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Speculating on EY’s future

September 23, 2008

With the demise of Lehman Brothers, Ernst & Young’s $31 million annual fee just went out the window. It’s a tiny amount in the scheme of things when you think that EYs last year’s global revenue came in at $21.1 billion. The bigger problem will be the lawsuit PwC’s advisors Linklaters are almost certain to dump in the firm’s lap. Here’s why.

It has now become routine for insolvency advisors to sue the incumbent audit firm at distressed companies. In EY’s case, there is plenty of collateral evidence in the firm’s 2007 global review that EY set its stall out as a firm that not only understands the world of capital markets, but is assiduous in its pursuit of conservative asset valuation policies. It doesn’t take a $1,000 an hour lawyer to work out that those claims are so far removed from reality as to be tantamount to misrepresentation of the most egregious kind. At least that’s what I would expect lawyers to say. Check out these statements:

We’re bringing the right level of financial skepticism to critical areas such as fair-value determinations, reserving, off balance sheet structures, and liquidity. We’re requiring consultation without professional practice leaders on significant of unusual matters. We’re focusing attention on events that occur in these volatile markets subsequent to the date of financial statement. And we’re carefully reviewing client disclosures for timeliness and transparency. (Chairman’s Q&A page1)

As a profession we are very aware that when we are performing an audit we are working for the owners of the business - the investors - and not the management. And so we see it as our responsibility to engage with out stakeholders , and to speak out and provides leadership on important public policy natters affecting the capital markets. Chairman and CEO Jim Turley (Chairman’s Q&A page 6)

Curiously of all the Big 4, EY is the least transparent. Apart from top line revenue, it is nigh on impossible to discover how many partners the firm has. Neither is it possible to accurately estimate profit per partner. The closest we can get on the profit front goes back to 2000 and a NYT article which disclosed partner share at around $400,000 based on revenues of $10 billion. A simple doubling up doesn’t work.

On the people and revenue front, the Big Four Alumni blog estimates:

Ernst and Young does not appear to report the breakdown of these by ranks. Our estimate for Ernst indicates that its partner ranks grew by 7.1% and professional staff grew by 16.4%. It seems that Ernst was certainly more active than the other firms in the labor marketplace and more likely to extend offers.

Revenues per partner for the Big Four firms also increased substantially as partner ranks increased much slower than revenues. Each partner sold on the average $2.81 million in 2007.

Taking an average profit margin of 35%, that puts average industry partner profit at something around $983,000. How much of that is held back in reserve is another matter. None of these figures gets us close to the EY reality but they serve as vague waymarks. Francine McKenna has some market data but the picture remains cloudy for individual firms. What we do know however is the way EY is organized. From the same article by Francine:

All partners participate in a single pool of earnings.

Turning to the question of litigation and once again, per Francine who quotes from the FT in 2007:

“…audit firms have limited resources and have rarely settled lawsuits for more than $200m.”

Earlier today, US legislators were arguing the toss over a financial services rescue package amounting to $700 billion. Lehman’s third quarter losses alone were reported at $3.8 billion. It is now in a firesale situation.

Given all of the above, I can see lawyers going after EY globally. You participate in a single pool - that means everyone gets hammered when the lawsuits start flying. I hate to say it but when Francine predicted that one of the Big 4 might collapse it seemed plausible but deeply worrying. At the time, Francine and I discussed this issue in considerable depth, concluding that it would take a catastrophic event to bring another of the Big 4 down.  In August, James Peterson declared in reference to the ostrich posturing among the Big 4 that:

It will take courage beyond that shown so far, for a Big Four chief executive to inform his partners that their business model is broken, and requires replacement for the sake of future survival.

If not, hindsight will charge the profession’s current leaders, whose state of public denial still avoids that difficult step, with a dereliction of their stewardship obligations to their younger generation. Because nobody else is going to rise to the occasion, the question is whether it matters enough today that they will.

Given the scale of investor losses and anti-government sentiment over bailouts, I believe we are witnessing the first act in a play that will be looked upon as the catastrophic trigger event that changed the profession forever. That is if it is not annihilated by lawsuits first. Just as the US investment banking community has been rendered extinct.

The closing question must be however, why pick on EY? Simple. They’re an easy target for a business that is now in the toilet.

