By Jerri-Lynn Scofield has worked as a securities lawyer and a derivatives trader.
One so-called unintended consequence of the financial crisis and the inadequate Dodd-Frank reforms has been to consolidate or maintain the status quo within different types of financial players, rather than encourage competition. So, for example, the U.S. banking sector is more concentrated now than before– too-big-to-fail institutions are even bigger, and many smaller regional players have been forced to merge.
Additionally, despite much sound and fury promoting greater competition in the market for credit ratings, no alternative to the “issuer pays” business model–with all its embedded conflicts of interest– has emerged. As a recent SEC report documents, rating agency performance remains woeful, in part due to persistent conflicts of interest. But so far, no new entrants have made significant inroads into the combined market share of Standard & Poor’s, Moody’s Investor Services, and Fitch Ratings Inc., which the SEC estimates together issued 96% of the more than 2.4 million credit ratings outstanding as of end-2014.
For the biggest accounting firms, concentration began even earlier, during George W. Bush’s administration, when the big five became the big four. In the wake of the Department of Justice’s (DoJ) pathetic enforcement record on corporate fraud during the Obama administration–particularly regarding financial institutions–it’s worth remembering this wasn’t always the case. During Bush’s tenure, federal prosecutors successfully prosecuted–and jailed–corporate executives from Adelphia, Enron, and WorldCom, among others.
The decision to pursue a criminal charge against Arthur Andersen for Enron-related activities caused the accounting firm’s bankruptcy. This ultimately led former Obama Attorney General Eric Holder to follow his previously enunciated “Holder doctrine”, under which the DoJ opted to seek civil settlements and monetary penalties for corporate transgressions rather than individual or corporate criminal claims. The ostensible reason was to avoid triggering a major corporate bankruptcy, which would inflict significant collateral damage, on employees and otherwise. Further, in the case of a too-big-to-fail banks, it was argued, dire systemic consequences might follow. (In September 2015, Deputy Attorney General Sally Quillian Yates authored memo announcing a significant tightening of individual accountability for corporate wrongdoing. So far, surprise, surprise, no major upsurge in prosecutions has occurred.)
Now, big four auditing firm PricewaterhouseCoopers (PwC) faces potential exposure to three significant legal actions for allegedly negligent audits. And depending on the outcome of this ongoing litigation, the big four might become the big three. Statutes of limitations considerations dictate that, these will probably be among the last lawsuits brought as a consequence of actions arising from the financial crisis.
The first action kicked off earlier this month in the Circuit Court for the 11th Judicial Circuit of Florida before Judge Jacqueline Hogan Scola, and could itself potentially inflict a knock-out blow on PwC. As reported by CVN, which is producing a live webcast and gavel-to-gavel recording of the trial, attorneys for the Taylor Bean & Whitaker Mortgage Corp.’s bankruptcy trust accused PwC of performing negligent audits that contributed to Colonial Bank’s multibillion collapse during the mortgage crisis. Taylor Bean & Whitaker was one of the largest U.S. mortgage lenders before a 2009 raid by federal agents led to its subsequent bankruptcy declaration.
Plaintiffs seek to recover $5.5 billion in damages from PwC for allegedly failing to detect a multiyear fraud carried out by Taylor Bean executives involving funds deposited in Colonial accounts from problematic mortgage loans (e.g., that were either non-existent or had previously been bought by other investors). PwC audited the accounts of Colonial’s mortgage lending division. The bankruptcy of Colonial’s largest customer, Taylor Bean, led the Federal Deposit Insurance Corp. (FDIC) to shutter the bank in what was the sixth largest banking failure in U.S. history.
“Year after year, Pricewaterhouse didn’t do their job, they didn’t follow the rules and they failed to detect the fraud,” said Steven Thomas of Thomas Alexander Forrester & Sorensen LLP in his opening statement, as recorded by CVN. This action presents the jury with the question– to what extent is an auditor responsible for detecting potential fraud?– an answer that has yet to be conclusively settled legally.
