Monday, 20 May 2019

European Auditing Regulations Begin to Take Effect

In 2016, a number of new rules regarding the auditing of large financial institutions within Europe were established. The regulations had a number of aims and we will discuss them in today’s post, but one of the major aims was to ensure further transparency when it came to the auditing of PIEs, or ‘Public-Interest Entities’. Interestingly, this designation allows the EU to capture financial institutions that hail from outside of the EU, and in today’s news the first test of those regulations was passed when Goldman Sachs announced that its new auditor from 2021, in complying with the rotational elements of the regulation, would be Mazars, marking the Bank’s first move outside the so-called ‘Big Four’ auditors in its history.

The regulations that came into force in 2016 have a number of aims including: ensuring further transparency; providing statutory auditors with a strong mandate to be independent; develop a more dynamic audit market; and to improve the supervision of auditors within the EU. There are, as one would imagine, a number of elements to the reforms, but we shall focus on one in particular and that is that PIEs need to change their statutory auditors every 10 years. The EU maintain that there are obvious risks with PIEs having links to the same auditors for 50 or 100 years, and that ‘mandatory rotation will hence contribute to a better audit quality’. There are variations that the EU allow for, like the ability for member states to reduce this period to 7 or 8 years, and allow for a maximum of an additional 10 years with the same auditor. The EU pair this with increased restrictions on the non-audit services an auditor can offer to a PIE whilst simultaneously performing auditory services. Quite rightly, these include aspects such as tax, consultancy, or advisory services, decisions that lead to the auditor playing any part in the management of the PIE, and also services linked to structuring, allocation, financing, and investment strategies. It was accepted that there would be a delay before we saw the actual effect of these reforms given that PIE-auditing contracts were due to be renewed on individual bases, and today we saw the first instance of these regulations taking effect.

One would assume that if a PIE would have to move away from the Big Four, then they would just filter down the accepted hierarchy within the industry. In the UK, the fifth player within the industry was, until recently, Grant Thornton. It has therefore caused huge interest within today’s business press that rather than acquire the services of Grant Thornton, Goldman Sachs has decided that its next contract for the auditing of its European Business will be with Mazars, not with Grant Thornton or BDO – now recognised as the fifth largest player - who many had imagined would be in the running. It has been suggested that this decision was not altogether voluntary, with it being reported that the Prudential Regulation Authority questioned Grant Thornton’s ability to conduct the audit, in what will be a massive blow to the company if this is true. Nevertheless, the Financial Times discusses how, via Professor Gordon of the University of Michigan, ‘it is a step forward… Mazars has the opportunity to dispel the myth that only the Big Four are capable of auditing the largest, most complex companies’. The business press have been clear that this is a massive coup for Mazars, who whilst recording revenues of €1 billion+, have still struggled to break the stranglehold of the Big Four.

For Goldman Sachs, the picture is arguably quite clear. It cannot select another member of the Big Four after PwC – with whom they have a historic connection – because all of the other members of the oligopoly currently provide a number of ancillary services. Yet, in moving down the list to Mazars – recognised as being the eighth largest firm – the Bank has potentially done something that it will fundamentally benefit from. All eyes will be on Mazars now to see how it performs, so its audits and the auditing process should be remarkably clean and above board. Goldman will also receive favour for engaging with the spirit of the regulation and leading the way for something which the EU has injected a lot of capital. Whether Mazars will step up to the plate and ‘dispel the myth’ only time will tell, but one imagines they will do. The question then will be how will the Big Four respond, because it has been reported that EY have already taken legal action against the EU in order to change, or postpone the reforms. History tells us they will not go down without a fight.


Keywords – audit, Goldman Sachs, Banking, Mazars, business, @finregmatters

Wednesday, 15 May 2019

Barclays and the Too-Big-to-Jail Myth

We have examined Barclays on a number of occasions here in Financial Regulation Matters, with a number of posts focusing on the Bank’s dealings with Qatar at the height of the Crisis. The approach taken by Barclays – to deal with Qatar for emergency funding during the height of the Crisis rather than seek Governmental support – has been the subject of a number of investigations since and has brought a number of regulatory bodies into the picture. In today’s post we will examine the interconnecting dynamic that exists between a number of British regulators and the economic, political, and societal factors that affect their ability to effectively regulate. We will not revisit the developments between Barclays and Qatar in any great detail here, as it has been covered before in the blog and by the business media. Rather, we will focus on developments detailed in today’s business press that suggest that the Bank of England, via its Prudential Regulation Authority body, argued to prosecutors at the Serious Fraud Office that criminal charges brought against the Bank ‘could destabilise Barclays’.

