reserves were for estimated future liabilities and how they came up with a number given the total loans sold by type and the current claims by various parties. I said it’s time for someone, perhaps the SEC, to demand more detailed disclosure about reserves for repurchase risk.

When I challenged the SEC to push harder on the reserves issue they stepped up. But disclosures are still not complete.

Here’s an excerpt from the New York City Comptroller’s shareholder proposal that did appear in the Bank of America proxy document dated March 30, 2011:

…Resolved, shareholders request that the Board have its Audit Committee conduct an independent review of the Company’s internal controls related to loan modifications, foreclosures and securitizations, and report to shareholders, at reasonable cost and omitting proprietary information, its findings and recommendations by September 30, 2011.

The report should evaluate (a) the Company’s compliance with (i) applicable laws and regulations and (ii) its own policies and procedures; (b) whether management has allocated a sufficient number of trained staff; and (c) policies and procedures to address potential financial incentives to foreclose when other options may be more consistent with the Company’s long-term interests.

Board’s Response to Proposal 7

The Board recommends a vote AGAINST Proposal 7 for the following reasons:

• our company has already taken significant steps to ensure that appropriate internal controls are in place, including additional controls and processes we have implemented following a comprehensive self-assessment of our foreclosure processes, as well as an environment of heightened regulatory scrutiny by state and federal authorities, including certain bank supervisory authorities ;

• we actively manage the loan modification and foreclosure processes to ensure that we have strong internal controls over our mortgage service operations;

• we have been a leader in providing foreclosure alternatives, assisting homeowners and constituent groups to resolve home loan issues through loan modifications or other solutions where possible; and

• our company has already provided extensive public disclosure regarding the requested information, which makes the report sought by the proposal unnecessary.

In each case where the Comptroller’s shareholder proposal made it to an April Annual Meeting agenda, management recommended a “no” vote for the proposal.

The proposals all failed to gain a majority vote.

At Bank of America, the shareholder proposal gained a strong 40% “yes” vote. At Citigroup, the “yes” vote was just shy of 30% and at Wells Fargo a little less than 23%. At JP Morgan Chase the coalition’s proposal did not make the Annual Meeting Agenda because a similar proposal, according to the JPM Chase Board, was in line ahead of theirs.

Michael Garland, Executive Director for Corporate Governance for the New York City Comptroller, told me that his office will continue to press for the independent reviews. These reviews, the Comptroller insists, should not be performed by the banks’ auditors since, “we do not consider the existing audit firm to be independent since they previously signed off on the internal controls.”

New York City Comptroller John Liu: “ Our pension funds are long-term investors. We’re going to be around a lot longer than any of the management or the board members of these banks. As shareholders we will continue to insist bank boards clean house until we see independent audits of their mortgage and foreclosure practices.”

Other interested parties have been pressing since the spring of 2011 for reviews of, and changes and improvements to, the banks’ policies, procedures, and processes around loan modifications, foreclosures, and securitizations. There have also been several calls for more transparency, and honesty, in the banks’ allocations of reserves for loan losses and litigation.

On May 12, FDIC Chairman Sheila Bair testified before the Committee on Banking, Housing, and Urban Affairs of U.S. Senate:

Serious weaknesses identified with mortgage servicing and foreclosure documentation have introduced further uncertainty into an already fragile market.The FDIC is especially concerned about a number of related problems with servicing and foreclosure documentation. “Robo-signing” is the use of highly-automated processes by some large servicers to generate affidavits in the foreclosure process without the affiant having thoroughly reviewed facts contained in the affidavit or having the affiant’s signature witnessed in accordance with state laws.

The other problem involves some servicers’ inability to establish their legal standing to foreclose, since under current industry practices, they may not be in possession of the necessary documentation required under State law. These are not really separate issues; they are simply the most visible of a host of related problems that we continue to see, and that have been discussed in testimony to this Committee over the past several years…

Our examiners participated with other regulators in horizontal reviews of these servicers, as well as two companies that facilitate the loan securitization process. In these reviews, federal regulators cited “pervasive” misconduct in foreclosures and significant weaknesses in mortgage servicing processes. Unfortunately, the horizontal review only looked at processing issues. Since the focus was so narrow, we do not yet really know the full extent of the problem.

In April 2011, the Office of the Comptroller of the Currency (OCC), the Federal Reserve Bank (Fed), and the Office of Thrift Supervision (OTS)  - the IndyMac regulator – ordered fourteen large mortgage servicers to overhaul their mortgage-servicing processes and controls, and to compensate borrowers harmed financially by wrongdoing or negligence.

An article in Thomson Reuters’ News and Insight on May 19 describes the problems some were having with the setup of this Consent Order, specifically the way the “independent” reviews required by the Order were expected to be performed.

U.S. regulators are pinning their hopes on independent consultants picked by large U.S. banks to uncover the true depth of foreclosure misconduct seen at lenders. Regulators are close to signing off on these consultants, which are expected to include Promontory Financial Group, Treliant Risk Advisors and PricewaterhouseCoopers…

The key thing is that the independent consultant needs to recognize that the client is the regulators… and not the bank,” said Joe Evers, a large bank deputy comptroller at the OCC. “They need to be taking direction from us and they need to be meeting our expectations.”…

One issue is who would do the review if not the consulting firms. Regulators say they don’t have the manpower, and so they are looking for firms with the required expertise. Senator Reed suggested the regulators at least hire the firms directly rather than approve the banks’ choices. Evers said regulators decided not to take this approach because it would have raised government contracting issues that could have slowed when the reviews begin. He said the agency also has had success using third party reviews in past enforcement actions.

