EY thinks it can split and cash in while ringfencing audit liability
The idea that the SEC or PCAOB or UK's FRC are vetting the deal or will quash it is naive. EY will muck it up before that's even necessary.
Ernst & Young’s plan to spin off its consulting arm, and IPO, is not only repetitive, it is coming from a position of weakness not strength.
Mark A. Weinberger came to EY when EY acquired Washington Counsel, P.C., in 1996, which Weinberger had co-founded. In May 2000, the firm was renamed Washington Council Ernst & Young. Weinberger ran EY's national tax department until February 2001.
(Washington Council Ernst & Young was the subject of one of the few SEC enforcement actions related to auditor independence regarding tax services, actually tax lobbying for audit clients. It was an investigative piece by Reuters journalist Sarah Lynch that led to the action.)
Weinberger had succeeded retiring EY CEO Jim Turley, taking on the role of EY global chairman and CEO in July 2013. (Di Sibio wants to break up what Turley held together and then put together after Lehman.)
Weinberger has had an illustrious post-EY career. According to Wikipedia:
As president-elect, Donald Trump invited Weinberger and 15 other chief executives to join the President's Strategic and Policy Forum in December 2016, tasked with helping Trump establish an agenda that benefits the business community.[26][27]
In January 2019, EY announced that Carmine Di Sibio would succeed Weinberger, effective 1 July 2019.[28]
Following EY, Weinberger joined the board of directors of several corporations, including MetLife, Johnson & Johnson and Saudi Aramco. Weinberger serves as senior advisor FCLT, G100, World 50m and Just Capital .[29][30][31] Weinberger is also a member of the boards of directors for the National Bureau of Economic Research, Catalyst, American Council for Capital Formation, The Tax Council and The Bullis School; and the boards of trustees for Emory University and Case Western Reserve University.[32][33]
Weinberger co-chaired the Russia Foreign Investment Advisory Council[34] with Prime Minister Dmitry Medvedev. He chairs the Mayor of Shanghai's International Business Leaders Advisory Council (IBLAC).[35]
Back in June of 2013, I asked Mark O’Connor of Monadnock Research -which focuses on the business of consulting - to comment for my legacy blog, re: The Auditors, about Ernst & Young’s announcement of something called Vision 2020.
Apparently Weinberger inherited this initiative from Turley when he took over in July 2013.
EY Bets The Farm On Advisory With Vision 2020: A Guest Post From Mark O’Connor – Francine McKenna
Here are Mark O’Connor’s comments on Ernst & Young’s Vision 2020 strategy.
One important aspect of Ernst & Young’s “Vision 2020” is a global strategic initiative to reach $50 billion in revenues by 2020. That’s a very aggressive goal, and there are a few important reasons why that might be both out of reach and bad for global business.
Lofty goals like EY’s Vision 2020 serve a promotional purpose to attract top talent, and create the rationalization for promises of vast internal opportunities to keep top performers engaged. Beyond that, it allows current “EY” partners to move from the global advisory leadership sidelines to join principals at other Big Four firms reaping the rewards of higher-margin consulting work. But it is on this point that unintended consequences would likely foreclose any real possibility that the $50 billion aspect of EY’s 2020 strategic plan could be executed as currently conceived.
Carmine Di Sibio succeeded Weinberger, effective 1 July 2019.
And by 2020 what had EY achieved for global revenues?
Not $50 billion!
EY reports global revenues of US$37.2b in 2020 | EY - Global
The “knotty” tax practice
The WSJ’s Jean Eaglesham most recent story on the EY split focuses on its tax practice, calling it a “knotty” problem for the firm to solve before all can be said and done. Keeping revenue growing is key!
A thriving tax practice is also baked into EY’s ambitious post-split targets of around 21% a year revenue growth for the new consulting company in its first three years, and 7% to 8% a year for the audit-focused business.
Eaglesham’s article lays out the most important issues:
EY’s leaders are also haggling over whether and how the two firms will compete for the same tax work, the people familiar with the matter said. A so-called noncompete agreement, setting out areas where the audit-focused firm will agree to stay off the consulting company's turf for an initial period, is still being negotiated, the people said.
EY is facing this difficulty because it isn't planning a clean split. The audit-focused firm will still get around a third of its initial $20 billion revenue from tax and other nonaudit functions, according to the people familiar with the matter.
EY plans to send roughly one quarter of its tax practice to the audit-focused firm, although the proportions will vary markedly between different countries, according to the people familiar with the matter.
What’s the problem?
