Auditors Huff and Ratings Agencies Puff

Neither gatekeeper thinks investors should hold them accountable anymore

Five years later we can safely say: The auditors had a good crisis. Four large global public accounting firms — KPMG, PricewaterhouseCoopers, Deloitte, and Ernst & Young — have a monopoly on providing the legally mandated opinions on financial statements. Those opinions are required before a company can IPO, issue debt or sell shares. But even the industry regulator, the Public Company Accounting and Oversight Board, admits that investors no longer pay attention to the words auditors use, just the pass/fail grade assigned. PCAOB board member Lew Ferguson explained at a recent press conference:

There was widespread agreement that the present binary form of the auditor’s reporting model is useful but in a limited way. Many financial statement users indicated that they merely glance at the auditor’s report to make sure that the opinion is unqualified and then move on to other more useful information when analyzing an entity’s financial statements.

A passing grade, a nonqualified audit opinion, is no guarantee the company won’t fail weeks later as many banks did during the crisis.

Auditors operate on a “company pays” model, just like the ratings agencies. However, auditors continue to successfully avoid the accusations of conflicts of interest and bias that compensation model suggests. Those criticisms were reserved primarily for the ratings agencies after the crisis. That’s not to say auditors haven’t been sued or haven’t settled big for audit relationships with companies that failed, were forcibly taken over or even nationalized during the crisis. But you don’t hear about the auditors’ role during the crisis nearly as much as you do the ratings agencies’ crimes. There were no Congressional hearings to ask, “Where were the auditors?” and no calls for regulatory changes to their legal monopoly, like the ratings agencies endured. And the U.S. government hasn’t sued any audit firms for fraud.

No regulator wants to be responsible for another Arthur Andersen.

The largest global public accounting firms failed to prevent, warn, or mitigate the global financial crisis that’s still smoldering. The Big Four audit firms haven’t done much to prevent or detect crimes since either. The banks alone have committed crimes such as LIBOR rate manipulation, rogue trading, aiding and abetting tax evasion, manipulating energy markets, money laundering and control failures such as the “Whale” trading loss at JP Morgan.

Secretary of the Treasury at the time of the crisis Tim Geithner blamed everyone but the auditors in a speech in February of 2009 that detailed the Obama administration financial-bailout plan.

“…There were systematic failures in the checks and balances in the system, by Boards of Directors, by credit rating agencies, and by government regulators…”

Deloitte did pay $20 million for its “no audit at all” approach to Bear Stearns and also settled with audit client Washington Mutual’s shareholders. Deloitte got out early with small settlements for ailing mortgage originators American Home, Beazer and NovaStar, but is still on the hook for Merrill Lynch. Deloitte faces an upcoming trial and a $7 billion claim for the Taylor Bean and Whitaker fraud, one that could arguably put the firm out of business if awarded even at half of that.

However, Deloitte is still the auditor for General Motors, in spite of that company’s failure, bailout and Deloitte’s having been sued and settled more than once over the years for GM’s accounting frauds. Deloitte also remains the auditor of Royal Bank of Scotland, the largest crisis failure and still nationalized bank in the UK.

Ernst & Young is still on the hook with private plaintiffs and the New York Attorney General for its audit of Lehman Brothers, which failed in 2008. The SEC and Department of Justice have still not officially decided whether to paint the audit firm or its partners as negligent for its failed audit of Lehman.

PwC made out well, as auditors of a much bigger JP Morgan and Bank of America and still audits AIG — government owned until the end of 2012 — and “vampire squid” Goldman Sachs, which paid for more than one crisis-related crime. PwC does face the first and still only FDIC lawsuit against an auditor for a crisis era bank failure. PwC audit client Colonial Bank’s executives were co-conspirators in the mortgage origination fraud at Taylor Bean and Whitaker.

The ratings agencies have tried to defend themselves from accusations that their ratings were biased toward paying clients rather than rigorous analyses of credit risks by pleading a “freedom of speech” defense and, now, trying out the “puffery” excuse. The US government has accused S&P of two separate “schemes to defraud” federally insured purchasers of Collateralized Debt Obligations (CDOs) and Residential Mortgage-Backed Securities (RMBSs) when it claimed its ratings were independent, objective and uninfluenced by conflicts of interest.