The problem with this approach and the inherent conflicts of interest should be obvious to all but the most naïve observers.

It’s a joke for any government agency, especially one says they’re in the enforcement versus the supervision business, to defend an approach that allows the entity found guilty of wrongdoing to select the consulting firm that tells them how bad they were and how much they have to pay for the bad behavior.

It’s not like the agencies – Treasury, the General Accounting Office, the Federal Reserve, the SEC, and others like them – don’t have procurement teams that contract with professional services firms on a direct basis all the time. One only has to look at the assistance that all the Big four audit firms  - and lawyers and other consultants – provide to the Federal Reserve Bank, The SEC and the Treasury on the TARP program and related initiatives as a result of the crisis. The process, controls, and the rationale for direct contracting is already in place.

And let me assure OCC spokesperson Evers that audit firms like PwC will not look at the regulators as their clients instead of the banks unless someone makes them. They know where their bread is buttered and where their next meal is coming from.

The SEC and the PCAOB, the audit industry regulator, have said so.

The reforms from early this decade notwithstanding, I believe more can and should be done to emphasize the importance of independence and the auditor’s duty to shareholders and the public. It is integral to the foundation of the reason for requiring an audit in the first instance…I’m not suggesting that the role of an auditor should be that of an adversary; but it also cannot be, either in fact or in appearance, that of an advocate for the management of the company it audits. In a world where the mantra “the client is always right” can be typed in to Google and return over 8 million results in .30 seconds, I would suggest it is time to give serious consideration to changing the perceived “client” in audit relationships.

Auditors are, after all, paid by the clients they are charged with policing. As in other professions, auditors want to advance in their chosen profession which often means keeping the client happy and growing their business.

Auditor independence requirements serve as counterweights to those forces. One example of those counterweights may be found in the SEC rule that says an accountant will not be considered to have the necessary independence from its audit client if an audit partner earns or receives compensation based on selling non-audit services to the audit client. The purpose of this rule is to keep auditors singularly focused on the quality of their audits and not on nurturing a relationship that will make management more receptive to cross-selling efforts.

Despite those requirements, PCAOB inspection reviews of partner evaluation and compensation processes find examples of seemingly unrestrained enthusiasm — in partners’ self-evaluations, in their supervisors’ evaluations of their performance, and in agreed performance goals — for selling services to audit clients…We don’t see these problems in all the files we look at, but we have seen them in sufficient number to raise troubling questions, not the least of which are whether these audit partners are unaware of, or simply unconcerned about, the independence rule that should make such considerations irrelevant to their compensation, and why a firm would allow such unawareness or unconcern to continue unabated.

So let’s look at the proposed consulting firms. Promontory Financial Group, Treliant Risk Advisors and PricewaterhouseCoopers are professional services firms that serve the large banks directly on other consulting assignments.

The banks that must be reviewed are their existing or target clients.

PricewaterhouseCoopers (PwC) is the auditor of two of the banks that must be reviewed – Bank of America and JP Morgan Chase. That’s an independence conflict that can’t be overcome. PwC can not be involved in the reviews at these banks. Recently, retired PricewaterhouseCoopers’ Chairman Sam DiPiazza joined Citigroup as a Vice Chairman in the Institutional Clients Group and a member of the bank’s strategic advisory board. There’s another conflict for PricewaterhouseCoopers.

Where PwC is not serving a bank as auditor - namely Citigroup and Wells Fargo - they are already serving as a consultant. These three consulting firms want consulting business from these banks, now and in the future. If PwC is allowed to participate in reviews at Bank of America and JP Morgan Chase, PwC’s will seek to protect their audit relationships and avoid highlighting their own or their clients’ serious errors.

PwC will also seek to protect their fellow Big Four audit firm – KPMG – which audits Citigroup and Wells Fargo, owner of Wachovia one of the large mortgage originators. Although each audit firm has their own level of tolerance for client’s bad behavior and for accepting clients’ “judgments and estimates” there’s a least common denominator bottom line that keeps all the firms in line at all their large financial services clients.

As we saw during the crisis, any one of the Big Four auditors could at any time, by virtue of failure, acquisition, or merger, become the auditor of any of their fellow firm’s clients. No firm wants to inherit a client that’s too far out on the edge. As a result the largest firms are all as good – and as bad  – as each other in enforcing the standards in the most controversial areas.

In addition, given the firms’ self-insured status using a captive offshore vehicle that all the largest firms participate in, litigation against one audit firm as a result of finding mortgage fraud at their client hurts them all – in the pocketbook as well as reputationally.

The plans for independent reviews required by the banks’ Consent Order with the OCC, OTS, and the Fed are due July 13. Additional self-assessments were orderd for all banks, not just those under the consent decree.  Those are due September 30. According to HousingWire’s Jon Prior, the reports of the reviews will not be made public. Would it be possible keep the reports secret if the regulators had contracted for the reviews directly?

I think not.

On June 13, the Huffington Post’s Shahien Nasiripour disclosed that New York State Attorney General Eric Schneiderman had turned up the heat on Bank of America and other banks, servicers, and trustees of the mortgages that were securitized.

