Directorship, September 2006

What If One of The Big Four Fails?

Trying to avoid an Arthur Andersen-type disruption

THERE'S A SPECTER HAUNTING U.S. capital markets and it isn't Karl Marx. It's the prospect that one of the dozens of $1 billion-plus lawsuits pending against the Big Four accounting firms will be decided against one of them, either crippling the firm or causing an outright meltdown. "Could this threaten the existence of a firm?" asks Robert Kueppers, deputy chief executive officer of Deloitte & Touche. "The answer is that it possibly could." If so, he adds, "it would certainly create the kind of disruption that we all saw with the unraveling of Arthur Andersen.

 The auditing profession could be in trouble even if the firms simply choose to settle a percentage of the cases rather than fight them in front of judges and juries who may not have the highest regard for auditors. "The real threat comes from their vulnerability to those lawsuits," says Rod Hills, former chief of the Securities and Exchange Commission and partner at Hills, Stern & Morley, who has been active in spotlighting the issue. "They may have to settle. But how many times can you pay $100 million or $200 million?"

Ironically, it is no longer the U.S. government that poses a threat to the auditors. After indicting Arthur Andersen, effectively issuing a death sentence, the Department of Justice saw that the move from a Big Eight to a Big Four had undesirable effects— competition and choice were diminished. The new so-called oligopoly could charge premium fees, and many companies were obliged to turn to the next tier of accounting firms. The government's new tone was audible in Justice's decision not to indict KPMG for its allegedly fraudulent tax shelter practices. From a governmental point of view, implicitly at least, each of the Big Four is too big to fail. "It won't be Justice that puts them out of business," says a senior partner at a second-tier firm. "But it could be the marketplace."

The heart of the problem is that Deloitte, Ernst & Young, KPMG and Pricewaterhouse- Coopers are limited liability corporations that can't buy adequate insurance to protect themselves from large exposures. They are largely uninsurable against catastrophic cases, or what Bob Herdman, former chief accountant at the SEC, calls "nuclear cases." And if a firm's assets are wiped out, the partners become personally liable, which is what triggers fear of meltdowns. If the partners simply quit and leave, they are no longer liable. "The prospect of losing another major accounting firm—and the negative spiraling effect that would occur across the other firms and in our financial markets— must be recognized as a global economic concern," Ernst & Young CEO James S. Turley said in a speech in December.

But the climate facing the auditors is tough and getting tougher. Big pension funds and law firms are pressing many of the cases, either because of alleged fraud or simply because a company missed its earnings and that caused its stock price to drop, hurting the pension fund's portfolio. The auditors are getting drawn into the cases because they should have spotted the problem, say their detractors.

Megacases Against Auditors

Aon, which brokers reinsurance coverage among other services, identified 23 mega-cases against auditors between January 1998 and September 2005, including cases involving Andersen, which still exists as a legal entity. If the action was directed against the audit firm, Aon counted cases where the exposure was $1 billion or more. If the action was aimed at the client (naming auditors as additional defendants), it counted cases of $10 billion or greater. Some cases were still pending as of September 2005 but others had been settled, dropped or otherwise resolved. Here is the list:

• Adelphia (Deloitte)
• AHERF (PricewaterhouseCoopers)
• AIG (PwC)
• AMERCO (PwC)
• AOL Time Warner (Ernst & Young)
• Banque Cantonale de Geneve (E&Y)
• Carnegie (Grant Thornton)
• Cendant (E&Y)
• Enron (Andersen)
• Equitable Life (E&Y)
• Fortress Re (Deloitte)
• Global Crossing (Andersen)
• JDS Uniphase (E&Y)
• MicroStrategy (PwC)
• Parmalat (Deloitte and Grant Thornton)
• Peregrine Systems (Andersen)
• Qwest (Andersen)
• Sunbeam (Andersen)
• Superior Bank (E&Y)
• Safety-Kleen (PwC)
• Tyco (PwC)
• United Companies Financial (Deloitte)
• WorldCom (Andersen)

