When M&A Actors Share Auditors, Targets Get The Short Straw
A new study, Shared Auditors in Mergers and Acquisitions, documents a novel auditor conflict of interest. Data suggests that when an acquiring company and its target share the same auditor, the audit firms favor acquirers at the expense of audit clients who are M&A targets. These findings also strongly suggest that auditors prioritize their own self-interest and larger clients over smaller clients and their public duty, when an M&A opportunity forces a choice between audit clients in the firm’s client portfolio.
The researchers, Dan S. Dhaliwal of the University of Arizona Korea University Business School, Phillip T. Lamoreaux of Arizona State University, Lubomir P. Litov of the University of Oklahoma and Jordan B. Neyland of the University of Melbourne, provide evidence that the shared auditor impact is strongest when large companies acquire a smaller target and even more so when both audits are serviced from the same office.
The deal financial benefit is accrued largely at the expense of the target’s shareholders. Dhaliwal, et al. (2015):
“Results suggest that auditors frequently violate their duty to put the interests of their clients ahead of their own in what appears to be a failure to protect confidential client information within their practice offices.”
Regulators primarily focus auditor independence concerns on the effect of an independence violation, or conflict of interest, on the “quality” of a particular audit. When Arthur Andersen’s (AA) notorious audit client Enron went bankrupt as a result of massive accounting fraud, legislators, regulators and the general public agreed audit firms like AA had generally lost their way on audit quality and auditor independence and objectivity. AA, and the rest of the biggest global audit firms, often earned more fees from consulting and tax services to audit clients than from the required audit.
That trend has reemerged with gusto.
The Sarbanes-Oxley Act of 2002 (SOx) tried to fix the auditor/consultant conflict by prohibiting auditors from providing nine advisory services to audit clients. Unfortunately, those prohibitions have rarely been enforced since. In fact, Jim Doty, Chairman of the Public Company Accounting Oversight Board, said in June of 2011 that the regulator’s reviews of partner evaluation and compensation process found “examples of seemingly unrestrained enthusiasm … for selling [non-audit]services to audit clients.”
Recent regulatory sanctions and fines against PricewaterhouseCoopers (PwC) and Deloitte by the New York State Department of Financial Services (NYSDFS) have now gone beyond a regulatory focus on only public accounting firms’ audit relationships. All of the largest public accounting firms provide advisory services that fall between the cracks of what the US Securities and Exchange Commission — which regulates public companies and their audits — and the PCAOB — which regulates auditors of public companies in a post-SOx environment — think they are supposed to monitor. The NYSDFS claims Deloitte and PwC sacrificed independence, integrity and objectivity while providing consulting services to Standard Chartered and Bank of Tokyo-Mitsubishi, respectively, that were mandated by regulatory sanctions against the banks.
The NYSDFS expected Deloitte and PwC to stand in the regulator’s shoes and report back to them about the banks’ compliance with legal sanctions in an independent and objective way. Instead these two public accounting firms put profits and future business ahead of the public interest to help the banks evade further sanctions for money laundering violations.
The Dhaliwal, et al. (2015) study complements another working paper by Cai, Kim, Park and White (2014) that also examines, from a deal performance perspective, the effect of shared auditors on acquisitions. That study takes a pure finance approach and looks at how shared auditors reduce deal “uncertainty”. The benefit of “reducing uncertainty” accrues to the acquiring firm and this benefit is especially pronounced, according to Dhaliwal, et al. (2015), in deals that involve shared auditor offices.
From the Cai, et al. (2014) working paper:
“…auditors accumulate a considerable amount of information about their clients through conducting their audit procedures and through informal discussions with top management, allowing them to be helpful as information intermediaries both before the M&A (e.g., identifying potential merger counterparties and assisting with due diligence) and after the M&A (e.g., integrating accounting systems and internal controls)…this leads to a better understanding (i.e., reduced uncertainty) of those firms’ economics, as compared to those of firms using different auditors.”
