December 09, 2012

Auditors sued - the jig may be up on the false reliance game

In the global financial crisis, a curious question I asked was why auditors were not brought to task for failing to spot that some banks weren't bankable, so to speak? I was not alone in asking this question -- but it is not a popular question, nor an easy one, and the media and public have basically ignored the story.

However there are some hints that victims are starting to question this process themselves. In the news of late, HP ended up overpaying for a company:

(Reuters) - A new shareholder lawsuit over Hewlett-Packard's acquisition of British software firm Autonomy has named Big Four audit firms Deloitte and KPMG as defendants, alleging they missed numerous red flags about Autonomy's accounting.

The lawsuit, filed on Tuesday in federal court in San Jose, California, also named HP's board of directors, officers, and former executives, alleging breach of duty and negligence for their role in HP's acquisition Autonomy.

The company, HP, relied in part or in whole on the auditors' work:

HP Chief Executive Meg Whitman has repeatedly said that the company relied on audits of Autonomy, done by the UK arm of Deloitte Touche Tohmatsu, when it paid $11.1 billion for Autonomy last year.

HP last week blamed the majority of its $8.8 billion write-down on improper accounting at Autonomy. Whitman also said HP relied on KPMG's audits of Deloitte's work.

No surprise there, right? That's what we are supposed to do, right?

Well, wrong. Auditors will also point to those above statements, and infer that Whitman relied inappropriately. But this is at the very nub of the issue - there is no definition of what is appropriate, or, the auditor will have a hell of a time trying to convince a jury of that because what they've essentially done is to sell a product of reliance that they advise the purchaser not to rely upon.

And this may be the one silver lining from the global financial crisis - the jig may be up on the false reliance game. In Australia, a court has just ruled that Standards & Poors have to stand behind their ratings of financial products:

An Australian court has ruled that rating agency Standard & Poor’s misled investors by granting triple-A ratings on so-called Rembrandt notes or constant proportion debt obligations (CPDOs), which plunged in value during the 2008 financial crisis.

The Federal Court of Australia says S&P’s practices were ‘misleading and deceptive’ in rating two Rembrandt notes issued in 2006 and ruled that the 12 Australian municipalities that sued S&P over the securities are eligible for damages. The ruling also implicates ABN Amro, which created the securities, and Local Government Financial Services, which sold them.

S&P’s AAA rating of the notes ‘was misleading and deceptive and involved the publication of information or statements false in material particulars and otherwise involved negligent misrepresentations to the class of potential investors in Australia,’ Federal Court Justice Jayne Jagot writes in her November 5 ruling. ‘By the AAA rating there was conveyed a representation that in S&P’s opinion the capacity of the notes to meet all financial obligations was ‘extremely strong’ and a representation that S&P had reached this opinion based on reasonable grounds.’

The judgment is thought to be the first such ruling against one of the ratings agencies for a specific rating and may have implications for the agencies in other jurisdictions, according to the lawyers acting on behalf of the municipalities.

Jagot says ABN Amro also ‘engaged in conduct that was misleading and deceptive and published information or statements false in material particulars’ and ‘was knowingly concerned in S&P’s contraventions.’

The defence of S&P is that the councils should not have relied on the product - the same defence that the auditors will present. The problem is that if this were to hold true, the product has no value. Or, as another Lehman Brothers case had it:

“How was it that relatively unsophisticated Council officers came to invest many millions of ratepayers’ funds in these specialised financial instruments? That is the fundamental question at the heart of these proceedings,” mused Justice Steven Rares, before pronouncing judgement in a case that has far-reaching implications for the regulation of financial services both here and internationally (Wingecarribee Shire Council v Lehman Brothers Australia (in liq) [2012] FCA 1028 at 14).

Wingecarribee Shire Council v Lehman Brothers Australia cuts to the heart of both the form and purpose of financial regulation: do investment banks owe fiduciary duties and can these be voided either by contractual terms or legislative exceptions?

But the product does have value because it is extremely costly! And indeed, such a defence is deceptive because the audit product and the ratings product, both, are sold only for one purpose: for unsophisticated people to rely upon.

So, welcome news -- the public and the courts may be becoming validly skeptical of the claims of all the players, not just the ones that went broke.

Posted by iang at December 9, 2012 04:58 AM | TrackBack
Post a comment

Remember personal info?

Hit preview to see your comment as it would be displayed.