Sunday, November 2, 2014

Quis Custodiet Ipsos Custodes?

For a watchman, he has remarkably few clothes. Or weapons.
Auguste Rodin, The Age of Bronze, 1876
“If you meet a thief, you may suspect him, by virtue
of your office, to be no true man; and, for such
kind of men, the less you meddle or make with them,
why the more is for your honesty.”

— William Shakespeare, Much Ado About Nothing

Francine McKenna of re: The Auditors recently expressed her dismay that the Big Four accounting firms have continued to be noticeably remiss about engaging reputable accounting firms to audit their own in-house broker dealer arms. The litany Ms McKenna recites of well-known and less-than-well-known failures and deficiencies public accounting firms have been accused of by the PCAOB and the SEC concerning audits of third party broker dealer clients is certainly eye-opening, and it does not give the casual reader much confidence they are sufficiently capable and diligent in this area. However, Ms McKenna’s central concern is a different one: in order to provide legally mandated audits of their own broker dealer units, the Big Four must hire unrelated third party audit firms, and the firms they have hired are tiny, no-name, no-account nobodies.

This, on its face, appears to worry Ms McKenna, and it is reasonable to presume it should worry the rest of us who are less informed about the ins and outs of public accounting than she. However, while I profess absolutely no expertise or credentials in the area of public accounting, I do have an insight into the facts of the matter which may allay some of Ms McKenna’s and her audience’s concerns.

For one thing, as a lawyer who read her post inquired, the curious among you Delightful People might wonder why public accounting firms have broker dealer subsidiaries in the first place. Well, the answer to that—notwithstanding the corporate doublespeak Ms McKenna cites from the firms in question—is quite simple: they like to do investment banking. They like the fees, they like the prestige, and they are often thrown into situations where clients do hire them to provide capital raising or M&A advice. In particular, the Big Four accounting firms have over the years developed a huge and thriving business providing financial due diligence, accounting, and audit services to private equity firms in connection with the latter’s frenetic buying, managing, and selling of companies. Private equity firms, the cognoscenti among you may recall, are paragons of corporate outsourcing, and because they normally consist of three ex-investment bankers, a part-time bookkeeper, and the bookkeeper’s dog, they must employ an army of outside lawyers, consultants, and advisors every time they want to do a deal. Chief among these, of course—save the ineluctable lawyers—are accountants, since virtually none of the private equity professionals are qualified accountants, either (nor can they be bothered to take time from dealmaking to tot up balance sheets, income statements, or other such trivia).1

Private equity firms are occasionally willing to hire accounting firms as deal advisors in addition to their accounting duties because 1) what the hell, they’re already neck deep in the numbers anyway, 2) they may owe the accounting firms some love for the last ten deals which blew up and for which the PE firm accordingly stiffed them on their accounting fees (“We’ll make it up to you next time”), and 3) they’re normally much cheaper than real investment bankers. So Big Four accounting firm partners are always wheedling and cajoling their financial sponsor clients to let their pet investment bankers “do something,” and sometimes the PE guys let them. By the same token, relationship managers at public accounting firms are always looking to soak their corporate audit clients for additional fees, and the occasional corporate client decides to use his audit firm’s in-house bankers to raise some financing or do some small acquisition or divestiture, often for similar reasons to the PE guys.2

* * *

Now the trick is, of course, that if you decide to offer M&A advice or capital raising services to anyone, including PE firms and corporate clients, the redoubtable SEC requires you by law to register as a broker dealer. This is based on the notion, as I have explained elsewhere, that such services normally entail recommendations concerning the purchase and sale of securities, which is the third rail of financial market regulation in this country. Unfortunately, the law currently makes no distinction between a small band of semi-retired corporate development guys who advise on one or two deals per year and a globe-straddling colossus like Goldman Sachs. The former can just as well operate out of a suitcase. The latter not only advises on billions of dollars of M&A and raises billions of dollars of capital for its institutional clients, but also maintains client accounts, handles funds, and does all sorts of other security-related things for a much broader range of retail and institutional clients. Both are, de jure, “broker dealers,” and both require annual audits.

But if all you do is agency business like advising institutional clients on M&A and raising private debt or equity funds from institutional clients, the types of things which the SEC wants to check you are doing or not doing are relatively few and uncomplicated. For example, they want to know whether you are taking custody of or handling client funds at any point (normally no) or, if you are raising funds from institutional investors, you have controls in place to make sure they are indeed qualified for the deals you offer. They want to make sure you have written policies and procedures and adequate capital to support the business you conduct. But the financial complexity of a pure agency advisory business is very low. You have fee revenue, compensation expense, unreimbursed marketing and T&E expense, and other general and administrative expenses. The balance sheet and retained capital you require to run such a business is minimal. From an auditor’s perspective, it is a pretty darn simple business to audit.

And this, as I understand it, is what the broker dealer units of the Big Four accounting firms do. They are not taking custody of client funds, investing money on behalf of customers, or maintaining large sales and trading platforms which operate across multiple geographies and markets. Notwithstanding the size and complexity of the Big Four, their broker dealer platforms have got to be pretty trivial. Accordingly, it makes sense that they have chosen to hire pissant little audit firms to satisfy their SEC-mandated requirements because 1) their businesses are simple enough to be adequately audited by a couple CPAs operating out of a strip mall and 2) the strip mall CPAs are going to be a hell of a lot cheaper than a larger firm. This latter point is important since it is likely—and Ms McKenna confirms it in the case of PwC—that most of these broker dealer arms are either losing money or making a pittance.

Now if this is not true, and Ernst & Young is running a hedge fund like MF Global inside its broker dealer or selling restricted biotech warrants to unqualified widows and orphans, then obviously none of the above is true or adequate. But if that is the case, I think E&Y and the SEC have a much bigger problem than Ms McKenna has tentatively identified.

Related reading:
Francine McKenna, When Big Four Audit Firms Need an Audit They Choose Cheap (Medium, October 14, 2014)
Francine McKenna, Update: The Shoemaker’s Children… The Big Four And Their Own Broker-Dealers (re: The Auditors, October 27, 2014)
In Loco Parentis (April 13, 2014)

1 This is in sad contrast, regular readers of these scribblings will recall, to private equity firms’ endemic reluctance to hire M&A advisors like Yours Truly for the combined reasons that 1) PE professionals believe they can do deals themselves and 2) doing deals, unlike accounting, is fun.
2 In the UK and Europe, where I understand public accounting firms have a closer historical and statutory advisory relationship to their clients, they actually maintain a relatively robust position in the advisory league tables for mid-sized and smaller deals, unlike their poorer American cousins. When it comes to big public deals, however, investment banks dominate there as they do here.

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