The Florida action brought against PwC is noteworthy in that it has proceeded to trial. PwC was not unique in seeing the demise of clients during the financial crisis. In fact, all the major accounting firms saw some clients fail or receive bailouts. Yet unlike PwC, these other accounting firms have successfully avoided trials and instead pursued settlement strategies. One reason for their taking such positions is no doubt the costs of litigating complex financial claims. Another is the unwillingness to expose to public view the unpalatable process of financial sausage-making that constitutes the auditing process. Settlement records are generally sealed and not made public.
Those firms that opted for settlement have capped their liability at a fraction of PwC’s potential exposure. MarketWatch reports that Ernst & Young paid $99 million to investors and $10 million to the New York state attorney general’s office for its role Lehman Brothers’ auditor. KPMG also opted for quick settlement, and in 2010 settled for an undisclosed amount for its audit activities for major mortgage originator New Century. KPMG also shelled out an additional $24 million for auditing the accounts of Countrywide Bank, prior to when Bank of America made a distressed acquisition.
MarketWatch also noted that Deloitte also opted for settlements. JP Morgan purchased Bear Stearns at a fire-sale price in March 2008 and Deloitte subsequently settled its exposure as Bear Stearns’ auditor for $19.9 million. For its role as Washington Mutual’s auditor, Deloitte contributed $18.5 million to a multi-party settlement. Deloitte subsequently earned hundreds of millions of dollars reviewing J.P. Morgan’s exposure to foreclosure fraud claims for the Bear Stearns and Washington Mutual mortgages it acquired when it purchased these institutions.
If it survives the Florida action, PwC is facing two further trials, including an action brought by the FDIC and docketed for federal court in Alabama in February of 2017. Federal district judge for the southern district of New York Victor Marrero allowed the second to proceed when on August 5 he denied PwC’s motion for summary judgment in a $1 billion lawsuit filed by the administrator winding down MF Global. (Jon Corzine, CEO of that firm, was former CEO of Goldman Sachs, as well as a former U.S. Senator and former New Jersey Governor.) The Wall Street Journal noted that the judge determined the administrator “has presented sufficient evidence to create a material factual dispute” as to whether PwC’s accounting advice contributed to MF Global’s 2011 bankruptcy. PwC separately settled a claim concerning the adequacy of PwC’s audit of MF Global’s pre-failure internal controls for $65 million.
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Readers, we’re sorry that production problems made this post a pre-prandial rather than a breakfast read. WordPress, while not having a cockpit like the F-35 (thank goodness) isn’t exactly a Piper Cub, either.
That said, Jerri is a subject matter expert in this field, so please repay the post with your comments. It’s not every day a Big Four Accounting firm is put at risk of going belly up!
A story I was told by a retired Peat Marwick partner:
An auditor was in the elevator with the firm’s president. To break the usual awkward silence, he hit upon a clever practical joke.
Turning to the executive, the auditor announces, “GOTCHA!”
The exec clutched at his chest and dropped dead from a heart attack.
Returning to the company’s books, the auditors uncovered a massive fraud of which they’d had no clue.
In the new version of this story, the company president turns to the PwC auditor, announces “Gotcha!” … and the auditor drops dead.
Seems like so many whistle blowers. They may not die of a heart attack, but it seems the stories of some of the most successful are pretty well hidden from the public to help them fade from memory in remarkably short time.
Alayne Fleischmann comes to mind, with Jaime Diamond’s seeming to up the settlement offer from $3 Billion to $9 Billion. I think I’d rather see some high level execs jailed, as the settlements just seem to encourage them to more carefully hide their misdeeds.
I believe many of the Arthur Anderson lower echelon (the ones that were inclined to be honest agents) went on to work in firms run more ethically from higher echelons. I do appreciate that no matter how good their reputation had been before the leadership corrupted the practices (irregardless of regulatory effectiveness), the once respected name was retired in disgrace (as Airlines sometimes do after disasters).