The obvious question to ask on the back of this news is whether intervening in such a manner is appropriate. A number of prominent onlookers (including Professors Prem Sikka and Emilios Avgouleas) have commented today that today’s revelations demonstrate regulatory ineffectiveness, ultimately suggesting that such dynamics only serve to continue such destructive practices (referring to too-big-to-jail). According to the Financial Times, the BoE’s top banking supervisor spoke with David Green, the then-Director of the SFO, and warned that a criminal prosecution would result in ‘unpredictable consequences’ for the bank and, therefore, the sector. It is important to note that the source of this revelation has not been identified and that all parties concerned are refusing to comment as of yet, but the implications are extraordinary. The Financial Times continue by making the point that Barclays was charged by the SFO anyway, with there being very little effect to the position of the Bank as a result. This then brings into question the concept of using fear to lobby on the behalf of the regulated entities.

Admittedly, that concept sounds conspiratorial. The official understanding of the concept is much more subtle, with then-Deputy of the Bank of England Andrew Bailey – now in charge of the Financial Conduct Authority – explaining in 2014 that regulators around the world (meaning US regulators mainly) need to put their ‘cards on the table’ before penalising regulated entities so as not to cause systemic risks. This was the reasoning behind George Osborne, then-Chancellor of the Exchequer, writing to the US Federal Reserve to ‘express concern’ over the impact of charges against British-based Banks like HSBC. There are perhaps two schools of thought in this instance. One may suggest that regulators need to be concerned with systemic issues to avoid a repeat of the Financial Crisis and are justified, therefore, in considering the impact of large penalties against important entities within a given sector. This makes sense. However, there is an issue with the application of that approach.

If we consider the actions of the FCA regarding the release of an investigative report into the conduct of RBS (a majoritively state-owned Bank), then the intervention of the regulator to stop the publication of that report takes on a different meaning in light of today’s suggestions. The implications of understanding decisions from within this too-big-to-jail lens means that systemically-important financial entities can transgress without damaging consequences. Regulators, wary of systemic repercussions, will intervene on the regulated entities’ behalf. Whilst the case of Barclays may not necessarily be directly applicable, it is telling that there was very little effect to its position as a result of the prosecution (which has since been scrubbed). In reality, RBS has continued on pace through the GRG scandal. HSBC is surviving just fine irrespective of massive fines. There is enough evidence to suggest that penalties can be exacted (let us just stick with financial penalties for the time being) without there being a systemic risk. If we accept that to be true, then a reality comes to light which is a difficult one to accept, perhaps. That reality is that financial regulators protect the regulated entities, not the victims of their crimes. The rationale for that position is complicated however. Who is to say what the dominating factor is in a regulator’s decision-making process, but the pattern is certainly one of perpetrator-first, rather than victim-first. Perhaps, the rationale is irrelevant. The impact remains the same, and that impact permeates the economic cycle so that in good times the perpetrator is prioritised, and in bad times the perpetrator is prioritised. Perhaps that is a systemic reality that explains the majority of decisions that take place – the system is the most important aspect. That understanding fundamentally changes the concept of ‘systemic importance’.


Keywords – financial regulation; banking; UK; Business; @finregmatters

Monday, 6 May 2019

Kraft Heinz and its SEC Investigation Threatens to Impact Others

In February Kraft Heinz announced that the Securities and Exchange Commission was opening an investigation into its accounting practices. In this post, we will examine the potential scope and ramifications of that investigation as, although Kraft Heinz have not found any irregularities internally, there are a number of associated organisations who will potentially be embroiled in the scandal if it is found to exist.

We have discussed Kraft Heinz as a company before here in Financial Regulation Matters, mostly on account of its failed attempt to take over Unilever in 2017. Whilst the subpoena was announced in February of this year, it was actually received in October and the subpoena related to the firm’s ‘accounting policies, procedures, and internal controls’. The company then, in February, took a $15.4 billion impairment charge, or a ‘writedown’, and that is now believed to be something the SEC are also investigating. The company stated that the writedown reflected ‘lower margin expectations’, but this also ties into a concerted strategy to divest across the company on account of its growing $30.9 billion debt pile. This somewhat justifies the views taken in the previous blog posts regarding the differing styles of capitalism adopted by 3G and Berkshire Hathaway, and that of Unilever. Since that failed attempt and the rapturous attention Wall Street have given the company, 3G’s notorious approach for slashing the company to pieces has inevitably backfired, with the firm losing $75 billion from its value in just 2 years and the $15.4 billion writedown concluding that period. The exact same trend can be witnessed in 3G’s other businesses, like Anheuser-Busch InBev NV, the world’s largest brewer of alcohol.