New York Attorney General Eric Schneiderman has targeted Bank of America, the biggest U.S. bank by assets, in a new probe that questions the validity of potentially thousands of mortgage securities and their associated foreclosures, two people familiar with the matter said.The investigation, which began quietly in recent weeks, is part of a larger inquiry that is scrutinizing whether mortgage companies and Wall Street firms took the necessary steps under New York state law when creating mortgage-backed securities.

There was a movement by all the state attorneys general to force a global settlement on the banks to remedy the wrongs of the crisis, in particular with regard to bad documentation and unjust foreclosures. That effort has repeatedly been hit by defections and roadblocks.

From William Greider in The Nation on June 28:

As facts about the banks’ ugly behavior gathered headlines, the fifty state attorneys general came together to demand reforms. The effort was chaired by Democrat Tom Miller of Iowa and actively coached by Washington officials from the Justice Department and HUD. The Obama administration is eager to get a settlement, fearing that state-by-state litigation will injure the banks and maybe derail the foreclosure process.

The AGs first suggested a settlement of $20–25 billion—even though the true public loss would probably be much greater—plus a commitment from the banks to clean up their procedures. In exchange, the AGs would agree to release the banks from potential liabilities that states might pursue. The banks’ counteroffer was a trivial $5 billion, which suggests that they are not taking the AGs too seriously.

[New York Attorney General Eric] Schneiderman agreed to participate with other AGs, but warned from the start that New York would refuse to give up its right to hold banks liable—to sue and collect damages or impose court-ordered reforms. Other strong states, including California and Massachusetts, evidently agree. That alone would presumably doom the deal-making, since any settlement that does not include New York and California would probably not be worth much to the bankers.

In January, Bank of America settled with Fannie Mae and Freddie Mac over repurchases but there are several other suits outstanding with the Federal Home Loan Banks and private investors. Bank of America recently caved in to another group of investors. On June 29, the Financial Times FT Alphaville blog reported that a settlement had been reached between Bank of America and some bondholders.

…several news outlets (the Wall Street Journal had it first, and here’s the FT) reported last night on the expected $8.5bn settlement reached between the bank and the aggrieved parties, and earlier this morning BofA confirmed the details in a statement.

The key driver of the expected loss is the representations and warranties provision of $14.0 billion, including $8.5 billion for the settlement agreement on legacy Countrywide mortgage repurchase and servicing claims, and an additional $5.5 billion increase in the company’s representations and warranties liability for non-GSE exposures and, to a lesser extent, GSE exposures.

The company also expects to record $6.4 billion in other mortgage-related charges in the second quarter of 2011…

Audit firms PricewaterhouseCoopers and KPMG, as well as the other two members of the Big Four, are all around this crisis – in the banks, the ratings agencies, and in the regulators. And there’s a pervasive revolving door between the regulators and the banks and institutions they regulate, as well as between the regulators, the regulated, and the auditors and attorneys that serve us as watchdogs and guardians of the public interest.

But the Taylor, Bean & Whittaker convictions prove that mortgage fraudsters can be prosecuted.

The best way to get truly independent assessments of how much is wrong with the processes and the paperwork and how much compensation should be paid is for regulators to step up and take direct responsibility for the problem.

Independent individuals and firms, people who are not beholden to the large banks and financial institutions, do exist. Many next tier and regional or boutique firms have the expertise and are not in the day-to-day business of auditing or taking on large projects with these institutions.

It’s time for the regulators to build a more permanent task force of public servants rather than private profiteers to tackle these issues. The problems are really big, they’re going to get worse before they get better, and they’re going to be around for a long time.

The main page image comes from this site and this essay on the challenges to the criminal justice system, penned in 1997.

Post Script: This was a great movie about plaintiffs’ lawyers.

Post Post Script:  When I told readers in January to sell or short the banks – in particular Bank of America – the bank’s closing price was $14.667.  On Friday July 1, Bank of America closed at $11.09.

Ever wondered what it would be like to see your name in print?  Most auditors do not aspire to seeing their name in the papers.  It’s a career-limiting move to be cited in a bankruptcy examiner’s report or a disciplinary order issued by the PCAOB.  But that’s just what might happen if you follow your partner’s orders blindly and roll over. Be very wary if asked to participate in a pre-inspection file review and you’re asked to add evidence of reviews and signoffs, insert documents after the fact, change conclusions or recreate analyses.

Last week Going Concern reported the latest findings of the UK version of the PCAOB, the Audit Inspection Unit.  There were two troubling findings that you may have dismissed as uniquely British – faking facts in support of weak assertions and “premature” discharge of the audit report before true completion.   Going Concern quoted Accountancy Age and FT Alphaville:

“Auditors have also been accused of altering documents before handing them to regulators and putting cost savings ahead of quality {and} some cases where partners signed audit reports before the audit was complete.”

Have you ever been involved in “cleaning up” a file in preparation for an internal risk and quality review or a PCAOB inspection?  Do you know when to say “when”?

Recent cases may provide some guidance.  In the New Century Financial case, junior auditors and professional practice specialists saw their names in the bankruptcy examiner’s report because they raised issues and were ignored or overruled by engagement and professional practice partners. In one instance, issuance of the 2005 audit report was delayed until the last minute because of concerns expressed by a KPMG hedge accounting specialist.

He was overruled.