PWC revenue for 2015 $35.4 billion. How much payout is a deathblow?
It still looks to me like the responsible individuals are externalizing the losses from falling on their heads.
That’s global revenue not profits and US revenue is only about 12 billion. As my story at MarketWatch notes only US firm is defendant and will br solely responsible for any verdict. The tipping point number nited in my piece is pretty low.
Does the Federal Government’s AG office prosecute for the second trial on behalf of the FDIC?
Does the Federal Government’s AG office prosecute for the third trial on behalf of the Bankruptcy Administrator? (Seriously, accounting advice contributing to a bankruptcy is a prosecutorial offense? I thought advice was free speech or some other BS excuse.)
If the FG’s AG is responsible for prosecuting in either case, I won’t be holding my breath for a positive result (the demise of PwC).
– a positive result (the demise of PwC).
But that would put 200,000 people out of work, the majority of whom, again, had no agency in the decision process that led to the legal action. As long as the people who make those decisions don’t have to face real consequences, the behaviors are effectively rewarded. The Holder doctrine, and the crushing whistleblowers, puts those jobs in a hostage situation.
To me, that would look like 200,000 people who could come together forming smaller firms to compete for the legitimate work that remains to do in the wake of PwC’s demise.
I tend to agree. IIRC tens of thousands lost their jobs when Arthur Anderson went belly up and the world didn’t end.
This may be a dumb question, but couldn’t an audit firm be put into receivership until all the problems are sorted out? I understand the reluctance to do so by our captured regulatory agencies but wouldn’t it be possible if there were a will?
“…This may be a dumb question, but couldn’t an audit firm be put into receivership until all the problems are sorted out? I understand the reluctance to do so by our captured regulatory agencies but wouldn’t it be possible if there were a will?…”
I believe many AA associates did move on to better firms, but I do like the receivership idea if they at least change the name to something like “Reformed Arthur Anderson 2.0”
This is not to argue with you but the work itself doesn’t go away so it doesn’t necessarily follow that the people that actually do it will be unemployed for long, if at all.
However that certainly doesn’t mean they wouldn’t prefer not to risk that — the “hostage situation” is a quite apt description.
What happens is the individual offices are purchased by other firms with little changes of faces. Unfortunately this practice leads to more and more concentration. The next two firms (5 and 6) are tiny compared to the Big 4 and unfortunately many of them are even less trained at evaluating risk since they perform far fewer SEC clients.
What should be done is the Big 4 needs to be broken up. At one time it was the Big 8. They should never have allowed the consolidation of the firms.
Yes but presumably some fraction of them participated in their firm’s complete failure to do its job, at a worker bee level if nothing else. At some point one’s participation in a corrupt organization has consequences. This is a truth I repeat to myself about once a week on the drive to work.
Peter Pan, if I were PwC, I’d fear a Florida jury and some tough plaintiffs’ lawyers with a lot of trial experience rather than feds who’ve been weaned on the rhetoric of the Holder memo and its progeny. It’s the Florida trial that poses the greatest risk. http://www.tafattorneys.com
And as for Steve H, I probably should have linked to some of Jim Peterson’s analysis in my piece but was worried about going on overlong. He’s been tracking the issue for at least a decade and itemising and modelling some of the factors that suggest the tipping point for an accounting firm to get into real trouble is a whole lot smaller than annual revenue figures might otherwise suggest:
http://www.jamesrpeterson.com/home/2015/01/draft-january-1-2015-the-financial-fragility-of-the-big-four-accounting-firms-updating-the-tipping-point.html
I know accounting isn’t typically, ahem, shall we say, considered to be the most riveting of topics. Ditto for the financial health of audit firms. This link, however, lays out the analysis in a concise and readable way. Interested to hear what you think.