Another potential aspect is that PricewaterhouseCoopers, Kraft Heinz’s auditor, may become embroiled in the firm’s troubles. There has been very little suggestion of this in the business media, but the issue of accounting malpractice, if not uncovered by PwC in its auditing of the firm, will surely become an issue if the SEC find malpractice as part of their investigation. This would be particularly unwelcome for PwC, given that it has only just received a ‘record’ fine from British regulators (£6.5 million over it auditing of BHS), and much larger fines from US regulators ($335 million regarding the collapse of Colonial Bank). When we consider that there is a growing call to reform the industry and, essentially, dismantle the hegemony of the Big Four, yet another scandal could have massive effects for the future of the auditing industry (although it likely will not, given the power dynamics within that particular oligopolistic industry).

Kraft Heinz represents a particular mode of capitalism that is pure in its intention. It does not tolerate what it deems as inefficient (workers were recently denied ‘perks’ such as free cheesestring products whilst on duty), and its owners (3G in particular) are incredibly renowned for its brutal cost-slashing policy. However, even though the businessman who can do no wrong – Warren Buffet – chose to back 3G in a number of its endeavours, there are troubles ahead for that mode of capitalism. This is troubling for Buffet too as Berkshire Hathaway, his investment vehicle, starts readying itself for life without Buffet at the helm – it is almost certain that this will be a tumultuous time for the vehicle as investors cast scrutiny on the real company without its famous leader. The impact of this current investigation into Kraft Heinz could be far reaching indeed.

Keywords – Kraft Heinz, Capitalism, PwC, Business, Audit, Warren Buffet, @finregmatters

Thursday, 2 May 2019

An Update on Scope Ratings

In February of last year we looked at Scope Ratings, a new entrant to the credit rating marketplace, on the back of an article by this author in European Company Law. Since that date, there have been a number of positive developments for Scope so in today’s short post we will be updated on those developments.

Scope Ratings is a German-based rating outfit that has ambitions to challenge the hegemony of the Big Three – S&P, Moody’s, and Fitch Ratings. So far, since its inception in 2011, it is certainly not backing away from the challenge. Currently, the firm is Europe’s largest Credit Rating Agency (European-based, at least), and employs more than 200 staff across seven offices (Berlin, Frankfurt, London, Madrid, Milan, Oslo, and Paris). Recent successes, especially within the Structured Finance department, recently saw Guillaume Jolivet appointed to the agency’s Board, which founder Florian Schoeller suggested is an ideal fit as he is ‘ideally positioned to help the group become a leading provider of credit intelligence and Europe’s champion credit rating agency’. Additionally, Scope has recently appointed Ralf Garrn as Head of its Digital Development, with Garrn coming from Euler Hermes rating which he founded in 2001 (which is now co-owned by Moody’s). So, internally the agency is performing well and is on course to reach its aim of attempting to challenge the Big Three. Externally, they have received news recently that is a massive boon.

Two major German insurance companies have joined the growing list of investors who are supporting the firm. HDI, and Signal Iduna, are two of the major players within the German pension-fund marketplace and their joining of Scope now takes its investor base to nearly 70, which is impressive given this particular marketplace. To accentuate this recent growth spurt, the agency has been awarded its licence to perform rating services within Switzerland, which it sees as an area of growth following recent investments there. This is all incredibly positive. However, and only time will tell if this is true or not, the ‘tipping point’ has not been reached yet. That point refers to the moment when the agency truly comes into the Big Three’s (and in reality, it is the Big Two) sphere of influence and the leading oligopolistic agencies have the decision to make of whether to attempt a takeover, to directly challenge, or to allow the oligopoly to grow to four members. Oligopolies, of course, have no set number but there is usually a natural equilibrium and for the credit rating oligopoly it appears that three is the magic number. Therefore, Scope’s growth, whilst fantastic news for the sector and for investors, is charting a path that almost all other non-Big Three agencies take, and the results are always the same – be taken over, stop growing, or cease to exist. Hopefully Scope can buck this trend, but the theory of oligopolistic organisation, and also history, tells us that this may be a difficult task.


Keywords – Business, credit rating agencies, Scope Ratings, @finregmatters

Wednesday, 1 May 2019

Edward Bramson Shines a Spotlight on the Concept of the Free Market

We have examined the potential reconfiguration at Barclays before in Financial Regulation Matters, and in today’s post we will pick up on some comments made in today’s business media ahead of Barclays’ AGM on Thursday. The focus and speculation surrounds that of Edward Bramson, a so-called activist investor who many believe is aiming to cause substantial change within the massive bank. In this post we will look at Bramson more closely, and then discuss a concept that is being advanced as a ‘norm’ but which calls into question the very nature of the marketplace.

