What Damages Can E&Y Afford and Survive?
posted by Lawrence Cunningham
Probably $1 billion, but not much more. Let’s explore.
Global banks are settling US government lawsuits for what looks like big money. Goldman Sachs earlier this year settled a securities fraud claim for $550 million. UBS recently settled tax fraud charges for $750 million. And Deutsche Bank will now fork over $553 million to settle a similar case.
These are large nominal amounts but they will not remotely break the banks. These firms are financial titans, each commanding some trillion in assets and boasting bountiful annual revenue: Goldman Sachs $52 billion; UBS $44 billion; and Deutsche Bank $37 billion. Payments such as those are significant but not crippling.
The same cannot be said of similar amounts if they had to be paid by the world’s global auditing firms. Those firms (Deloitte, Ernst & Young, KPMG, and PWC) command financial assets trivial compared to those of the global banks, with firm value residing primarily in personal and professional reputation (so-called “human capital”). Revenues are much less than at banks too, about $20 billion for E&Y and KMPG and $25 billion for Deloitte and PWC.
That revenue costs more than bank revenue too and is spread across a far larger employee base. E&Y and KMPG employ about 140,000 apiece and the others about 170,000 each. By contrast, Goldman has a mere 35,000 employees, with 65,000 at UBS and 82,000 at Deutsche Bank. In addition, those financial firms have access to insurance to cover at least certain kinds of losses arising from legal liability, whereas the auditing firms lack that resource and instead self-insure.
Even so, the auditing firms have absorbed considerable payments in legal liability claims in the past decade. Each firm incurs up to a dozen or so settlements in the modest range of a few to ten or so million dollars in any given year. Occasionally larger payouts occur, with nine to date exceeding $100 million: $110 million, $125 million, $200 million, $217 million, $229 million, $250 million, $335 million, and $456 million. All those but the last involved single-company frauds—the latter, the record to date, is KMPG’s settlement of tax fraud charges akin to those Deutsche Bank and UBS likewise settled.
No doubt, those figures sting, but are affordable. It’s easy to infer that E&Y, roughly of equivalent capacity to KMPG, could pay $500 million or more, perhaps twice that, if it had to settle the case involving Lehman Brothers. But amounts exceeding that could be crippling given the comparatively small asset base, fractional revenue, huge payroll, and reliance on self-insurance. The risk of a larger demand is realistic too, given the larger size of the Lehman fraud compared to the previous single-company cases the firms have settled.
December 22, 2010 at 3:59 pm
Posted in: Accounting, Current Events
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Responses (5)
Dave Hoffman - December 22, 2010 at 4:29 pm
Doesn’t it turn a bit on the insurance policy’s terms & limits?
Lawrence Cunningham - December 22, 2010 at 5:15 pm
Yes for standard commercial Errors & Omissions insurance, but not so much for the large accounting firms, which don’t have such insurance. They self-insure using captive off-shore insurance subsidaries.
dave hoffman - December 22, 2010 at 6:46 pm
Ah, sorry that I didn’t read your post carefully enough – you of course mention this, but I didn’t catch the reference. Is there a reason that they don’t buy first-party insurance against the loss?
Jake - December 22, 2010 at 6:58 pm
Agree with Hoffman. Let Cunningham divulge his evidence, assuming he has any, showing that Big 4 accounting firms are solely self-insured, or, heavens to Betsy, self-insured through captive offshore entities. (Drum roll and high pitched violins, please.)
Lawrence Cunningham - December 22, 2010 at 7:30 pm
Dave (and by implication Jake, hold the drums and violins):
I review the evidence available about insurance practice at the large accounting firms in several of my papers, most closely in this piece from William & Mary Law Review (2007):
http://papers.ssrn.com/abstract_id=1012919.
The following is from the Introduction to the Wm. & Mary piece, with details elaborated inside. (My other articles in this line of research also appear on my SSRN download page as numbers 5, Columbia Law Review 2006, and 10, UCLA Law Review 2004.)
This Article contributes a new transactional alternative to address risks of catastrophic audit failure: having auditing firms issue bonds to capital markets (called catastrophe bond securitizations) to provide coverage for these risks. This innovation follows from the Article’s analysis of longstanding debates about the relative merits of establishing caps on damages for auditing firms in securities liability cases. In those debates, a common argument favoring caps is the absence or limited availability of insurance to address the liability. This forces auditors to resort to self-insurance programs that they operate through captive affiliates. This Article’s transactional proposal responds to this insurance-based argument.
On the evidence available, self-insurance appears to be better than external insurance so that the insurance-based argument does not necessarily support damages caps. The former bundles risk monitoring and distribution within audit firms whereas the latter separates the two functions. Even if the argument were valid, moreover, the inquiry reveals superior alternatives that can be designed to address losses arising from audit failure. These are (1) financial statement insurance—which has been discussed in the literature and tailors coverage to risks of ordinary audit failure and (2) catastrophe bond securitization—which has not been mentioned in the literature and is introduced here as a way to pool and distribute risks of catastrophic audit failure through capital markets. The former bundles risk monitoring and distribution within insurers while the latter rebundles them outward to capital markets.
The Article thus tentatively concludes that the insurance-based argument favoring damages caps warrants analytical skepticism. Analytical skepticism is the most the conclusion can reach, however, because the evidence available for a definitive determination is limited. Auditing firms, which are privately owned, provide virtually no public information necessary to evaluate these issues. Auditing firms do not publicly disclose any meaningful information about their financial condition or results, disclosing instead summary data on assets and total worldwide revenues broken down by geographic region and business line. They provide no disclosure concerning internal or external insurance models or capacity and only cursory information about internal organizational structures, controls or governance. In the course of some of the following analysis, therefore, an inferential picture of practices is developed.
Subject to those limits, after reviewing the terms of debate and introducing basic principles concerning the role of insurance in public policy governing auditing, the Article explores two alternative models that exist and two that could be created to address auditor liability for audit failure. The first of the two existing models is, of course, traditional professional liability insurance, still commonly obtained by smaller and medium-sized auditing firms and once commonly used by the four large auditing firms but now only to a modest, specialized extent. Remarkable about this form of insurance is how it separates the monitoring by auditors from distribution of the risk of audit failure. This separation or unbundling of risk monitoring and risk distribution can contribute comparative disadvantages to the audit function.
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