Bottom line if you want to cut to the chase is I think his most recent calculation for each of big four US practices to get into real trouble IIRC ranges from $900 million to $3.6 billion (as of Jan 2015, depending on the firm). (Some of the things he considers: how difficult it would be for these firms, which are partnerships, 1) to get partners to pony up for massive amounts; 2) draw on their international affiliates; 3)turn to their nominal domestic peers/competitors.
“By contrast, third-party equity is simply not available to the private accounting firms owned by their individual partners.” and “… combine to show that a four-firm structure is irreducible.”
So the partners walking would crash the whole system. TBTF again.
That makes accounting a riveting topic, when it’s written in a way that encourages understanding. Well done.
I don’t begin to have anything approaching the comprehensive understanding of the financial system that Yves has. But this concentration problem (and also the unpredictable interconnections in complex systems) is something I know has been discussed extensively before on this site. Dodd-Frank failed to address the general problem across a plethora of areas.
it seems to me the system isn’t tightly coupled at all. the system can be conceptualized as a set of actors who relate to each other in a way that seems deterministic (in which case ttight coupling may be an outcome) but isn’t really. The system includes central banks, technical authorities, politicians and voters. They do what they want in a very non-deterministic way, fudging, bailing, ignoring, pretending, grudgingly acknowledging with elliptical language, then refudging. Tight coupling implies a determinism that is counterfactual to reality. No asteroid has hit since 2008. That event made a strong impression on people’ minds but it was the last war. The system is also a somewhat arbitrary . Where does your bathroom toilet begin and end? It’s not a set of obvious components that occupy 3 dimensional space, it’s simply an organizing idea that helps you pee in the right place — nor is the system. a set of obvious components in a higher dimensional space. it’s just a set of ideas and actors and both are chaging continually at the margins to avoid thee very consequences of a deterministic tight coupliing. It’s actually pretty loose
If everyone agrees on the desired outcome, and knows the parameters of what’s allowed and required in their part of producing the desired outcome, then I agree the current system doesn’t require a deterministic tight coupling. Not when all the incentives seem to be aligned and unhindered by effective regulation. In fact, the looser the coupling, the better. Plausible deniability, etc. I wonder if the PwC suit outcome will have any effect on the incentives or on what’s understood as the desired outcome.
yves: Stop making stuff up.
craazyman: but that’s where the growth in the system is!
Voltaire (trans.): To learn who rules over you, simply find out who you are not allowed to pee on.
I just fixed my bathroom toilet. I know exactly where it begins and ends!
I know the answer crazzyman…
Gates fiction-less capitalism, after enlightened self-interest osmosis filter removed the offending friction…
Disheveled Marsupial…. now “I” can be anything it – wants – and anywhere it – wants – without those pesky spatial dramas….
Jerri-lynn,
I didn’t see in the post (but that could be my fault) why pwc didn’t try to get a settlement done cheaply as in some of the other cases that you’ve cited. Going through discovery seems like lots of potential for bad PR, even if they were to get a favorable judgement in the end.
Also, how much potential is there for a hefty jury award to be overturned on appeal?
It seems like pwc would have done something to put this to bed if there is real existential risk here. The partners would be foolish to risk flirting with disaster. Or is there a lot of hubris at work where they believe they’re untouchable like lehman believed themselves to be?
I just saw your comment re settlement and had already responded below that I don’t know the answer. I agree with your point about the potential bad PR risk from conducting discovery.
There is significant potential for large jury awards to be overturned on appeal– the Supremes have really circumscribed what they have deemed to be unconstitutionally excessive damages awards in a series of decisions over the last couple of decades.
As an aside, lots of these issues are interwoven with the funding of political parties– trial lawyers (aka plaintiffs’ attorneys) associations have been solid Democratic donors– at times, I believe, they were the single largest Democratic contributors. Whereas the so-called tort or legal reform movements, sponsored by various business interest groups and trade associations, break for the Republicans– who promote measures to make it more difficult to pursue class action lawsuits.