Those specialists are needed to help with complicated tax, valuation and other issues that affect the audits of many big companies. Carmine Di Sibio, EY’s global chairman and chief executive, said regulators vetting the deal “want to make sure that [the mostly audit firm] will have the right skill sets to perform high quality audits.”
Some of EY’s 70,000 tax professionals do both audit-related work, such as checking companies are complying with tax rules, and consulting work, like advising on tax avoidance. Tax specialists are also involved in the firm’s fast-growing technology side, helping companies to outsource routine tax matters.
Getting the tax split right is crucial to the success of the breakup. The tax group employs nearly a quarter of the firm’s staff and generated $11.4 billion of the firm’s $45 billion in revenue in the fiscal year that ended in June. Each EY tax employee generated on average around one fifth more revenue than the typical audit employee for the 2021 financial year, according to Monadnock’s data.
Yes, that’s the same Monadnock Research and Mark O’Connor I quoted in 2013 about EY ‘s Vision 2020 initiative.
I tweeted about the story:
Which regulators was EY chairman Carmine Di Sibio referring to when he says they are “vetting” the deal?
Regulators like the SEC and PCAOB have stayed out of the Big 4 firms’ consulting businesses, including tax, in the US in the past. Any sanctions or enforcement activity was left to the states, if at all.
I wrote back in 2013:
The reality is the consulting practices of the Big Four audit firms – and of their lesser competitors – exist in a regulatory no-man’s land. The PCAOB legally can only address audit quality and SEC won’t touch it unless there’s an independence issue with consulting to audit clients. The SEC’s enforcement actions for independence violations have, since Sarbanes-Oxley initiated the additional nine prohibitions against consulting to audit clients, been few and far between. That’s in spite of numerous examples that independence violations are still occurring and occurring in a big way.
It’s up to renegade regulators like Ben Lawsky and private plaintiffs to keep the consulting side of the audit firms honest.
What was I talking about?
When PwC and Deloitte compromised their integrity and objectivity while consulting to Bank of Tokyo-Mitsubishi and Standard Chartered, respectively, on anti-money laundering compliance issues, it was the New York Department of Financial Services — not the SEC or PCAOB — that fined the two firms millions and barred their financial services units from doing business with banks in the state.
And despite non-stop allegations of conflicts of interest during the post-financial crisis foreclosure review initiative spearheaded by the Fed and OCC, which hired consultants including from three of the Big 4 audit firms to develop damage estimates for the major banks related to fraudulent foreclosure practices, no one stopped any of the Big 4 from collecting billions before the whole thing was called off and settled for a flat sum.
When the SEC’s former Chief Accountant Jim Kroeker (now Vice Chairman at FASB) and former PCAOB chairman Jim Doty were asked about one particularly obvious Big 4 consulting conflict of interest during Congressional testimony in March of 2012, during the period of the foreclosure reviews, they both punted.
ACCOUNTING AND AUDITING OVERSIGHT: PENDING PROPOSALS AND EMERGING ISSUES CONFRONTING REGULATORS,
STANDARD SETTERS, AND THE ECONOMY
HEARING BEFORE THE SUBCOMMITTEE ON CAPITAL MARKETS AND GOVERNMENT SPONSORED ENTERPRISES OF THE COMMITTEE ON FINANCIAL SERVICES
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED TWELFTH CONGRESS SECOND SESSION
MARCH 28, 2012
Printed for the use of the Committee on Financial Services Serial No. 112–112
Mr. MILLER OF NORTH CAROLINA. Thank you, Mr. Chairman.
There has already been some discussion of concerns about a lack of independence for conflicts of interest by auditors. That is the reasoning behind the proposed requirement of retaining auditors.
But that seems to be a recurring concern.
It was a concern in Enron and those other scandals during that period. And the biggest auditing firms, the big four accounting firms, still have consulting firms that are affiliated that are as large, and as possible, as the accounting firm. I know that there are some not some limitations on how much overlap there can be between the—consulting firms and the auditing firms.
But right now, the OCC and the Fed are both doing reviews of foreclosure practices by the bigger servicers that are all affiliates of the biggest banks. And both essentially have allowed the servicing firms to pick their own reviewers. It appears from the engagement letters that had they made public that most of the reviews are being done by the consulting firms that are affiliated with auditing firms. And it certainly has raised some questions about conflict of interest.