Edward Bramson has held many positions as one might expect of a serious investor, but it is through his investment vehicle Sherborne and Company that he is making headlines at the moment. Through that vehicle he has amassed a 5.5% stake in the bank and it is being reported across the business media that, tomorrow (Thursday), he will ask shareholders to elect him to the Board of the bank. His stated reason for this is that he wants to scale back the Bank’s investment arm and force it to focus on areas of stability (and growth in part) in their commercial and credit card departments. However, whilst sections of the business press suggest that he is unlikely to be elected to the Board, it has been discussed that there are concerns around the performance of the investment arm and that his suggestions may carry more favour than people expect. It is indeed a battle for the ideology of the bank, with current CEO Jes Staley priming the bank to take on the Wall Street elite, and Bramson wanting to change the focus inwards. Yet, whilst the Financial Times made the interesting comparison between Bramson and the ‘Night King’ from HBO’s Game of Thrones, there is an underlying issue that has been brought into the limelight that forces us to ask what the economic reality is in today’s society.

Writing for the Financial Times, John Gapper states that, since the Crisis, ‘regulators are rightly cautious about how banks are run, and would look sceptically on an abrupt change of strategy pushed through by a maverick’. This declaration is interesting for a number of reasons. Firstly, yes it is right that regulators be cautious, but on the same day that regulators have allowed Lloyds to reduce their capital buffer, it is difficult to see complete consistency in this cautious approach. Yes, the two are very different, but the issue is that regulators are not necessarily equipped to run a multinational bank, so is it correct that they may have the opportunity to define the approach taken by one of those banks? Regular readers will know that the approach taken here in the blog is certainly not one of brazen free-market capitalism, but the suggestion made by Gapper is not insignificant. This is a leading financial media outlet supporting Staley’s view of taking Barclays further into Wall Street – but, is he right in doing so? The performance of the investment arm suggests not, but this is counteracted by the widely held belief that a diversified bank is better equipped to deal with storms. That may be widely believed, but that does not make it the only approach. It is unlikely that Bramson will be successful in the AGM, but the media coverage of this issue demonstrates a wider problem whereby massively impactful decisions are being guided by journalists and potentially rubber-stamped by regulators who may not, necessarily, have the expertise to make such decisions in the private bank’s business.


Keywords – Edward Bramson, Barclays, Banking, Business, @finregmatters

Monday, 8 April 2019

Fitch Ratings Receives a (European) Record Fine for yet another Conflict of Interest

In this short post, we will review the news from a couple of weeks ago that Fitch Ratings, the third member of the Credit Rating Agency oligopoly, has been fined by the European Securities and Markets Authority (ESMA) for breaching its conflict of interest-related rules, specifically with regards to its ownership.

Fitch Ratings is the third member of the rating oligopoly and, like S&P is not a public company. Therefore, its ownership structure is a little more opaque and difficult to accurately determine. We know that the firm is owned by the influential Hearst Group, but only after the Group increased its stake in the agency at the expense of previous majority shareholder, French conglomerate Fimalac, in 2014. It is in relation to the ownership of Fimalac that this current regulatory action relates. Yet, whilst most CRA-related transgressive behaviour revolves around weighted bias – weighted in relation to the power dynamics within the rating industry and its connection to issuers and investors – this particular transgression was far more obvious.

ESMA had been investigating Fitch’s ratings of a French Supermarket group called Casino. The investigation has now concluded that, in relation to its ratings of the Casino Group from 2013 to 2015, the agency had failed to ‘meet the special care expected from a credit-rating agency as a professional firm in the financial service sector’. This was because between 2013 to 2015, one of the supermarket’s Board – Marc Ladreit de Lacharriére – also owned a stake in Fimalac. As Fimalac was a majority owner of Fitch at the time, this conflict should have been declared; this is based on rules established in 2013 that states that nay shareholder with more than 10% in the agency must not sit on the board of a company the agency then rates. For not declaring and then removing the conflict, ESMA has fined Fitch Ratings a record fine of €5.1 million. According to the Financial Times, that fine covered three other breaches for similar violations.

What this episode does is bring into the limelight the potential for transgressive behaviour within the credit rating industry – it is not agency specific. In 2015 S&P was fined a record $1.5 billion, whilst Moody’s was fined $864 million. First time observers may think that this demonstrates this behaviour as only existing at the very top of the industry and, thus, creating a ‘duopoly’ instead of the oft-cited ‘oligopoly’. However, the truth is that Fitch provided documentary evidence detailing the transgressions of the other two instead of settling with CalPERS – the Californian pension fund that initiated the legal action against the Big Two – which tells us that they were not entirely guilt-free, but possessed the evidence needed to avoid being caught up with the Big Two. This current story tells us that it is the modern version of a ‘rating agency’ which is actually the transgressive vehicle, and not one particular agency. Fitch Ratings said, in response to the fine, that they are well aware of the European Regulations and acted in good faith. If this is true, then a record fine would not have followed. There are many transgressive industries within the financial sector, but the sheer consistency of transgressive behaviour from within the credit rating industry is remarkable, and shows no sign of abating.