Guess, however, who was one of the few Democrats to vote for George W. Bush’s successful Class Action Fairness Act? Our good friend Barack Obama, when he was a U.S. Senator. So, if you believe, as I do, that campaign finance drives much of American electoral politics– a line of reasoning well-explored by my academic mentor, Tom Ferguson– that vote should have been one clue that Barack would be looking elsewhere for money. Ferguson has subsequently traced links to financial and Silicon Valley donors.
Back to your question about an appeal. I’m no expert on the ins and outs of Florida civil procedure, but I believe in the interim after the jury delivers its verdict and before an appeal is heard– and I don’t believe that an appeal is allowed as a matter of right but is discretionary– that PwC would be required to post a bond for some portion of the judgment. I’m answering this off the top of my head and am really speculating– I was never a litigator and instead did transactional work. So I can say you’re asking good questions, but I cannot give you firm answers to all your queries.
Jerri-lynn,
Thanks for the reply. It seems that the prospect of a death-watch for a big firm in just about any industry these days is necessarily a heavily politicized one.
Worked with tom ferguson, huh? Good stuff! I recall reading about the dems switching major backers when kevin philips wrote about how the dems were lined up with hollywood, big pharma and big tech and finance during the clinton years.
My piece postulates why they didn’t settle. Basically the number proposed was likely too big for them to afford.
So in summary:
1. Any settlement would be large enough to bring them down.
2. A jury trail with the verdict + award going against them will bring them down.
So they’re screwed unless:
3(a). They think they can appeal any jury award down to a point where they can survive. Trusting in the captured SCOTUS ? They would also have to believe that what comes out during discovery in the original trial would not be terminally damaging for their reputation(s), or nothing that throwing a few junior partners under the bus can’t fix.
3(b) They think that somehow (?) they can get the Feds to take the case over and the Holder Doctrine would then apply.
Jerri-Lynn — Thanks for the reference — and if I may be tolerated for one sentence of self-promotion: I’ve been writing about the issues confronting the Big Four for a good while — in short form on my blog, Re:Balance — and in fully-addressed form in my book, published by Emerald in December, “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms.”
Many of the points raised by your commenters are addressed there in detail; inquiry is welcome, and inputs and reactions are welcome.
Jim Peterson
Thanks for the article and the peterson link, this seems a pretty relevant passage, among others,
“Those settlements and government fines could only be funded, however, out of the investor-supported balance sheets of the publicly-held banks and other corporate defendants. By contrast, third-party equity is simply not available to the private accounting firms owned by their individual partners.
Given the continued myth that the Big Four are protected by insurance, it must also be noted that these numbers are net of whatever cover may in fact be available. Which is neither good news nor especially relevant.
That is because of the effective absence of commercial insurance coverage of the large firms at the currently expanded catastrophic levels. The fickle cyclicality of the insurance market means that even today’s shrunken, thin and ragged insurance capacity would ill protect against the chilly horrors of the inevitably recurring new litigation nightmares.”
i’d guess there’s some nervous execs, and like others wondered what kept them from settling. Maybe brinksmanship, as he also contends that the industry couldn’t survive on three majors?
“unwillingness to expose to public view the unpalatable process of financial sausage-making that constitutes the auditing process.”
why didn’t the others holdout and use this excuse? PwC must be on the hook majorly.
btw, isn’t this the same angle (sausage-making) the Derivatives market fell back on?… it worked for them.
You know, this makes me wonder why we aren’t hearing more about the role the big four accounting firms played in the mortgage crisis. This is an admittedly small-time example, but my credit union gets routinely audited for adequate controls on our underwriting processes among just about every other aspect of our operation. Then the feds send in their examiners to see how we respond to the auditor’s recommendations. Wasn’t there at least some expectation that the auditors had to do the same kinds of control testing for the big banks? God I sound like such a rube…
Great piece – thanks! The thing that strikes me is that despite everything, collectively we do not appear to have learned our lesson about the role of the ratings agencies, and the limitations in the models that the use.