The pure finance approach of Cai, et al. (2014) describes the phenomenon well but totally bypasses the question of whether what the shared audit firm does to “reduce uncertainty” is legal or ethical.
The shareholders of target companies that share an audit firm with an acquirer are usually harmed when auditors assist audit clients with deal identification, deal matchmaking, and bid determination, according to Dhaliwal, et al. (2015).
The AICPA Code of Professional Conduct (Section 301) states:
“A member in public practice shall not disclose any confidential client information without the specific consent of the client.”
Sadly, “while auditors may be acting to connect targets with acquirers (perhaps with their clients’ knowledge), they may unintentionally bias the information to the benefit of the acquiring firm or be more “forthright” with the acquirer given the long term incentives of auditors to maintain a client relationship with large acquisitive clients,” according to Dhaliwal, et al. (2015).
Shared auditor situations occur in nearly a quarter of all public company acquisitions. From 1985–2010, the study period, approximately 26% of all acquisitions among clients of Big-N audit firms have a shared auditor. (In 1991, when there were eight Big-N auditors, 32% of all deals were shared-auditor deals. By 2009, the N in Big-N became, via mergers and the dissolution of Arthur Andersen, four — Deloitte, EY, KPMG, and PwC. In 2009 36.8% of all deals were shared-auditor deals.)
The study suggests targets are more likely to receive a bid from a firm that has the same auditor than one that does not. The researchers believe that the substantial percentage of deals with shared auditors suggests auditors facilitate acquisitions among client firms. The study also finds that “deals with shared auditors have fewer bidders relative to deals without, consistent with increased bargaining power for acquirers with shared auditors.”
Premiums paid by acquirers in shared-auditor deals are nearly 4.2% lower than deals in which the target and acquirer have different auditors, according to Dhaliwal, et al. (2015).
“This finding is economically significant as it represents a reduction of 9.2% in the average premium of 45.8%, or an average discount of $36 million U.S. dollars in the purchase price.”
The average announcement day returns are also 1.80% lower for targets and 0.70% higher for acquirers in deals with shared auditors.
Given the multi-year nature of auditor-client relationships, the internal politics of actively favoring one audit client over another in an M&A situation can turn nasty. A request from an acquiring partner for confidential client information from a target client partner is an ethically challenged request, if not a border-line illegal one.
You may recall the case of Arnold McClellan, a partner in Deloitte’s San Francisco office who advised clients on the tax implications of M&A transactions. McClellan’s wife went to jail for a year for passing his confidential deal information, “pillow talk”, to her sister and brother–in-law in London who traded on it.
An excerpt of what I wrote about the case at the time:
M&A transactions are, naturally, confidential transactions. My strict interpretation of the McClellan deals says that Deloitte is not independent of their client McKesson with regard to their advice on the Per Se transaction. If Deloitte is the auditor of H&F also, they are not independent of H&F. McClellan and his Deloitte team are the go-to tax advisors on many of the H&F acquisitions, including the ones he is accused of trading on using inside information.
Why should an investor be concerned about Deloitte and McClellan’s exploitation of their confidential, trusted advisor, client relationship with McKesson, H&F, Avis Budget Group, Microsoft, and possibly others? Auditor independence rules exist to protect shareholders — to make sure the audit comes first.
The lead engagement partner and key partner team members of target firms, especially if serviced by a different audit firm office, may prefer acquisition bids to be withdrawn or to fail since the acquisition of a target client results in the loss of future fees and partner income for that partner or practice.
Overall, the evidence suggests that it’s the bidders, not the targets, who benefit from sharing an auditor during an M&A transaction. The researchers hypothesize that shared auditors “facilitate the flow of information between bidders and targets, and that the benefits of such mitigated information asymmetry accrue primarily to the acquiring firm.”