Keywords – Credit rating, Financial Services, oligopoly, EU, @finregmatters

Tuesday, 2 April 2019

The Acuris Sale as an Indicator

In today’s short post we will look at the news recently that important players within the financial marketplace are jostling for position with regards to the sale of a company that specialises in providing particular information to the financial world. The emergence of NewsCorp and the so-called ‘Big Three’ credit rating agencies as potential purchasers of Acuris suggest that this is a potentially important sale. However, the question for this brief post is whether the sale acts as an indicator for a much larger, and much more important sentiment.

Acuris, formerly the Mergermarket Group, is a ‘media company’ that specialises in providing financial information to the marketplace. More specifically, it has been noted for its excellence in providing information on Mergers & Acquisitions (M&A) to its subscriber base. Although its current owners BC Partners only purchased the company in 2013 for £382 million including debt, it is now widely rumoured that the company is for sale. That proposed sale is drawing in some of the largest players in the sphere, with News Corp and the so-called ‘Big Three’ credit rating agencies supposedly circling the company which onlookers suggest could go for more than £1 billion. However, there have been a number of reasons put forward as to why there is so much interest in the company, with those reasons ranging from the reliable subscriber base that the company enjoys, to the company’s year-on-year growth. Yet, one element that may be the case is that the potential purchasers are of the strong belief that the post-Crisis financial landscape will settle more than it has. One of the reasons why this potential sale suggests that is a theory put forward by the popular press and a leading audit firm: a relaxed financial environment results in improved M&A markets.

Bonamie et al find that what they call ‘policy uncertainty’ does negatively affect M&A activity. Lee agrees but in respect of cross-border M&A activity, which is obviously a major factor in the M&A marketplace owing to the globalised nature of the market; the Financial Times reported at the end of last year that global M&A activity for 2018 had eclipsed a previous record set on the eve of the Financial Crisis. So, there is evidence to suggest that global M&A activity is increasing and that the trend may continue. How do we know the trend may continue? One clear indicator of that being the case is the feverish speculation surrounding the sale of Acuris and, particularly, who is interested in buying the company. News Corp, S&P, Moody’s, Fitch, and private equity firms like KKR do not invest on sentiment, and it is their business to foresee trends. The credit rating agencies in particular work tirelessly in building a vast network of information services to take advantage of future trends, a fact evidenced by Moody’s relatively recent purchase of Bureau Van Dijk. If we accept that these market-leading players foresee some increased level of stability within the marketplace, then the question becomes is the regulatory framework strong enough, post-Financial Crisis, to constrain such companies from taking advantage of their position that they are currently jostling for position for? Has the credit rating regulation been improved enough so that the inherent conflicts of interest that remain within their business model do not affect the M&A market negatively in relation to this potential sale? The answer remains to be seen, but given the deregulatory sentiment on offer in the U.S. and the potential for a regulatory race-to-the-bottom post-Brexit, we may already have the answer now.


Keywords – Acuris, Credit rating agencies, M&A, NewsCorp, Business

Friday, 29 March 2019

Scandinavian Banks’ New Era of Scandal

On the back of revelations regarding Danske Bank and its connection to money laundering last year, it was revealed in the news yesterday that Birgitte Bonnesen, the CEO of Swedbank, had been relieved of her duties just minutes into the Bank’s AGM in relation to the organisation’s connection to dirty money. In this post we shall examine these connected cases further and learn more about the anti-money laundering issues facing banking organisations.

The incredibly reputable Danske Bank, Denmark’s largest lender, became embroiled in a money laundering scandal last year when it was revealed they had helped launder almost €200 billion in Russian and Baltic money since 2007. The case of Danske Bank revolves around the purchasing of an Estonian Bank that would become the vessel for money laundering from neighbouring States like Russia and the Baltic States. The leadership of Danske Bank were not only made aware of the issues as early as 2010, but actively promoted the increasing of ‘non-resident business’ i.e. money from non-Estonian Nationals up to a point when, in 2011, the Estonian Bank generated 11% of Danske’s total profits, despite only accounting for 0.5% of the bank’s total assets. There were a number of associated issues, like the bank having nobody in place as a compliance officer for anti-money laundering (flouting specific Danish laws in the process) and in 2014 a whistleblower brought to the attention of the Estonian bank’s leadership the fact that British LLPs (Limited Liability Partnerships) were being used to funnel money from people closely linked to Vladimir Putin and the Russian Intelligence Services. In 2015 the Bank closed its non-resident business in Estonia but they had not gotten away with their crimes, with Estonian prosecutors arresting 10 people in connection with the investigation and with Deutsche Bank’s American subsidiary being dragged into the mire for good measure.