OK, I’ll ask the dumb question – why has PwC not settled? Was it offered and refused? Or did they think they could do better at trial for some reason?
I would in years past applaud the gov – state or federal – prosecuting large financial malefactors. Thinking, naively, it would be prosecution with teeth that would act as a deterrent to others and would increase competition by opening a space. After watching what happened after 2007/8 I’m skeptical govt prosecutions will do anything more than hive off the weaker players and leave larger and more strongly connected bad actor TBTFs intact in an ever tighter circle that starts to look like govt fostered and sheltered near monopoly. I’ll watch the PwC case. Maybe the outcome and its effect on the larger accounting sphere will be a pleasant surprise. Thanks for this post.
That’s an excellent question, to which I don’t know the answer. It’s especially so since very few cases actually go to trial now, given the costs involved. Settlements are far and away the most common outcome. I’ve neither seen nor heard anything for why the parties decided to roll the trial dice.
– in pari delicto defense
Basically ‘they made us do it’ and point the finger.
Combine that with the First Corollary of the Iron Law of Institutions: The people who control the institution shall not go to jail. Which is what happened to the CFO of Taylor Bean, so this may be a bulwark supported with the full resources of PwC.
Jerri….
Am I to be informed the premium that T1 accountancy firms offered – hiving off risk – was in fact just the opposite eg, creating risk and spreading it globally….
Disheveled Marsupial…. feels like that episode of the young ones… the bomb in the common area… do we just look at it or will someone hit it and what will it eventually do…. stay tuned….
PS…. Welcome
Sorry until I see the ceo & cfo and others go to Jail this just more theater. Then sadly if any of them goes to jail it’s always the chauffeur. The fines do nothing for me or others in Amerika that are hurting. Thanks for the info.
Re: …”Statutes of limitations considerations dictate that these will probably be among the last lawsuits brought as a consequence of actions arising from the financial crisis.”
Disturbing that potential criminal behavior by a broad array of actors will likely never be prosecuted, and that those who engaged in such behavior have been effectively rewarded for doing so. Troubling longer-term implications for the rule of law.
Interesting post on a wonky subject near to my heart. When I sat for the CPA exam in the mid 70’s there were still eight big accounting firms and at my first job for the last of the monster conglomerates (since broken into pieces) I got to see how the sausage was made on a “top twenty” company audit. There was a fair amount of clubbiness between the Fin VP and the AA audit partner but below that level we followed clear standards that kept auditor and auditee roles separate. It seems to me looking back that the fatal error was the shift in focus at these firms from “boring” auditing to management consulting with its resultant higher fees and obvious problem of the audit side reviewing the accounting/business advice of the consultant side. That firewall has clearly failed as the revenues have grown.
Also, unless there is a partnership-wide conspiracy to commit fraud on a single audit (unlikely given the size of these firms) then I don’t understand why the partners and other managers involved in the specific fraud cannot be prosecuted without bringing down the whole firm.
” It seems to me looking back that the fatal error was the shift in focus at these firms from “boring” auditing to management consulting with its resultant higher fees and obvious problem of the audit side reviewing the accounting/business advice of the consultant side.”
Thanks for this comment re: conflict of interest within an accountancy firm. Could explain a lot.
One question strikes me: Given that the big 4 auditing firms are still partnerships I presume Sarbanes-Oxley does *not* apply ?
Sarbanes-Oxley only applies to companies which are registered in accordance with the 1933 and 1934 securities laws (in other words they are public companies or partnerships).
The Big 4 firms are private partnerships and thus are not regulated by SOX.
On the other hand SOX only applies to internal controls and financial reporting of a company’s results. PWC is being sued about the quality of their work.
These firms go through both internal and external peer reviews to ensure that their work is in accordance with GAAS (Generally Accepted Auditing Standards). In my experience I have found that PWC’s work has been of a higher standard than the other Big 4.