Most notably for JPMorgan Chase, their affiliates that did servicing, they picked Deloitte. And a big part of their review will be mortgages that came to JPMorgan from Bear Stearns, which they acquired, and from Washington Mutual, which JPMorgan Chase acquired. Deloitte was the auditor for Bear. And they are in fact a defendant in investor litigation for what went on at Bear and mortgage securitization. They are a defendant with Washington Mutual, also for the mortgages originated by Washington Mutual.
It seems like there is an ample disincentive for the auditing firm to find large problems with the mortgages originated by JPMorgan Chase, or now liabilities assumed by JPMorgan Chase, when they bought Bear and when they bought Washington Mutual.
There was an article in the American Banker earlier this month by Francine McKenna raising those questions. She has concerns about conflict, or certainly the appearance of conflict, or the lack of distance. I have those concerns as well. Do you all have those concerns? And should this have happened? How should the rules be changed, if you think so? Yes, sir?
Mr. DOTY. Congressman, first of all, you have highlighted the scope and complexity of the independence question. Independence and skepticism are a state of mind. And part of the exercise that we are engaged in is to try to understand as much as we can about that. I would have to say that with respect to the issue you put your finger on, it is an issue of another regulator’s area of expertise and jurisdiction. It is not part of our jurisdiction. It is part of the jurisdiction of the Federal banking regulators. And I think in the McKenna article you are referring to, the appropriate official of the Office of the Comptroller of the Currency speaks to it, and speaks to the issue. But I really would have nothing to add or nothing to comment on there. It is not my responsibility or the Board’s responsibility to confront that issue in this particular case.
Mr. MILLER OF NORTH CAROLINA. I understand. I have heard that it is not my job response many times. But it seems like it should be your job if an affiliate of an accounting firm is undertaking an investigation that may look at the work of the accounting firm with which they are affiliated. Why is that not something that some of you will look at? Would any of you look at that?
Mr. DOTY. We would in inspecting an engagement of any accounting firm. We would be concerned about business relationships with the affiliates of the accounting firm and the registrant or the issuer.
And we do look at, as I was saying to Congressman Sherman, the relative contribution of non-audit fees to the revenue of the firm when we do our annual inspection of the 10 largest firms.
Mr. MILLER OF NORTH CAROLINA. Anybody else? Mr. Kroeker, you have your hand on your button. Was it just a nervous twitch?
Mr. KROEKER. No, no, no. As it relates to the independence of the financial statement auditor, which is really the jurisdiction that we have for registered public companies, we would certainly be taking a look at that issue. It is a tenet of the independence rules that you can’t audit your own work, and a tenet of the independence rules follows that you can’t be independent if you have less than an objective sense of mind—that is, you are incented to come to a particular outcome. So as it related to the financial statement audit, that would be squarely within our responsibility. As it relates to any work that is done under a consent decree for the OCC or others, I don’t believe it would fall within our jurisdiction.
The SEC and PCAOB have never, in my recall, sanctioned an audit firm for independence issues related to the provision of tax avoidance services to audit clients, even the obvious ones that were publicized during Congressional hearings or by major and recent investigative journalism efforts, let alone the non-stop examples I’ve provided to them.
Neither the SEC nor PCAOB consider it their turf to look at how the audit firms conduct standalone consulting engagements, including tax engagements, unless it affects auditor independence at an issuer. That’s why they call it “auditor independence” not “independence and objectivity of audit firms even when they do other services not in connection with an issuer audit that might affect the public perceptions of their overall independence, objectivity and integrity as a watchdog for the capital markets.”
Finally, since US audit firms do not publish audited financial statements, the public has no idea whether the firms are financially viable, in particular when the firm is faced with potentially catastrophic litigation losses.
We’ve seen over and over that even plaintiffs have a hard time wrenching financial information from the firms when suing them, even if the objective is to gauge how much a firm is going to be able to pay, if they win.
Financial information is not routinely distributed to clients, prospective clients or anyone else because it is commercially and personally sensitive to the firm and its partners. File says it is PwC’s policy to “strictly refrain” from disclosing financial information to any outside parties, and regulators such as the SEC or PCAOB are not mentioned as an exception. The firms lenders, creditors, and sureties are an exception but on a limited basis and with non-disclosure agreements in place.
Quarterly and annual financial information, File says in the affidavit, is never disclosed to the public at large except in rare instances when strict non-disclosure agreements are in place.
PwC’s financial information is not prepared according to Generally Accepted Accounting Principles, says File in the affidavit.
The firm’s financial information is also strictly controlled within PwC and only partners and key admin staff can view limited information on a quarterly basis via a secure electronic portal but can not print, copy or forward it.