The once reputable Scandinavian sector took a massive hit over Danske and today Swedbank looks set to add to this degeneration in standards. The bank was raided this week by Swedish authorities looking for evidence of fraud and insider trading, whilst the US is currently probing Swedbank for its role in the Danske Bank scandal. The rumour is that Swedbank handled more than €135 billion in assets from ‘high risk clients’ and that the bank’s connection to Danske, and interesting Mossack Fonseca, is the cause for the probe. The Swedish Prime Minister – Stefan Lofven – stated that ‘this is absolutely unacceptable’ because scandals such as these ‘destroys confidence in the financial system which is important for society’. It is interesting to note that, even in Scandinavia where societal issues are, by and large, given much more reverence than in Europe and the US, the plague of transgressive finance has still managed to take a foothold. With Swedbank being potentially implicated in the Donald Trump affair – there is a suggestion that the bank handled payments from Ukraine to Trump’s campaign manager Paul Monafort – it is likely that this is just the start of a very long and very painful road for the bank, and most likely the Swedish financial system.


Keywords – Banking, Swedbank, Danske Bank, Money Laundering, @finregmatters

The Case of Purdue Pharma, the Sackler Family, and the Opioid Crisis

In the first of two short posts today, we will look at the case of the billionaire Sackler Family and their remarkable effect upon American society. The family, who own Purdue Pharma amongst a list of other ventures, have this week seen a massive legal action taken against them by the State of New York who argue that the company is ‘responsible for the opioid epidemic’ sweeping through the United States.

The attorney-general for New York has called the lawsuit the ‘nation’s most extensive’ with respect to the pharmaceutical industry and comes right on the heels of a $270 million suit that was settled in the State of Oklahoma on exactly the same grounds. Whilst the company and the billionaire family who own it did not admit guilt (settling parties rarely do, hence why they settle outside of court) it has potentially opened the trapdoors for litigation. It comes as no surprise then that the company is reportedly considering bankruptcy proceedings in the face of such an onslaught.

The company, which began life as the Purdue Frederick Company in Manhattan in 1892, was bought by the Sackler family in 1952 by Dr Raymond and Dr Mortimer Sackler. In the 1980s the company began manufacturing products that were derivatives of opioids, like morphine. In 1996, this programme is extended and the company develops ‘OxyContin’, or ‘oxycodene’ in an ‘extended release’ format. In 2005 the company begins developing increased security around OxyContin which is demonstrative of their understanding of the market for these drugs, and in 2010 OxyContin is redeveloped to include extra warnings over its usage. Nevertheless, the sale of what has been called ‘heroin in a pill’, has become a societal ill unlike many others (at least one that is officially sold to the public). The National Institute of Drug Abuse states that more than 130 people die every day after overdosing on opioids, whilst the Department of Health and Human Services declared a public health emergency in 2017 and themselves estimate that more than 11 million people misused prescription opioids in 2017 alone.

The scale of the disaster is tremendous and the opening of extensive lawsuits will likely see the end of Purdue Pharma and its competition. However, that is probably wishful thinking. The reality is that the people behind the company will not suffer or be penalised, the systems they developed where salespeople were paid six-figure bonuses for misleading Doctors will not be regulated, and moreover there is scope for the companies to make even more money. Rather remarkably, it has been revealed that not only do Purdue have massive stakes in other more generalised opioid products, they are now busy marketing and aggressively pushing the cure to the social problem they themselves exacerbated! It is all rather remarkable but not in the least bit surprising – that big business is encouraged to act in this manner at the cost of the public is a systemic norm that has been accepted. One would like to think the New York lawsuit would cause damage to the operations of the firm and the family, but considering the fact the cure is raking in billions of dollars, it is very unlikely.


Keywords – Pharmaceuticals, US, Opioid crisis, business, law, @finregmatters

Thursday, 28 March 2019

Ernst & Young in Trouble in Japan… Again

In this second post, we will look at the news that Ernst & Young (E&Y) are facing a massive and highly unusual (for Japan) $9 billion lawsuit for its audit failings that led to investors in Toshiba losing out significantly. As E&Y have already had issues with Toshiba, it is worth examining this current instance to see whether this is a continuation of auditing failings across the globe.