“The issue, however, had not yet been resolved to Klinge’s (KPMG Partner Financial Risk Management/Financial Derivatives Resource Group) satisfaction and it was still holding up KPMG’s audit opinion…In an e-mail exchange in the late evening of March 15, 2006, Kim (KPMG Senior Manager) learned that Klinge was not prepared to sign off on the FRM/FDR review…Donavan (KPMG Engagement partner) stated : “I am very disappointed we are stil discussing this. As far as I am concerned, we are done. The client thinks we are done. All we are going to do is piss everybody off.”

Ultimately…a high ranking member of the KPMG Department of Professional Practice, Terri Iannaconi authorized Donovan to issue KPMG’s audit report…also instructed Klinge to prepare and forward a sign off memorandum and instructed Kim to prepare a “disagreement memorandum” to document the dispute.”

Sources tell me they’ve been asked by audit teams, long after report issuance, to provide “backdated” reports and documents that were needed to “complete” the file. Auditing Standard 3 covers the requirements for audit documentation and lays out, in vague terms, the basic requirements for crossing t’s and dotting i’s.  But it’s your firm’s internal quality procedures that should mirror AS3 and provide sufficient and clear detail on exactly what is and isn’t allowed when it comes to “cleaning up the file.”

There’s a less well-known PCAOB disciplinary case that refers to changing documents after the fact.

(Mr. Nardi has since been reinstated by the PCAOB to practice.)

Ex-BDO Seidman Auditors Disciplined by PCAOB

The Public Company Accounting Oversight Board has disciplined two former auditors at BDO Seidman for failing to review the audit work of a junior member of the firm and then trying to cover up by backdating documents…The subordinate noted the absence of initials and signatures indicating that a detailed review had been performed.

(fm Note: There was probably time billed to the client for the partner and manager review but an absence of any time charged in the firm’s internal time reporting system. Regulators: you should be looking for this common discrepancy.) .

When Fitzpatrick returned from vacation the following week, Nardi directed her to initial and sign the workpapers and backdate them to dates preceding the issuance of the March audit report, even though she had not done a detailed review…”

Rule of thumb for junior auditors:  If a partner uses the word “backdate” it’s pretty certain he or she wants you to do something you may be famous for later – and not in the good way.  If you hear the word “backdate”, run as fast as you can in the other direction to your firm’s Ethics Hotline.

If you get no satisfaction there, try the PCAOB tip line or, maybe, the SEC’s new whistleblower tip line. If your client is a SEC registrant, there may be big bucks for you that will compensate for the fact you will almost surely lose your job, be blackballed from working for any other PCAOB registered firm and never hear from any of your former colleagues ever again.

Small price to pay for being on the side of right…

I’d be exaggerating if I told you the Lehman bankruptcy examiner’s report, and its scathing indictment of Ernst & Young’s role in the biggest failure on Wall Street, answered my prayers.

I pray for very little.

Peace of mind. Social justice. The health of family and friends.  Increased scrutiny of the role of the largest global audit firms in the international financial markets.

They’re modest entreaties but I sometimes wonder whether the gods are listening.

The Lehman bankruptcy examiner’s report, issued in March 2010, is a 2,000-word work of compelling non-fiction.  Anton Valukas, the examiner, gave us a model by which all future examination documents will be judged.

The report startled the media. Repo 105 – its creation and proliferation throughout the Lehman balance sheet – provided reporters, bloggers, pundits with something unexpected to write about. The inclusion of “colorable claims” against Lehman’s auditors, Ernst & Young, drove renewed interest in the audit firms, their role and responsibilities to shareholders, and the history of their regulation.

Coverage of Ernst & Young (EY) by major media lasted, in earnest, about two months.

In April, US media reported the investigation of EY was “picking up steam”, based on sources pointing to an investigation by the PCAOB. Hot air. The PCAOB’s investigations are secret and it would be odd for them not to start some kind of an investigation under the circumstances.

There’s been nothing much new written about EY and the Lehman case since. There were a few stories right away about plaintiffs adding EY to their existing lawsuits.  In June, the UK’s Financial Reporting Council (an accounting regulator) also initiated an investigation of EY’s Lehman activities.  In September, they added an investigation of EY’s reporting to UK regulators regarding Lehman’s handling, or rather mishandling, of client assets.

Ernst & Young was mentioned briefly in early September in a ~700 word Wall Street Journal article on the ongoing SEC investigation of Lehman’s executives.

As part of its probe, the SEC is also investigating the role of Ernst & Young, Lehman’s outside auditing firm. The examiner concluded that Ernst & Young “took virtually no action to investigate the Repo 105 allegations.” A representative for [EY] declined to comment Thursday.

Lawyers for the former Lehman executives have previously denied any wrongdoing related to the accounting moves, while Ernst & Young said it complied with generally accepted accounting principles.

Ernst & Young, take my word for it, will never be indicted by the U.S. government, as a firm, for its role in any Lehman fraud that’s eventually proven. It’s also highly unlikely – 1000 to 1 odds I’d say – EY will be fined by the SEC or the PCAOB, as a firm, in a civil or disciplinary case.

The Ernst & Young partners named in the bankruptcy examiner’s report, and maybe a national practice partner, might be sanctioned by the PCAOB or SEC. Later. Much later. We can predict the timing based on the SEC’s handling of the Bally’s sanctions.  Even with a slam dunk case, the SEC waited six years before they settled with EY.  The eventual sanctions against six Ernst & Young partners for the Bally’s fraud were too little and much too late to provide a deterrent or any real justice.

