Who keeps an eye on the auditors? (2 of 2)

Following on from the last post, here is another extract from the Radio National Background Briefing segment. It makes for great reading!

Former accountant and auditor who writes the accountancy watchdog column at Forbes Magazine, Francine McKenna.

Francine McKenna: The four largest firms-Deloitte, PwC (PricewaterhouseCoopers), Ernst & Young, and KPMG-they probably earn more than 100, 120 billion dollars worldwide. It’s a very large industry, just those four firms. And they employ worldwide hundreds of thousands of people.

Those numbers are made up of lots and lots of individual firms at the country level. So you have very large countries like Australia, like the United States, like the UK, like Germany, Japan, China, et cetera, where the firms may be very, very large and employ a lot of people and the revenues are very large, too. And it all gets added up together. However, each firm in a country is a private partnership, it’s a separate legal entity, it operates independently, and the firms, country-by-country, operate together under a brand name, like PricewaterhouseCoopers or like Deloitte and KPMG.

Stan Correy: Francine McKenna is making an important legal point about the big four audit firms. While, for example, KPMG China or Australia may have the same brand name, they’re separate entities. So if there are problems in KPMG China, that doesn’t mean KPMG Australia is to blame. And, as Francine McKenna explains, the ‘Big Four’ are past masters at avoiding blame.

Francine McKenna: We often say you can bring the auditors to court, but you rarely bring them to justice. First of all, they don’t go to jail because to go to jail they would have to be proved part of a fraud, complicit, then you would have to have the smoking gun, which doesn’t happen because the auditors don’t tell on each other-there’s sort of like the mafia, there’s this omerta-they never, never, never tell on each other.

Stan Correy: Nevertheless, with all this apparent incompetence, hiding behind complexity, and being too close to the people they’re supposed to be independently auditing, when are the audit firms liable? Francine McKenna says it’s tricky.

Francine McKenna: The other thing is that, you know, hardly anybody goes to jail. We have this, you know, ongoing debate now about how nobody is going to jail over the financial crisis and the auditors are at the bottom of the list in terms of people that anyone thinks deserve to go to jail about anything.

Stan Correy: Most big auditors have insurance against making mistakes and their good brand name is important to them, so they get the big clients. So they hate bad publicity and have a lot of defences ready. All this is being played out in a high profile case in Australia.

Journalist [archival]: Local stocks have tumbled three and a half per cent to a three month closing low, after retail property trust Centro announced it’s struggling to refinance $1.3 billion in debt…

Stan Correy: In late 2007, the shares of shopping centre owner Centro Properties Group collapsed after the company admitted it released misleading accounts to the market. The corporate legal drama involving Centro Properties Group then began, as investors who lost money wanted revenge. The drama involves management, directors, and auditors.

So, who was to blame for allowing the misleading accounts to be released? Well, two years ago, ASIC, the Australian securities regulator, brought proceedings against the directors on the board of Centro Properties Group and two managers, claiming they had breached their duties and had misled investors. In late June this year, ASIC had one of its rare legal victories.

ABC Newsreader [archival]: The federal court today raised the bar of responsibility for company directors. The court has ruled that directors of the giant property group Centro breached their duties by not picking up billions of dollars in errors in the accounts. In 2007, the directors approved the accounts, which showed the company had no short-term debt, understating the situation by about $3 billion.

Greg Medcraft [archival]: It’s a landmark decision in Australian corporate governance. I think it does send a very clear message to boardrooms across the country about corporate accountability.

Stan Correy: Greg Medcraft, the chairman of ASIC.

Justice Middleton rejected the directors’ argument that they relied on the expertise of outside auditors who had approved the accounts. But the Centro saga doesn’t end with the ASIC case. The directors of Centro are in turn suing the auditors, PricewaterhouseCoopers, and so are the people who lost their money in the Centro crash. There are two class actions against Centro and PricewaterhouseCoopers by investors-one by law firm Slater & Gordon, the other by Maurice Blackburn.

From Maurice Blackburn, senior associate, Martin Hyde.

Martin Hyde: Centro has brought cross-claims against its auditors. Centro said that if shareholders have lost money as a result of what went on it was partly or completely the fault of the auditors, PricewaterhouseCoopers. And so Centro and PricewaterhouseCoopers will fight it out and have to prove up the elements of their cross-claims at the hearing next March in the same way that we will have to prove up the elements of our case.

Stan Correy: It’s important to repeat what Martin Hyde just said. There are Centro investors suing Centro Properties and its auditors, PricewaterhouseCoopers. Centro Properties also has a claim against PricewaterhouseCoopers, its former auditor. And PricewaterhouseCoopers, in a cross-claim, is saying that the individual directors of Centro Properties and Centro executives misled the auditors. It’ll be QCs at ten paces for months.

Last June, Justice Middleton found that the Centro directors had failed in their duties when they approved the faulty 2007 accounts. The penalties will be handed down soon. ASIC wants the full punishment: fines and banned from holding office as directors. But Justice Middleton, while finding the directors ultimately guilty, wasn’t kind about the auditors either. He said there was evidence that the auditors didn’t understand the new accounting standards and that they didn’t inform the audit committee of a more than $1 billion error in the accounts.

Justice Middleton’s decision, according to Martin Hyde, reinforces the investors’ case against the auditors.

Martin Hyde: In one sense we still have to prove our case, and that hasn’t changed, but there are some aspects of the decision that may be helpful to us, and also if the judge goes on to make declarations about what happened, they are also potentially useful.

Stan Correy: So could you just give a summary of what your class action case is?

Martin Hyde: The Maurice Blackburn class action involves a range of investors, from the biggest institutions in the country right down to mum and dad shareholders, who lost money in Centro during the course of 2007. And we allege that the company and also the auditors engaged in misleading and deceptive conduct and also breached corporations law, and as a result our clients lost money.

Stan Correy: Martin Hyde from Maurice Blackburn.

The Centro case was widely reported in the international media, and at Forbes Magazine, Francine McKenna wrote a story on the judgement for her column.

Francine McKenna: I think it’s a very interesting decision; one, because the judge took such a very adamant position with regard to the directors’ responsibility and the clear direction that they could not abdicate responsibility to a third party advisor like an auditor. And that is the ready excuse that many executives and directors here in the United States use; in fact, our own US Attorney in Manhattan, I quoted him from an article, saying that we have a difficult time here prosecuting fraud cases, because executives say the auditor said it was OK, and the auditors say, ‘Our client gave us false documents,’ and so who am I to believe?

Stan Correy: In the recent ASIC case, the judge found that the directors couldn’t just delegate financial decision-making to the auditors. But PricewaterhouseCoopers, according to Francine McKenna, still has some explaining to do about their role.

Francine McKenna: And I think it’s going to be interesting to see what happens if PwC can also find a way to explain the fact that they didn’t stand up and do their job, I think, to communicate this information to the board of directors and not to let internal executives sort of paper over it and perhaps obfuscate the information from the directors themselves.

It’s a very interesting case both from the director and auditor perspective.

See you next post for something entirely different!

Keep well,

James E