Richard Breeden, a former chairman of the US Securities and Exchange Commission, cited a number of reasons, in a presentation in 2012 to the Public Company Accounting Oversight Board, that companies and audit committees weigh the choice of auditor carefully. That choice is made more difficult because there are only four global firms servicing almost all multinationals all over the world. Proposals to force mandatory audit firm rotation in the US, as it has been somewhat mandated in the UK, have met with significant resistance.
All of the reasons Breeden gave for companies to make a careful auditor choice center on the risk of information sharing within an audit firm and provide anecdotal evidence that regulators are aware of the potential information transfer within audit firms’ client portfolios.
Auditors act as behind-the-scenes information intermediaries between prospective targets and acquirers probably more often than generally imagined. The likelihood of the auditor becoming an information intermediary between an acquirer and potential target increases if the acquirer and potential target are serviced by the same audit firm office. In smaller markets, it’s likely audit clients in the same industry that could be matched for an M&A transaction, especially ones with complex accounting standards such as technology, oil and gas, or utilities may even have the same lead engagement partner.
The information sharing between client audit teams can be intentional or not. In a shared auditor situation, the target audit team will likely be more cooperative in the due diligence process with co-workers than auditors from another audit firm.
When shared-auditor bidders obtain an information advantage relative to competing bidders as a result of the formal or informal assistance of auditors, bidders with shared auditors can leverage this advantage into a better bargaining position with the target. Other potential bidders have less information and less incentive to bid. Reduced bid competition gives the bidder more negotiating power therefore reducing premiums paid.
Why would audit partners and their firms favor one client over another when a merger or acquisition opportunity arises? An auditor’s long-term incentives (even within a practice office) are more closely aligned with the larger acquiring clients. Shared investment bank advisors, for example, are more likely to favor acquiring firms when representing both a target and an acquirer in the same deal (See Agrawal et al., 2013). Audit firms and practice offices led by individual partners get paid more to develop and maintain relationships with larger, acquisitive clients than with small guppy-like ones.
The study also suggests auditors facilitate bidding among their clients and that sharing an auditor increases a potential target’s likelihood of receiving a bid. If bid facilitation is occurring, it is a violation of SOx auditor independence laws. Certainly it is illegal an unethical for the auditors to use their own SEC-registered broker-dealers to facilitate a transaction between audit clients. The SEC’s final auditor independence rule includes a section that speaks specifically to this scenario:
The final rule, however, will not alter current guidance as to the corporate finance consulting services auditors provide to audit and non-audit clients. For example, accountants, without impairing their independence, may advise audit clients in need of capital that one alternative is to do a public offering of their securities. Also, the staff has indicated that limited activities on the part of the auditor by way of general explanatory work and limited fact finding (such as identifying and introducing an audit client to potential merger partners that meet specified criteria) would not impair an auditor’s independence.
An auditor’s independence would be impaired, however, by entering into preliminary or other negotiations on behalf of an audit client, by promoting the client to potential buyers, or “with respect to subsequent audits of a client if the accountant renders advice as to whether, or at what price a transaction should be entered into.”
We can not conclude that audit firms are actually doing this based on the results, but the results suggest there are informational advantages to acquirers with a shared-auditor office. Phillip T. Lamoreaux, Arizona State University
The shared-auditor effect is stronger in the pre-SOx period compared to the post-SOx period. Post-SOx, deals with shared auditor’s offices still reduce deal premiums and target announcement returns in deals within the Big-N. The impact of shared auditors (offices) on transaction outcomes is reduced, but not eliminated, with the passage of SOx prohibitions on services auditors are prohibited from providing to audit clients such as investment banking, capital markets, valuation and broker-dealer activities.
The conclusion — that shared auditors influence deal outcomes — appears to be consistent across audit firms.
However, there is an Arthur Andersen effect… The study suggests that Andersen had the strongest effect on results in the pre-SOX period. For example, when AA was auditor for both companies, AA target clients enjoyed the largest negative effect on premium of all Big-N firm clients.