As part of one of Japan’s worst accounting scandals for some time, E&Y were fined $17.4 million in 2015 for ‘failing to spot irregularities’ in its audit of Toshiba’s accounts. The firm were banned from taking on new business contracts in the country for 3 months, and at the end of 2015 the firm’s regional Head resigned. Yet, this week the firm is once again making headlines in Japan for its performance, or lack thereof. The firm is facing a shareholder lawsuit for $9 billion and is accused of being partly responsible for Toshiba’s failure to ‘disclose losses at Westinghouse’ during 2012-13. Westinghouse is an American supplier of nuclear technology, but in 2012-13 was suffering losses that Toshiba was exposed to on account of its investment in the company. The individual investors bringing this claim against E&Y argue that had the losses on Toshiba’s books been made public sooner, then shareholders would have been more knowledgeable and would have been able to prevent Westinghouse from purchasing CB&I Stone and Webber in 2015, a move which compounded the financial distress of the companies involved.

As the case is ongoing it is difficult to suggest what will eventually happen. The case was originally much smaller and related to a separate accounting failure in Toshiba, but the investors have decided to add Westinghouse to the claim. It has been noted that the claim is unusually large for Japan and, as such, there may be a question to be raised as to whether E&Y will ultimately be forced to pay such a fee. Perhaps it hinges on the actions of the auditing firm and its connection to Toshiba; how has the firm performed since 2015? Have the firm been lenient or softer with their audits to repair the damage caused by the scandal in 2015? Have the usual conflicts of interest inherent within the modern auditing business model raised their ugly heads again? The case will either be struck out or settled privately so we may never know, but this represents just the latest in a very long line of supposed scandals that continuously revolve around this industry.


Keywords – Ernst & Young, audit, Toshiba, Japan, @finregmatters

Goldman Sachs Handed Record Fine by the FCA

In the first of a series of shorter posts today, we will react to the news that Goldman Sachs has been handed a financial penalty by the FCA for misrepresenting a vast number of transactions over the past decade.

In the largest fine of its kind ever given out by the regulator, the FCA has fined Goldman’s London Unit £34.4 million for ‘failing to provide accurate and timely reporting relating to 220.2 million transaction reports between November 2007 and March 2017’. Because Goldman agreed to resolve a proportion of the issue – issues relating to the firm’s change management processes and its maintenance of counterparty reference data – the figure of £43.4 million is actually a reduction on what should have been a £49 million fine. The firm is guilty of not complying with the rules of the Markets in Financial Instruments Directive, or MiFID, and is the second such action taken against a bank by the FCA in less than a month after UBS was fined £28 million for the same thing. In total, the regulator has now taken action against 13 organisations for this breach, including Merrill Lynch, Deutsche Bank, Société Générale, and Barclays amongst others.

The regulator is rightfully cracking down on these breaches because the data it would obtain from efficient record keeping is used to identify market abuses and financial crime. Such a widespread and historic flouting of these regulations fundamentally affects the capability of the regulator to efficiently monitor the marketplace, which is why the FCA were clear in their press release that ‘these were very serious and prolonged failures… accurate and complete transaction reporting helps underwrite market integrity and supervise firms and markets’. There is a focus on financial crime across the globe (perhaps in name mostly, but there is a focus) and this news must be attached to the continuing developments in Malaysia where Goldman is being sued over its role in the 1MDB scandal. However, perhaps it is too much of a reach to combine these issues and suggest that the banks do not take tackling financial crime seriously enough. Maybe. Yet, one angle that must be rejected is the notion put forward by Goldman that ‘we are pleased to have resolved this legacy matter’ – this is not a legacy matter. Furthermore, it would be preferable to remove this term and concept from the wider conversation because it is particularly unhelpful. Failings from 2007 to 2017 do not constitute legacy issues, and the composition of these large organisations and, crucially, their behaviour, show that very little has changed. The protection afforded by attempting to designate something as being part of the past ought to be removed if real and affectual change is to take place in the culture of financial services across the globe.


Keywords – Goldman Sachs, FCA, Compliance, MiFID, Europe, Financial Regulation, @finregmatters

Monday, 11 March 2019

The End of the Line for the Financial Reporting Council

In this very short post we will react to the news that broke today regarding the future of the Financial Reporting Council. We have covered the FRC on a number of occasions here in Financial Regulation Matters and the posts have been highly critical of what was a feeble regulator. We had only looked previously at the regulator and the fact that it was under review, but today the final decision was made on the future of the FRC.

Founded in 1990, the Financial Reporting Council was today confirmed by the Government as being no more. In its official press release, the Government stated that, after considering the Kingsman Review, the FRC would be replaced with a new regulator. That regulator will be called the Audit, Reporting and Governance Authority. The business media are reporting that the new regulator ‘will have stronger statutory powers, including the ability to make direct changes to accounts and powers to require rapid explanations from companies and publish reports about their conduct in the event of a corporate failure’. Sir John Kingsman, the author of the report that has underpinned this shakeup of the regulatory arena, probably set the process in motion when he labelled the regulator a ‘ramshackle house’ when the official report was published. In establishing the new regulator, the Government has been noted as stating that it was ‘strong’ leadership that will ‘change the culture’ within the accounting sector. However, it is worth noting that altering the culture in this particular field will be no easy task and, in truth, it is difficult to see how a different regulator will achieve this. The first indication of whether there is change on the horizon or whether it is business as usual will likely be the new regulator’s take on the Big Four’s claim that they will separate the consultancy arms from the audit arms themselves – if this is allowed, on the auditor’s terms, then it is business as usual. Another question is whether the audit industry can indeed undergo any major change in respect to the tumultuous period awaiting the UK once the country leaves the European Union – do the Government really have the capital to take on such a corporate behemoth?