Ernst & Young, as a firm, and their individual partners are named as additional defendants in private lawsuits against Lehman executives.  But the New York Court of Appeals in a 4-3 opinion refused to hold the auditors responsible for their role in frauds perpetrated by management in the Kirschner (Refco Trustee) v. KPMG and Teachers’ Retirement v. PwC (re: AIG 2002-2005 fraud) cases.  The opinion reaffirmed the application of the in pari delicto doctrine and the principle of imputation in these cases.

The judges who disagreed with the majority opinion said it best:

These simplistic agency principles as applied by the majority serve to effectively immunize auditors and other outside professionals from liability wherever any corporate insider engages in fraud…it is unclear how immunizing gatekeeper professionals, as the majority has effectively done, actually incentivizes corporate principals to better monitor insider agents. Indeed, it seems that strict imputation rules merely invite gatekeeper professionals “to neglect their duty to ferret out fraud by corporate insiders because even if they are negligent, there will be no damages assessed against them for their malfeasance”

The more successful a fraud case is against Lehman’s executives, the less likely EY or any of its partners will suffer any consequences for their acquiescence to or complicity in the fraud. That’s not to say the firm won’t suffer slowly and painfully from the enormous amount of time and money devoted to defending themselves in Lehman litigation and the rest of the suits they face.  And, of course, there is reputational damage with some clients. That’s why their Chairman has gone on the PR defensive.

But with regard to Lehman cases, EY can now take a breath. When executives commit fraud and are held liable, and especially when there’s a bankruptcy involved, auditors are rarely held responsible.

The judges make it almost impossible.

The majority of the New York Court of Appeals feels we should be as sympathetic to the partners of the poor “duped” accounting firms as we are to the creditors and shareholders of the companies, Refco and AIG, whose executives stole from them.

… plaintiffs’ proposals may be viewed as creating a double standard whereby the innocent stakeholders of the corporation’s outside professionals are held responsible for the sins of their errant agents while the innocent stakeholders of the corporation itself are not charged with knowledge of their wrongdoing agents… The owners and creditors of KPMG and PwC may be said to be at least as “innocent” as Refco’s unsecured creditors and AIG’s stockholders.

That leaves few avenues of recourse for the shareholders and creditors against the aiding and abetting service providers. If only the Department of Justice and the SEC, followed closely by the PCAOB, led the way in calling the audit firms to account for their professional impotence and the occasional deliberate legal deviance.

But the regulators will disappoint me.

Why?

The U.S. government needs Ernst & Young more than it needs me.

From The Congressional Oversight Panel Report, Examining Treasury’s Use of Financial Crisis Contracting Authority:

Ernst & Young has the largest amount of expended value attributable to its work.  Ernst & Young has performed work as a contractor under a procurement contract as well as a subcontractor under financial agency agreements.  Of the $32.2 million in expended value attributable to Ernst & Young, $10.7 million is related to a procurement contract for accounting services, and $21.5 million is related to subcontracts under financial agency agreements, $17.7 million of which was expended under a contract with Freddie Mac and the remaining $3.8 million was expended under a subcontract with Fannie Mae.  In addition, Ernst & Young has been granted the same $22 million multiple awards as PricewaterhouseCoopers.

Well, you might say, those contracts were handed out at the peak of the crisis, September 2008.  What could the U.S. Treasury do? There are only four large accounting firms that could possibly get the tough job done.

PricewaterhouseCoopers – auditor of Goldman Sachs, AIG, JP Morgan Chase, Bank of America, the twelve Federal Home Loan Banks and Freddie Mac – is the largest contractor to the Treasury under the financial crisis contracting authority.  KPMG is the Treasury’s own auditor and was preoccupied with auditing failed New Century and Countrywide, getting sued by former client Fannie Mae, and trying to hold on to troubled Citigroup, Wells Fargo and Wachovia. What were Deloitte’s conflicts? Deloitte was busy with its own problems as auditor for Bear Stearns, Washington Mutual, Merrill Lynch, GM, and Fannie Mae as well as auditor of the Federal Reserve Bank system, itself.

However, in a slap in the face to Lehman employees and shareholders all over the world and to the U.S. taxpayer who’s paying the bill, Ernst & Young was awarded another contract by the U.S. Treasury in July of 2010, two years after the crisis and only three months after the Lehman bankruptcy examiner’s report was published.  This contract, a blanket purchase contract for Program Compliance Support Services effective until July 2015, is essentially a blank check.

In addition to the contracts with the U.S. Treasury, Ernst & Young – along with Deloitte and PricewaterhouseCoopers -  is a key vendor at the New York Federal Reserve Bank.

From the New York Federal Reserve Bank Vendor Information page:

Maiden Lane LLC (re: Bear Stearns)

² Although the detailed description of the scope of work set forth in this contract has been redacted due to confidentiality concerns, a general description of the scope of work is as follows: E&Y was contracted to perform due diligence on the assets in the Maiden Lane LLC portfolio to assess and evaluate the quality and accuracy of financial information provided by Bear Stearns & Co. and obtained from external sources prior to acquisition by the LLC. E&Y identified all cashflows from the determination date through the closing date to facilitate settlement of the assets into the LLC. E&Y tracked and verified post close cash flow adjustments with the Investment Manager.

