SEC Should Calm Markets, Ahead of Possible Audit Crisis
posted by Lawrence Cunningham
If you thought the 2008 credit crisis that temporarily froze global debt markets wrought havoc, watch out for the next shoe to drop. At stake is the viability of global equity and other financial markets that could freeze if one of the four large auditing firms goes extinct.
And the existence of one of them, Ernst & Young, is threatened, as it faces the prospect of billion dollar liability for botched audits of Lehman Brothers, the defunct investment bank struggling in bankruptcy. It is an eerie echo of the fate of erstwhile big auditing firm Arthur Andersen, which dissolved after its culpability in 2001’s Enron fraud emerged.
Today, only four auditing firms have the resources and expertise to audit the vast majority of thousands of large public corporations. If one of those dissolved, its clients would have to scramble to find a replacement. Some of the remaining three lack requisite expertise for some of those corporations and others would be disqualified from auditing due to consulting work they do for them.
The result would be hundreds, possibly thousands, of large corporations who could not get their financial statements audited as required by US federal securities law. Stock markets could go berserk, along with other financial markets. The costs now, of moving from four firms to three, would dwarf those incurred when Andersen’s dissolution moved the total from five to four.
It does not appear that the US government, specifically its Securities and Exchange Commission, has any plans to deal with this prospect. It should. And it should announce them promptly to get ahead of any market crisis the failure of E&Y, or of the other three, would wreak.
If not, the credit crisis of 2008 will look mild in comparison. After all, the credit crisis was readily addressed by government pumping enormous amounts of capital to rejuvenate liquidity; an auditing crisis cannot by solved by throwing money at it.
Allegations against E&Y are credible, making liability risk meaningful. The magnitude of potential loss certainly approaches $1 billion and may be much higher—alleged manipulations at Lehman ran to scores of billions of dollars. E&Y, which self-insures against such risks and is unable to obtain significant external insurance, would face dissolution if compelled to pay such amounts.
The SEC should promptly prepare and announce steps to address that possibility. Alternatives, none of which is attractive and all pose costs, include:
* quickly seeking to break up the remaining three firms to eliminate conflicts of interest;
*quickly hiving off partners and resources of the existing E&Y (or other threatened firm) commanding expertise other firms lack, to enable them to continue auditing such clients; and/or
* relaxing auditing requirements or standards, by extending corporate audit deadlines or rules governing requisite auditor independence.
Though none of these is attractive or cost-free, they are far less costly than the probable costs of market havoc that could result if no plans are made. Longer term, I have laid out a series of prescriptions, in an article written a few years ago warning of the pending problem.
Observers should also watch the SEC closely as it participates in addressing the allegations against E&Y. SEC Commissioners, whose duties are to protect investors, will face a dilemma in evaluating how tough to be on the firm.
A tough line would be warranted in the name of protecting investors in Lehman Brothers, and signaling a commitment to audits of high quality.
But too tough a line would risk extinguishing E&Y, jeopardizing audit availability, and even equity market efficacy, for at least a meaningful period of time, wreaking havoc on investors.