“No such thing as a failed experiment ….
only experiments with unexpected outcomes.”–
American engineer-architect R. Buckminster Fuller

 Is the Big Four’s
concentrated control of large company audits a real problem? Persistent voices
of concern and attention extend back at least to the 2006 study for the
Financial Reporting Counsel (here), recently joined by global leadership of
BDO and Grants (here and here).

If so, is there a
credible case to incentivize their exchange of market dominance for liability
limitations?

Those issues were addressed
this month in a paper from the American Antitrust Institute – here. In an
all-too-rare burst of clarity, the AAI forthrightly recognizes that:

With
pending claims totaling billions of dollars, the Big 4 audit firms face serious
threats to their survival…. (L)iability exposure substantially exceeds the
combined partner capital of the Big 4 firms… (They) contend that liability limits
are necessary to prevent the loss of another Big 4 firm, which would throw the
global financial system into chaos. (footnotes omitted)   

The AAI’s
suggestion would be a legislated trade-off: “government incentives to break up
the Big 4 into smaller, more competitive firms” – namely, a liability cap conditioned
on a firm divesting itself of, say, 20% of its domestic revenue and the
personnel serving the surrendered clients.

Can’t work –
because of the many problems with the underlying but unachievable assumptions. 

But before getting
there — the AAI deserves credit at least for recognizing the completeness of
the Big Four’s market dominance – auditing “nearly all of the world’s public companies with annual sales over $250
million” (emphasis in original) – with even tighter limitations on auditor
choice in such industries as metals and mining, energy, air transportation and
financial services.

Start with the
political unacceptability of liability capping at a level that can assure Big
Four survival. I have spelled out before (here) the financial limits of the
large firms’ private partnership structure and their membrane-thin working
capital, under which they cannot withstand litigation shocks above the $1 – $2
billion range – a tiny fraction (by either amount or percentage) of the
exposures in their pending lawsuit inventory.

As the AAI paper
summarizes, critics of liability protection point to the firms’ average litigation
payouts, as a percentage of revenues and as compared to the far larger total of
alleged damages. They fail to recognize – as do the arguments for capping from
the profession itself — that averages are meaningless when the “outlier” of a
single verdict, falling outside the misleading comfort zone of a bell-curve
model, could and would be devastating.   

So: because
American politics offers no cover for protection at those levels, that side of
the proposed AAI bargain is no solution. What of the other side — the
plausibility of large-scale competitors emerging from the suggested divestiture
program? The facts dictate otherwise.

First, an abundance
of small practices already exist. Why they have not coalesced into global-scale
practices is a long-familiar story of limited geographic scope, expertise, risk
appetite and readiness to invest.

Second, the smaller
sector does not inspire confidence in its strength or capacity for quality
growth to global scale. Of the largest, BDO’s Seidman firm in the US is on a
deathwatch, facing the post-appeal enforceability of its $521 million jury
verdict in Miami. Grant Thornton – not yet fully disengaged from the Refco matter in which lawyer Joe Collins
just received a seven-year prison sentence – now faces the fall-out of being
fired by Koss, its public but family-dominated Milwaukee client, whose CFO
managed for years to steal amounts in excess of the company’s total net revenue
(on which, to read Francine McKenna in unusually high dudgeon, see Re:The Auditors.)

Third, as a
practical matter, how would global-scale competition emerge? If a Big Four firm
were to hive off a small geography-based practice, that newcomer would suffer
handicaps of capacity and expertise no different that those of the current
smaller firms.  If a large firm
were to shed an entire industry practice, no new competition is added to serve
that industry. And if instead, it were to divide a viable large-scale practice,
then each of the two sub-practices
would be burdened with shortages of expertise, personnel and the capital
strength necessary to build to scale and withstand their risks.

In summary, the
AAI’s aspirations fall victim yet again to the Nirvana Fallacy – the defect in
logic I described (here) in the comparison of a failing situation
against an idealized state, without recognizing that the assumed achievement is
impossible under real-world limits, flaws and constraints.

The large firms
grew that way for service-based reasons. And dreams of expanding the population
of pygmies do not, sadly, increase the likelihood of evolving a giant.

At bottom, the
AAI’s most seriously under-examined assumption is that the “catastrophic”
disintegration of another Big Four firm “would throw the global financial
system into chaos.”

Why so? To the contrary,
if the now-standard auditors’ report were suddenly not to be obtainable from
any source, who would miss it?

Regulators and
politicians would have convulsions, to be sure. But as the financial crisis
itself has shown, that is daily practice for office-holders in the hermetic
confines of Washington and London and Brussels.  

Should the stock
exchanges be closed, if a Big Four failure meant that one-quarter of the large
listed companies lacked an audit report? Could those companies’ securities be
barred from trading? Unthinkable. Out where capital really flows and trade is
actually engaged, the world’s markets would shrug, start the process of
designing new forms of assurance from a blank page, and move on.

And the splintered
pieces of the former Big Four would provide ample building blocks for a new
assurance structure – without, pace
the AAI, any need or use for the unintended and unpredictable hazards of
another failed experiment.

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