PwC also argued in the TBW court filing that its tax returns would be useless to TBW in determining PwC’s net worth or ability to pay punitive damages. That because the majority of its annual income is distributed to partners each year…
Is the SEC or the PCAOB really ready to tell EY, or any of the rest of the Big 4, how to manage their business if they want to split again? Did they weigh in on whether those transactions were structured well the last time?
My personal experience as a KPMG Consulting Managing Director when it spun off into Bearing Point, is that no regulator told the firms what they could do and could not do. (I worked to help separate the Latin American consulting practices from the audit firms. As I recall, the non-US firms have minds of their own. The German firm was most difficult to convince. Something about a “Vogel in der Hand”. )
If the SEC had weighed in, maybe they would have weighed in negatively on a bunch of Federal Services consulting partners, guys who had never run a for-profit business, leading Bearing Point as a public company.
Bearing Point was run into the ground and filed bankruptcy seven years after its IPO in 2002. (I never got any windfall!) And then its government business was sold to Deloitte and its commercial consulting business sold to PwC. Did the SEC, PCAOB or the FTC have any opinion on the anti-competitive, incestuous nature of that whole saga?
Obviously not.
Has the SEC or PCAOB ever reviewed or weighed in on any of the acquisitions made by the Big 4 since to see if conflicts regarding clients lists that overlapped with audit clients were managed well? Based on my experience at PwC in 2005-2006, not even the firms worry about those issues. Does anyone until they cause a big problem?
The WSJ’s Jean Eaglesham mentioned in July that regulators were looking at two things that don’t often get talked about publicly: audit firm financial viability and branding practices. In particular, she says that regulators are interested in how well the separate, smaller audit firm would be able to manage billions in debt — what is actually the partnership’s unfunded pension plan.
That debt is around $10 billion in promised payouts to retired partners, which is effectively an unfunded pension plan, according to the people familiar with the matter. U.S. audit partners are concerned that the obligation—some $7 billion in the U.S.—would fall mostly on their firm, which will be much smaller after the split, the people familiar with the matter said.
Eaglesham writes that the unfunded pension plan issue might concern regulators, including the SEC. Eaglesham also claims that the SEC could “quash the deal.”
I do not recall the SEC ever quashing a deal the Big 4 wanted to make, including when PwC and Deloitte bought the carcass of KPMG’s former consulting firm, Bearing Point. A couple more examples:
PricewaterhouseCoopers Trying To Buy Consulting Revenue Again With Diamond Deal
When Mark O’Conner of Monadnock Research asked for my initial reaction to the PwC/Diamond deal, I had to admit I hadn’t thought much about it. Diamond Technology, a true-blue Chicago born and bred company, is small potatoes. Diamond never achieved the billion dollar revenue goals the founder had dreamed about. Mel Bergstein is reputed to be a lot like a lot of former Arthur Andersen partners – an egomaniac. Huron Consulting provides another recent example. Their egos get in the way of realistic business sense and their self-serving grasp frequently exceeds their true market reach.
There are Chicago River tour boat-size stories here about Diamond, which used to be called Diamond Cluster. But I knew more about the firm based on my attendance in 2003 at Harvard Business School’s Leading Professional Services Firms executive education program. We discussed a case study on Bergstein and Diamond called, “Diamond In The Rough.”
PwC To Acquire Booz But Broader Not Better For Integrity Of Global Capital Markets
Almost every news report about the proposed acquisition mentioned the potential auditor independence conflicts that will inevitably occur when Booz consulting partners fold engagements with PwC audit clients into the new combined firm. Those conflicts will happen because it’s highly likely many Booz consulting clients are audited by PwC. After all, PwC has the largest audit practice of all the global firms even if it trades largest firm honors with Deloitte every other year.
Former Securities and Exchange Chairman Arthur Levitt was dramatic about the dangers to investors of the auditor independence conflicts. (Levitt’s been singing this song forever, bless his heart! Me, too.)
Levitt told Bloomberg News, “We are slipping back.” He would know. Here’s Bloomberg/BusinessWeek:
Levitt, who is on the board of Bloomberg LP, the parent of both Bloomberg News and Bloomberg Businessweek, clearly isn’t a fan of such moves: “As the accounting profession becomes more committed to consulting, their audit activities have got to be questioned.”
(The branding issue Eaglesham mentioned relates to questions about enforcing non-competes and auditor independence issues. Given previous experience, I doubt that the SEC or PCAOB will step into legal conflicts between former partners and since EY plans to still produce “around a third of its initial $20 billion revenue from tax and other nonaudit functions,” there’s going to be bunches.