TALF

AIG Lending Arrangement

⁴ Although the detailed description of the scope of work set forth in this contract has been redacted due to confidentiality concerns, a general description of the scope of work is as follows:

With respect to AIG, E&Y was contracted to provide advice on the insurance businesses; to perform valuations of the entities posted as collateral; to provide assistance in developing cash flow projections; to provide support for the divestiture process; to provide advice and assistance with domestic and global regulatory issues; to identify and report on compliance with covenants within the Credit Agreement; to provide assistance in assessing accounting and tax considerations, including off-balance sheet arrangements; to provide project management support; to provide advice and assistance on compensation issues; to provide assistance and support in assessing internal audit at the firm; to provide advice and due diligence on contemplated transactions, including SPVs and securitizations; to develop a document repository; and to provide advice and assistance in monitoring business unit performance within AIG.

With respect to ML LLC, ML II, ML III, E&Y was contracted to perform a diagnostic on the operational and financial close procedures, and to assist with the analysis of accounting matters. In addition, with respect to ML II, E&Y was contracted to perform due diligence on the assets to assess and evaluate the quality and accuracy of financial information provided by AIG and obtained from external sources prior to inclusion in the trust. E&Y identified all cashflows from the pricing date through the closing date to facilitate settlement of the assets into the LLC. E&Y tracks and verifies with the administrator all post close factor changes through August 31, 2009. With respect to ML III, E&Y was contracted to perform due diligence on the assets to assess and evaluate the quality and accuracy of financial information provided by AIGFP and obtained from external sources prior to inclusion in the trust. E&Y identified all cashflows from the pricing date through the closing date to facilitate settlement of the assets into the LLC. E&Y tracks and verifies with the administrator all post close factor changes through August 31, 2009. With respect to TALF, E&Y assisted with accounting procedures and the analysis of accounting matters.

Even I have to admit that this work makes EY pretty indispensable.

And, therefore, immune from prosecution.

But don’t take my word for it.

On October 14, the Congressional Oversight Panel (COP) issued its monthly oversight report, “Examining Treasury’s Use of Financial Crisis Contracting Authority”. The report highlights many of the issues raised in testimony by the Project on Government Oversight (POGO) and in their letter to Congress.

The Panel highlighted two big reasons why the U.S. Treasury and, by extension, their subordinate agencies the SEC and PCAOB and sister department Justice won’t jeopardize the viability of vendors they’re counting on the most to support them during these very trying times.

a. Future Industry Regulation

Acting in its regulatory capacity, Treasury may need to regulate a business that it is also employing to do work.  It is hard to see how Treasury could avoid the perception of a conflict of interest if it implements industry-specific regulations or regulates an individual business, and such oversight could have direct implications for the ability of a contractor or financial agent to perform…It is also possible that a firm could attempt to leverage its relationship with Treasury to enhance its capacity to lobby effectively with other regulators…particularly relevant in the wake of Dodd-Frank Wall Street Reform…

You may have noticed that the audit industry was pretty much left out of the Dodd-Frank reform bill, even as the bill destroyed the business model of the ratings agencies.  The ratings agencies, as you know, operate under the same direct-pay business model that compromises the independence and objectivity of the audit firms. The SEC also quickly enacted additional safeguards after the Supreme Court reaffirmed the viability of the PCAOB under the Sarbanes-Oxley Act.  These “safeguards” provide an appeals process for audit firms that feel victimized by the PCAOB’s “arbitrary and capricious” disciplinary actions.

c. Overreliance on Individual Firms

Ensuring that contracts and agreements are awarded to a broad group of firms may be critical to minimizing conflicts of interest. Awarding a large number or value of contracts or agreements to one specific firm may leave Treasury overly reliant on that particular institution. Such overreliance may cause Treasury to be disproportionately dependent on certain firms or industries…Forcing senior Treasury officials into the simultaneous role of regulator and client may place them in an awkward position. Likewise Treasury may be hesitant to implement certain types of accounting reforms when it has an outstanding contract of $24.6 million with PricewaterhouseCoopers (pwc), particularly when such reforms would subject the investment of taxpayers funds to more risk.

Translated, that means don’t count on the Department of Justice or the SEC to question pwc’s role in the Satyam or Glitnir frauds, to pressure pwc to resign as auditor of AIG even though their true client, AIG shareholders, has sued them repeatedly, or to answer for their duplicity with regard to allowing widely different valuations of the same assets at Goldman Sachs and AIG.

Main page image courtesy of NowPublic, Crowd Powered Media, Creative Commons License, The Serenity Prayer in Spanish on the Mexican Side of the Border

It was a great first day yesterday.  I’ve been telling Matt Kelly, Editor of Compliance Week, that this year is better than ever. One profound change is the Twitter presence this year.  Last year I was the only one Twittering, Matt did not yet have blogs on the Compliance Week site, and fewer people knew or cared what I was doing or why.  This year, I share the front row at every presentation (and the backchannel) with several bloggers/Twitterers.  I’ve now met Doug Cornelius, Bruce Carton, Alex Howard, and Eric Cohen live.  I also had a chance to talk with two out of three of my panelists for the Maryland Association of CPAs Business Expo panel, Colleen Cunningham and Susan Webster. (The third panelist on the 16th in Baltimore is Joanne O’Rourke of the PCAOB.)  And I ran into Tony Chapelle from the FT’s Agenda publication, where I was quoted last year.