The government claims S&P knew or believed their ratings were none of the above.

S&P, owned by McGraw Hill and audited by Ernst & Young, says that “independent, objective and uninfluenced by conflicts of interest” are “commands for how business should be conducted. They are not actionable representations of objective facts.” S&P’s also boasts about its Codes of Conduct that describe its “mission” to preserve the “objectivity, integrity and independence” of its ratings, to “endeavor to avoid conflicts of interest,” and to “strive for analytic excellence at all times.” S&P touts its “credibility and reliability,” and that “[S&P] has a longstanding commitment to ensuring that any potential conflicts of interest do not compromise [its] analytical independence.”

S&P, in its request to dismiss the U.S. government case against it, quotes several cases where judges decided that these claims are too general and subjective to back up a federal fraud charge. Statements about the “superiority of [one’s] qualifications” are not actionable, according to a case where Marin County, CA sued Deloitte’s consulting firm. In addition, a “general, subjective claim about a product is non-actionable puffery”, according to the Newcal Indus. v. Ikon Office Solution case.

A federal Second Circuit Court opinion, filed just six weeks before the government filed its complaint in February of 2013, said that the same S&P statements the government relies upon in its complaint cannot be the basis for fraud under federal law. In July, however, U.S. District Judge David Carter for the Central District of California denied S&P’s request to throw out the Justice Department’s lawsuit using some very terse language.

Despite defendants’ protestations to the contrary, the court cannot find that all of these ‘shalls’ and ‘must nots’ are the mere aspirational musings of a corporation setting out vague goals for its future. Rather, they are specific assertions of current and ongoing policies that stand in stark contrast to the behavior alleged by the government’s complaint.

In similar fashion, Judge Shira Scheindlin of the Southern District of New York slammed auditors Ernst & Young (EY) and PricewaterhouseCoopers (PwC) who sought to dismiss claims against their firms in a class action lawsuit related to the bankruptcy of OSG. OSG is a tanker company that, on March 24, 2010, conducted a public offering of three hundred million dollars of unsecured notes. OSG filed registration statements and prospectuses for regulators and investors that included financial statements with unqualified audit opinions from EY and PwC. None of the filings or financial statements included a material tax liability that eventually drove the company to bankruptcy in November 2012.

Judge Scheindlin wrote:

Defendants argue that the entire Audit Opinion is a statement of belief or opinion under Fait because it contains the word “opinion” in its title, and prefaces its conclusions with the phrase “in our opinion.” However, it would render Section 11 meaningless to find that an accountant’s liability turns on this semantic choice. Auditors may not shield themselves from liability under Section 11 merely by using the word “opinion” as a disclaimer...It is difficult to imagine what Congress might have meant by an accountant’s certification if not an audit affirming the accuracy of the documents in question.

An auditor’s opinion is not just puffery about its product, the audit report, but something that investors and the capital markets count on. The auditors’ opinion is the manifestation of its public duty. This attempt by lawyers for EY and PwC ,from prestigious auditor defense firms Latham and Watkins and Mayer Brown,to weasel out of liability by claiming that an audit report with the firm’s signature is a mere “opinion” is embarrassing. Next thing you know the auditors will be claiming the audit opinion is a protected expression of free speech under the 1st amendment.

Joshua Silverman of Pomerantz Law, who represents plaintiffs in actions against auditors and other defendants in securities class action lawsuits, had this to say about Judge Scheindlin’s decision:

“If Judge Scheindlin’s reasoning is followed by other courts in the Second Circuit, a circuit split is likely to emerge, significantly increasing the possibility that an auditor liability claim will make its way to the Supreme Court.”

Judge Scheindlin is a highly respected judge. The reasoning of her decision about auditors is based upon the language of the statute and not the narrow facts of the case. Hopefully that will be enough to prevent lawyers for any other audit firms from trying this lame tactic ever again.