E&Y, KPMG and PwC all declined to comment. Privately, however, some auditors argue that law firms are exploiting the legal system for quick gains. The traditional balance between audit firms and law firms seems to have been knocked askew. "The valuations of these damages have grown so high that a broader array of law firms, other than those specializing in shareholder suits, has taken notice," one partner of a Big Four firm argues. "They can ring the bell, make a lot of money and go on to other things. They are actors who may be less sensitive to the systemic consequences of a judgment that a firm cannot pay." In his view, law firms used to take a different view. He says their logic was, "We'll squeeze you, but not too hard, because we want you to be there the next time."

What can be done? At least for now, precious little. It does not appear that the Public Company Accounting Oversight Board (PCAOB) will come riding to the rescue. "The board recognizes the issue, but it's not something the board has come up with an answer for," says Christi Harlan, director of public affairs at the PCAOB. Securities and Exchange Commission Chairman Chris Cox has expressed concern about the systemic risks facing the audit business, but the political climate is so hostile to big business and their supposed apologists, i.e., the auditors, that it would be difficult for him to act. Here are the pros and cons of suggested strategies for addressing the problem:

Let market forces fix it. Grant Thornton's Cono Fusco

Let the Market Solve the Problem

Grant Thornton's Cono Fusco argues that companies and accounting firms can address the structural issues facing the audit industry without government intervention. Read More

And aside from Grant Thornton, experts doubt that second and third-tier firms have the necessary global reach. "The issue that many multinational companies see is that their international networks aren't as strong as the Big Four's network," says Bob Herdman, now vice chairman of Harvey Pitt's Kalorama Partners. "That perception is a hindrance to their ability to step in and fill their shoes."

Fix the highly litigious legal system. The Chamber of Commerce, in its January report entitled "Auditing: A Profession at Risk," argues that the root of the problem is that it's too easy, and lucrative, to bring big class action lawsuits on behalf of shareholders. But in view of the political strength of the trial bar, meaningful action to reform the legal system seems unlikely.

Let the SEC fix the problem. Herdman says many of the cases are being brought under the SEC's 10b5 rule, which covers civil litigation in fraud cases. He argues that the SEC could unilaterally decide to cap the audit firms' exposure. "People who are against that believe that the threat of civil litigation is what it takes to get professionals to do a good job," he says. "But if it were capped at $100 million, that would be a more than adequate deterrent against doing slipshod work." The problem with this one, say Washington insiders, is that a firestorm of political opposition would erupt if Cox were perceived to be going soft on auditors. "The backlash would be pretty strong," says one.

Create greater clarity in accounting standards, so auditors are less vulnerable. That's the preferred solution of Rod Hills, who helped organize two sessions of the American Assembly at Columbia University on the subject. "Our regulatory system is over 70 years old. It's creaky," he says. Many types of financial statements are obsolete, and audits have become a "commodity" rather than a valuable management tool, he declares. Big questions such as how to define the fair market value of intangible assets are unresolved. All of which may be true, but the odds of getting the SEC, PCAOB and the Financial Standards Board to move swiftly on these issues, in cooperation with the International Accounting Board, seem remote.

Help the profession become insurable. The Chamber argues that the PCAOB should promulgate a "safe harbor" standard for the auditors so that they have no legal exposure in the event of fraud. "A safe harbor would provide clarity to the investing public about the meaning of an audit opinion, and it would allow firms to determine when they have satisfied their responsibilities," it said. But the Big Four are skeptical that the political climate would permit that move either. None of the players in the drama see a clear outcome. "The audit firms are in a very difficult position," says David Chavern, vice president of the Chamber. "They are both at risk and unpopular at the same time." Chavern says many people realize there's a problem, but it's unclear whether they can mobilize to create a solution in time. What worries auditors most—and what should worry anyone who cares about the smooth functioning of the U.S. financial system— is that it will take a huge jolt to one of the Big Four before Washington even addresses the issue.