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Written by Dennis Howlett · Filed Under General, Tax and Ethics | Leave a Comment 

Insanity alive and well in the US

September 23, 2008

As legislators and politicians scramble for a solution to the US’s self inflicted financial markets crisis it seems a key stumbling block is executive compensation. According to the Wall Street Journal:

Mr. Paulson has argued that pay limits shouldn’t be part of this plan because they could discourage firms from participating. Treasury is also arguing that it isn’t feasible to expect thousands of companies to change their executive compensation structure just to participate in the program and says such a move would discourage small banks and credit unions from participating. Some lawmakers are looking to call Mr. Paulson’s bluff, thinking that many institutions would find the choice between limits on executive pay and bankruptcy an easy one. But Treasury is insisting that is a false choice and that the program isn’t aimed at preventing firms from filing for bankruptcy but is instead supposed to help relieve pressure on firms that are being weighed down by a glut of assets they can’t sell.

Punish? Why not? The choice is self evident. Apply curbs and still get well remunerated. Or be out of a job with nowhere to go. It doesn’t take a rocket scientist to see that. Except when you’re sat in the middle of a crisis. Judgments quickly become clouded.

Interestingly, the WSJ also notes:

C. Fred Bergsten, director of the Peterson Institute for International Economics, called the package essential, given the unusual circumstances. He predicted taxpayers would ultimately be on the hook for about $100 billion, once the government resells the securities it plans to take off financial firms’ hands.

That’s not as bad as it sounds. The US tax gap is speculated to run at some $300 billion. If the US government gets serious about closing the gap as an integral part of measures to shore up the financial services industry then that potential loss is well covered. Somehow I doubt that will be top of mind, even though the US government can leverage this crisis to scurry through a spending budget they see as appealing to voters ahead of the US election.

Either way, it will be a fudge and Main Street USA is going to be in for a tough time.

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Parallel lines: Germany and Canary Wharf

September 22, 2008

Richard Murphy describes the $2.5 billion promised bonus payout to Lehman Brothers New York staff by Barclays as ‘depressing.’ I describe it as obscene. Is there no end to the cynicism that pervades the financial services industry? But more than that.

If the Sunday Times assertion that:

TAXPAYERS in Britain face up to 5p in the pound in extra taxes because of the credit crunch created by the banks, leading economists have warned.

…is correct then it has echoes of the 5% tax cost that arose out of the re-unification of Germany. I recall the Berlin skyline being dotted with cranes in the early years of reconstruction. Today most of those cranes have disappeared, leaving behind a modern skyline that contributes to making Berlin a wonderful destination.

Will the UK say the same in years to come? I doubt it.

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Written by Dennis Howlett · Filed Under General, Tax and Ethics | 4 Comments 

The irony of the financial crisis

September 19, 2008

The BEST ad ever from AIG to avoid disastersTwo stories, one reflected up on by Jeff Nolan and another extracted by Richard Murphy made me think about the irony of what’s going on in the US right now and which may yet wash over to Europe.

The first story from the NY Times lucidly explains the actions of the US government in making bail or not decision in the cases of AIG, Fannie and Freddie, AIG and Lehman Brothers. The second, from the FT asserts: This greed was beyond irresponsible.

Here’s the irony. The very methods which at one time put millions into trader’s hands yet got these institutions into trouble and which are finally the source of public outcry will mean the US taxpayer foots the bill. Despite that many are complicit in tax avoidance as a core strategy for business planning. Forget the rights or wrongs of bailing out or ditching institutions under stress. What government can turn a blind eye to that toxic combination? And just why should the taxpayer bear the brunt?

If it is going to be policy for government to act as the final backstop when markets run into trouble then surely there has to be a much more rigorous form of examining what’s going on within the financial services industry. Deregulation is fine but as one colleague said today:

The fact remains that government’s role in our economy is at an all time low right now by ANY measure.  We’ve tested the limits of pure free market, fend for yourself capitalism and frankly it sucks.

I’ll add in something both Richard and I have long said or implied: without a morally bound ethical compass, we all go to hell in a hand basket. Courtesy of inept and emasculated government, aided and abetted by an incompetent audit profession bending over to an industry that has a single agenda: greed at any cost. Does that seem right to you?

UPDATE: added video from Loic LeMeur via Seesmic - more irony.

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