Ernst & Young, one of the Big-4 auditing firms left in the world, faces a grave lawsuit filed a couple of hours ago by New York’s Andrew Cuomo, the incoming governor’s last major act as state attorney general. The lawsuit is based on fraudulent accounting committed by Lehman Brothers, the failed investment bank, that E&Y either overlooked or condoned, as I explained last March.
The AG seeks unspecified damages the audit failure caused, certainly running to the hundreds of millions and easily reaching into the billions. Given that E&Y does not have external insurance to cover such losses, but self-insures, the lawsuit could put the firm’s survival at risk. Even so, settlement talks, going off-and-on since March, failed, suggesting that the firm is banking on being exonerated. That is quite a gamble.
As I told the New York Times and readers of this blog in March, if the case impairs E&Y’s viability as a going concern, a corporate financial reporting crisis should be expected. It would be acute compared to the modest scramble that corporate America faced after government prosecutors a decade ago drove from the profession the Big-5 firm, Arthur Andersen, auditor of Enron Corp. Then, 1/5 of companies needed to find a new auditor and most were able to count on one of the remaining four with little trouble.
Today, 1/4 of public companies would be obliged to find a replacement auditor; thanks to rules stated in the federal response to Enron, the Sarbanes-Oxley Act of 2002, about 1/3 of those would be unable to engage any of the 3 remaining firms because of conflicts of interest (those other firms provide internal control or tax advisory services making them ineligible to render financial audits). Amid such a crisis, and with only 3 available firms, the existing structure of the auditing profession would be unsustainable.
It would be reassuring if the Securities and Exchange Commission could tell the nation that is has foreseen this contingency and developed plans for addressing it, as urged last March and in 2006. Alas, I am not sure that it is prepared to do either.