And I doubt the level of auditor independence enforcement will be much different — which means de minimis— than it was after the last round of splits between 1999-2002.)
EY is facing lawsuits from a spate of recent failed audits including multibillion-dollar legal claims in Germany and the UK over its allegedly failed audits at Wirecard AG and hospital operator NMC Health PLC. EY told the WSJ it stands by its audit work.
Eaglesham quotes Lynn Turner, a former SEC chief accountant:
Regulators will want to be assured the audit-focused firm will have a strong enough capital base to withstand any risk it faces.
That’s assuming a lot.
First, in the last 20 years has the SEC or PCAOB ever been concerned or weighed in on growing unfunded pension plan obligations at the Big 4 when they were facing significant legal jeopardy? I’d love to know!
The unfunded pension plan situation is the way these partnerships work – your capital contribution and “pension” benefits are primarily non-qualified plans. That means the partners become creditors of the firms in case of a bankruptcy. That’s why the Arthur Andersen partners were so screwed when the firm ceased operating with an ongoing significant litigation overhang.
Did the SEC check in on EY’s financial viability and balance of its unfunded pension plan when everyone thought it would go the way of Andersen because of its audit of Lehman Brothers? Did anyone check in on PwC’s unfunded pension plan when it faced three break-the-firm trials in an eighteen-month period, settled two and then was hit with a record damages decision by a judge for the third?
Did the SEC look at KPMG’s financial viability when it decided to reluctantly fine it only $50 million after the top of its audit practice was criminally prosecuted for stealing regulatory data for the PCAOB? (Actually, I think SEC Chairman Jay Clayton did, since the fine was 1/9 of what KPMG was fined back in 2005 — $450 million — for a criminal non-indictment for tax fraud that didn’t even touch its audit practice, hitting only its tax practice.)
Eaglesham wrote in July that EY U.S. leaders had preliminary discussions on the split with SEC Chairman Gary Gensler. Of course, the SEC and Gensler would not confirm or comment.
Di Sibio now suggests in Eaglesham’s latest that someone is working to make sure that a new round of cash-out transactions by consulting partners tired of paying for lousy audits will prevent the standalone audit firm from retaining “the right skill sets to perform high quality audits”.
That is hilarious.
As if EY, or any of the other firms, have enough of the right skill sets and are managing them effectively to perform high quality audits consistently. As if the regulators have ever been bold enough to second guess the Big 4 and gather enough information about the firms’ finances and obligations to authoritatively judge financial viability.
Finally, law business pundit David Lat wrote on September 10 that when Ernst & Young splits its auditing and consulting business, it might be bad news for law firms—but not for Linklaters and Slaughter and May, the firms tapped by E&Y to advise on the transaction. If your memory is like an elephant, you may recall that Linklaters was the law firm that gave EY client Lehman Brothers the UK all clear legal letter clear on its Repo 105 sale accounting treatment.
From the FT back then:
Linklaters, the elite London law firm, faces the prospect of being swept up in legal action surrounding Lehman Brothers’ collapse after it emerged that the firm signed off on controversial transactions that allowed Lehman to shift billions off its books. Anton Valukas’s report into Lehman’s demise reveals that the investment bank turned to Linklaters for a legal opinion blessing the use of so-called “Repo 105” transactions when it could not obtain a suitable opinion from US lawyers. The transactions allowed Lehman to temporarily move $50bn of bad assets on and off its balance sheet in the months leading up to its demise, making the bank appear healthier.
If you are a really wise elephant, you may also recall that Linklaters represented all the Chinese Big 4 audit firms when the SEC ineffectively tried to rein them in on cooperating with US regulators in the event of frauds. I wrote, back in 2014, quoting from the SEC Administrative law judge’s opinion:
PwC sent via counsel, a letter dated December 2, 2011 in response to a Sarbanes-Oxley 106 request for work papers from SEC investigators regarding one of its clients. The letter also attached a letter dated December 1, 2011, from Linklaters, which supplemented a Linklaters opinion letter dated November 2, 2011 obtained in response to the earlier SEC investigator request about the same client.
The letter of November 2, 2011, from Linklaters, a law firm in Hong Kong affiliated with Linklaters LLP of London, provided an opinion that “Chinese law prevented PwC from giving work papers directly to U.S. regulators.”
© Francine McKenna, The Digging Company LLC, 2022