The Big 4 – time for the resumption of the exercise of judgement

December 21st, 2010

The FT has noted:

New York state prosecutors could file civil fraud charges against Ernst & Young for allegedly helping Lehman Brothers hide debt, according to a person familiar with the matter.

The office of Andrew Cuomo, the New York attorney general who will be sworn in as the state’s governor next month, could file a lawsuit as early as this week, this person said.

If a lawsuit is filed, it would be the first allegations involving Lehman since the bank filed for bankruptcy in 2008, and the first charges against an accounting firm in connection with the financial crisis.

No doubt the issue relate to repo deals undertaken in the UK to get round US accounting requirements and it is important to note E & Y said they had no comment but had required with accounting regulations. To some degree I’m going to accept that they might have done – having carefully noted the difference between complying with the spirit and letter of the regulation in question – which seems a vexed question in gernal on this site at present – and will move on to the more systemic issue of concern which also comes from an FT article, shared in the public interest:

Fresh details have emerged of secret talks between bank auditors and the government during the financial crisis, as regulators prepare changes to the auditor’s role to lessen the risk of similar chaos.

Letters disclosed to the House of Lords economic affairs committee by KPMG shed light on why auditors did not in general express doubts about the viability of UK banks and building societies during the crisis.

They show how the Big Four audit firms – Deloitte, Ernst & Young, KPMG and PwC – wrote to Alistair Darling, then chancellor, in November 2008 for advice as to whether they could describe UK banks as going concerns. Their letter was written two months after the collapse of Lehman Brothers and tried to gauge the extent to which the government would continue to prop up financial institutions.

The audit firms wrote that the post-Lehman turmoil had left them “having to second guess government actions” when assessing whether a bank could access sufficient funding for at least a year – the minimum for it to be viewed as a going concern.

They argued that a bank could fail if the auditor’s report on its annual financial statements contained an “emphasis of matter” paragraph drawing attention to uncertainty about its going concern status.

Controversially, the auditors added that the government could help ward off such disclosures by reassuring them that it would continue to recapitalise failing banks. The letter led to a meeting between the Big Four’s UK bosses and Lord Myners, then City minister, in mid-December 2008.

Following these talks, Lord Myners wrote to the four firms to reassure them that “the government remains committed to taking whatever action is necessary to maintain financial stability, protect depositors and protect the taxpayer”.

This is more serious. First, so significant was the matter that it seems to me that it would still have required specific reference in the accounts.

Second, it is apparent that limited liability was breached at this juncture.

As Dennis Howlett has said on this:

It’s a very long time since I undertook audit work in any depth but unless things have changed there’s a few things going on here that require explanation.

  1. Have the Big Four attempted to abdicate their responsibilities to the shareholders of the banks by seeking to obtain an understanding of likely government action? The answer appears to be a qualified yes. In my day it was standard practice to take up third party confirmation where it appeared that third party support was needed in order to keep a business afloat. The qualification went something like: ‘On the basis of our examination of the assets and liabilities, XYZ may not be a going concern. We have received assurances from [named third parties] who have provided financial undertakings to maintain the capital base of XYZ.’ There are plenty of variations on this broad theme but that’s the essence. We would have been be remiss in our responsibilities to clients if we had NOT sought assurance and crafted some sort of similar wording. In my day, banks and other third parties (like large suppliers) relied on the audit report in order to understand how companies might stay afloat. I’m sure the irony of this situation is not lost on those auditors in similar situations today.
  2. The FT describes the exchanges between the Big 4 as ’secret talks.’ Why? The Big 4 are said to have been afraid that qualification might lead to collapse. If that’s true then surely they already knew or had grave concerns about their ability to sign off a clean report and the viability of the banks they were auditing. It doesn’t matter which way you slice and dice this argument you come up with the same answer: ass covering.
  3. Did the Big 4 discuss the issue in terms of a veiled threat? In other words did they turn to government and say something like: ‘We think the banks are in trouble to the extent we need assurance from YOU that government will bail them out. If not then [name your bank here] could go out of business.’ That’s not stated though commentators seem appalled that the Big 4 might operate this way. As they should. But then given the UK government’s proclivity for spending tax payers money to shore up pretty much any bank, it doesn’t take a genius to work out what government’s response was likely to be.

I buy all that.

And Dennis’ further comment:

What the hell is going on with our profession? How many more desperate measures will we see the Big 4 take before either litigation or firm government action is taken to sort out what is rapidly becoming an anachronism that feather beds a few to the detriment of the many.

I am sure the defence will be “we played by the rules”.

As with tax avoidance, no doubt.

But what is becoming increasingly clear is that a society where playing by the rules is the aim is not sustainable. Auditors and tax accountants are meant to exercise their professional judgement. And candidly I don’t think they are. And that is dragging down the whole basis of the corporate edifice with risk to the entire market system, at cost to us all.

Those with a neoliberal bent who argue otherwise threaten us all. The time for a revival of the exercise of sound judgement is now.

Written by Richard Murphy

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