Follow the rest of the conference via Twitter hashtag #CW2009

As always, one can plan an agenda, but you have to be flexible.  I woke up at 4:30 Chicago time yesterday and by late afternoon, even after lots of Starbucks espresso, I was cashed. Skipped the Oracle presentation after I got a late afternoon email that rescinded their Thursday dinner invitation from last week.  I was a little peeved.  It was written as if I had asked them to please ask me, pretty please, to come and eat their food. Which I did not.  I can make my own fun.  But to make an invitation and then rescind as if they found someone more interesting, more sexy, or less threatening was rude and unacceptable.  Well, I guess I just go to the Tweet Up early.

BTW If you are at the conference or in Washington DC, please come out and meet me, and whomever else the cat drags in, at Busboys and Poets, a place recommended by my friend Max.  It’s at 14th and V Street and anyone else will show up after 8:30.  Hope to see you.  Cash bar.

So who did I see yesterday?

The opener was an interesting presentation by SEC Commissioner Luis A. Aguilar on the Regulatory Agenda.  It was newsworthy for his statement that he supports a combining of the CFTC with the SEC. Unlikely to happen, though.  The CFTC says no. Legislators says no. 

Next up Fannie Mae Chief Compliance Officer Bill Senhauser discussed the immense challenges his firm has encountered during the credit crisis, and how he is trying to restore trust both inside and outside the company. This guy is a superstar.  Stay tuned for an in depth look at who he is, what he’s doing there, and why you need to keep an eye on him.  Never thought I’d say this about Fannie Mae, but with guys like this in senior positions, I’m hopeful for the future.

Former SEC Deputy Chief Accountant and Compliance Week Columnist Scott Taub reprised his  “top 10″ things you think you know about the SEC, and why you’re wrong. Scott is a Chicago guy and University of Michigan/Michigan native.  We’ve had some long talks and longer lunches.  After his presentation we had some lunch together and I saw him in action at a table full of folks who had no idea who he was.  He’s a smart, savvy former-SEC A-Lister who’s also just a “regular guy.”  A separate post will go in depth on his presentation and my very informal interview.  Takeaway for now?  You just might see Scott Taub, talker extraordinaire, on Twitter, under my tutelage.  

Finally, I attended KPMG Partners John Farrell and Rocco deGrasse ’s presentation with Office Depot’s Chief Compliance Officer Bob Brewer that discussed how effective enterprise risk management program/GRC program can help to mitigate risks. The bonus part was, thanks to Rocco, a discussion of FCPA-related pre-acquisition/merger activities.

These Tweets pretty much sum up that presentation. Here. Here. Here. 

Image Source

Not so long ago, Dennis Howlett and I went public with a bet:  

Which Big 4 audit firm is the next to fail?

This may seem like a dead pool – a quite depressing and morbid fascination with something that will add pain and misfortune to so many.  I have been accused of being so totally negative that I strain credibility.  After all, isn’t there anything good to say about any of the firms?  

Isn’t some audit failure natural? Isn’t some error and omission in the audit process the result of a rational cost/benefit formula at work – one that determines how much more testing, sampling, investigation, questioning, and verification work should be done to reduce risk of material misstatement to an “acceptable” level?

Isn’t everyone cutting staff in this recession? Why can’t the audit firms run a business like any other capitalist and make a profit? Why are auditors any more responsible for the public interest than lawyers?

Aren’t plaintiffs’ lawyers too aggressive and going after audit firms only because they have “deep pockets” ? Aren’t auditors responsible only for certifying based on what management tells them? Can anyone hold them responsible if they were “duped” by bad guys? 

The litany of crybaby defenses goes on and on.

Frankly, it’s getting a little tedious.

Let’s face facts. Dennis may be right.  It may be EY that’s next.  

Even before the conviction this week of four current and former partners of Ernst & Young for criminal tax fraud involving tax shelters, EY had a bundle of other trouble.  They were the auditors of Lehman Brothers and are being sued for their role in that failure. They have Madoff exposure.  They are also co-auditors for Societe Generale and auditor for UBS – two problem children, for sure. There is speculation about EY in other quarters, and although I don’t agree with their reasoning, the conclusion is the same.

Dennis believes that I’m betting on PwC as next to fail.  I don’t honestly remember committing to that, but I’m willing to go with it for the sake of argument.  This is in spite of the fact that the other Big 4 have plenty to worry about and the next tier firms are in no way ready for prime time.  Wishful thinking that BDO can somehow win their appeal in the Banco Espiritu Santo case, that Grant Thornton won’t get hurt by Refco, or that McGladrey is innocent in the Sentinel case is trumped by the fact all have additional exposure to Madoff.

KPMG, of course, has New Century, Anglo Irish Bank, Citi, Siemens, and others.

Deloitte, well, too many to count. And the Parmalat case is a potential model changer. And a very embarrassing insider trading scandal. Then there’s the loser consulting gigs and a declining demand for consulting, all of which makes for never ending cuts and a not so rosy outlook.

And yet, for my money, PwC is still the closest to the precipice, if only now because of Satyam.

Think about it.  It’s their third strike (at least that we know of) internationally after Japan and Moscow.  Two of their Indian partners, for God’s sake, are still in jail – thrown to the prosecutorial sharks by the Indian Central Bureau of Investigations. The Chairman (soon to be retired ) of Pricewaterhouse International Limited, Sam DiPiazza, has pulled out all stops in investigating what occurred in India, sending US and other professionals to “assist” colleagues in India with comprehensive audit quality reviews, and personally meeting with Indian government officials and others worldwide to try to repair the “lost trust.”

And then there’s PwC’s Madoff exposure.  

And the lawsuit for wage and hour violations in California that they’ve already lost on the facts but are vigorously appealing. They completely flubbed the administrative responsibility test in this case and will lose the licensing argument.  Why?  Because the fear mongering they’re trying to stir up through proxies (there have been friend of the court briefs filed by business organizations sympathetic to PwC) are just that. Empty threats. The law firms have nothing to be afraid of if audit firms are required to pay overtime to not-yet-licensed associates. The law firms exposure is minimal.  After all, you pass the bar and are a licensed attorney in most states by late fall of the year you graduate.  Most law firms don’t tolerate a delay or a failure to pass the bar the first try, especially for top graduates. Contrast this to the audit firms. You can work for five to seven years, eighty hours a week during busy season, before making Manager level, the typical cutoff for future promotions without a CPA.  

And there are still questions lingering over their role in Northern Rock. And their forays into gambling audit have not been so successful all the while they’re advising the US to open up online gambling in order to reap the tax revenues.

The rumbling has also started in the comments on this blog over PwC’s stealth “reductions in force” and their broken promises over start dates and starting salaries to graduates. It’s fully expected that additional staff cuts will come soon and be of such a volume that it will be hard to hide behind the “didn’t fit with our performance culture” excuse.  

Finally, there’s the strategically disastrous purchase of BearingPoint’s Commercial Services practice.  Sources tell me due diligence has been non-existent, it’s solely an ego-trip for current leadership, and there’s a shell game going on in public statements regarding their interest in full blown systems integration services. The probability that  integration of the operations, financials, staff and infrastructure will be smooth and trouble-free is in the low single digits.

Yep.  Of the Big 4, my bet is with PwC US to fail in the next twenty-four months.

Photo Source

“A friend recalled this scene from decades ago: The president of a small Orthodox synagogue in New York had apparently absconded with about $2 million from the congregation, a huge sum in those days. But since he had not yet been formally charged or arrested, he was free to attend Shabbat services. Which he did.

Seeing the alleged scoundrel, another man — a Holocaust survivor — rose and faced his fellow congregants, banged on the bimah table and demanded a judgment from the rabbi before the Torah portion was chanted. “In America, if you are willing to work hard, you can earn a living,” the man said angrily. “You don’t have to steal!”

…there is a gnawing temptation to subject Bernard Madoff to such a ceremony, to publicly point the finger on behalf of the family members, friends, rabbis, business partners, communal leaders and untold numbers of ordinary folk whose lives and good causes have been permanently disrupted by his audacious, unfathomable deceit and say: You didn’t have to steal! You didn’t have to steal from us, your people!…”

What’s worse is that those who should be the guardians of the public trust and watchdogs for those who can not watch for themselves were, in the words of one source today, “…either complicit, incompetent or duped.” None of these conclusions is very appetizing.

From the Jewish Daily Forward again:

“…Any doubt that the proper regulatory function of the federal government was stripped bare and impotent during the Bush administration should now be laid to rest. Even the chairman of the Securities Exchange Commission had to acknowledge that his agency was shamefully asleep at the wheel. Congress, too, must work swiftly to undo the mess it helped create on its sprint to deregulate too many sectors of the economy that clearly cannot be left to guard their own hen houses.”

Within the last forty eight hours or so, at least four lawsuits have been brought against audit firms by clients of so called “feeder funds” that invested in Madoff funds.

From The Financial Times:

Top accounting firms were hoodwinked by Bernard Madoff’s alleged $50bn fraud as well as several leading banks and some of the world’s biggest hedge fund investors, according to lists of service providers to Madoff-linked funds.

PwC, KPMG and Ernst & Young, three of the “big four” accountants, and an arm of BDO International, the fifth largest, were all auditors of the feeder funds which channelled money into accounts at Mr Madoff’s New York brokerage.

The New York Law School became the first Madoff victim to target an accountant this week when it named BDO Seidman in a lawsuit alongside Ezra Merkin and his Ascot Partners fund, which invested almost all its money with Madoff and was audited by BDO.

PwC was auditor of Fairfield Sentry, the $7.3bn feeder fund run by New York-based Fairfield Greenwich; of Kingate Global, a $2.75bn feeder fund run by London’s FIM Advisors; and of Gibraltar-based Reliance Management’s $488m Defender fund.

KPMG audited two of Tremont Group’s Rye Select funds, which had $2.37bn invested with Mr Madoff. Other Tremont funds also invested with Mr Madoff, giving clients of the the New York-based manager a total exposure of $3.3bn, according to people familiar with the situation.

Ernst & Young audited at least four feeder funds. Two of them with $2.5bn are from Herald Asset Management, linked to Vienna’s Bank Medici, which is part-owned by Unicredit of Italy. The other two funds with $870m are managed by Pioneer Alternative Investments, a Unicredit subsidiary.

Fairfield itself is now considering suing PwC…”