Ultimately, the FRC pushed its luck. Clear conflicts of interest and token gestures to eradicate such conflicts were a step too far in the wake of Carillion and BHS – now the regulator has to stop accepting all of its dinner invitations from those it was supposed to protect the public from.


Keywords – FRC, Audit, Regulators, Financial Regulation, Business, UK, @finregmatters

Monday, 4 March 2019

Technology Companies and Competition: Are There Lessons to be Learned from Banking?

In this post, we will examine the calls made today by a US Senator in relation to the leading technology companies. We covered the issue of oligopolies and market dominance in a recent post, and the issues are the same within the technology sector. However, a legislative approach that was taken in the 1930s is being cited as a good approach to take now, which is line with the common mantra in the modern day where everything was better and more effectual ‘in the past’. In this post we will take a step back to examine whether that past approach really was effectual, and discuss whether it really is applicable to the modern marketplace.

David Cicilline, a Democratic Head of the House antitrust subcommittee in the US, said today that imposing a system akin to the Glass-Steagall Act upon the technology industry would potentially serve to restrain the size of the largest technology companies and bring them in line with a more consumer-based purpose. Speaking to the Financial Times, Cicilline said that ‘one of the things that we did in the financial services space is Glass-Steagall, where you separate out functions… it’s an interesting idea whether there would be a way to think about separating what platforms do versus people who are selling products and information – a Glass-Steagall for the international [technology companies]’. The call essentially relates to the proposed separation of social media companies from the elements within them that sell customer data. There is a growing sentiment within the media that companies such as Facebook, Google, Apple, and a few others are growing far too large and, with the development of a new task force within the Federal Trade Commission, there are now developments in place to actively constrain the growth of these all-enveloping tech giants. However, Cicilline, who is regarded as a leading authority on tech-regulation within the legislative/regulatory arena (in terms of his political authority), concludes his interview with a review of the Glass-Steagall Act: ‘what we did in the financial services sector, that seemed to work pretty well for a long time… we then repealed it and had a big problem’. The question is whether this nostalgic view of the legislation is an accurate representation of the application of it.

The Glass-Steagall Act, otherwise known as the Banking Act of 1933 (the ‘Glass-Steagall Act’ actually refers to four specific provisions within the Act), was a piece of legislation enacted in 1933 to combat the size and development of what is often referred to as ‘universal banking’. The Act sought to separate commercial and investment banking arms, and thus prevented the investment banking arms from taking deposits, and the commercial banking arms from dealing in non-governmental securities (including underwriting such securities) amongst other aspects. The literature is awash with a number of reasons for the enactment of the Act, and also differing explanations of the process of the Act coming to be. The ‘official’ story, for want of a better term, suggests that on the back of a number of securities-related scandals in the 1910s and 1920s, there was a political movement to take regulatory and legislative action within the finance sector. One of the scandals was that of the so-called ‘Match King’ Ivar Kreuger (analysed in this brilliant book by Professor Frank Partnoy) which saw the Swedish businessman develop an array of exotic financial products (many of which went on to play a major part in the Financial Crisis) that enthralled and eventually entrapped Wall Street and the public. However, it is widely accepted that it was National City Bank (the ancestor to today’s Citibank) and its charismatic leader Charles E. Mitchell that lay at the heart of the reason for the Act’s enactment. Mitchell was quoted in the mid-1920s as stating that he wanted the bank to sell securities to the public ‘just as United Cigar Stores sold cigars’. The amount of securities on offer to the public duly increased, with it being noted that between 1922 and 1931, securities departments within federally recognised banks went from 62 to 123, and separate securities affiliates increased from 10 to 114. The effect was an inevitable one, with massive losses incurred by those who had invested in the securities despite not knowing the true strength of them – although they were supported and validated by third-parties (a familiar story). So, in light of this, an investigation was set up and led by Ferdinand Pecora – what would come to be known as the ‘Pecora Hearings’ – and the Committee found, after investigation, that a separation of commercial and investment banking would serve to offer protection to the wider system (amongst other things). Bankers were blamed for selling ‘unsound and speculative securities’, commercial banks were accused of converting bad loans into security issues, and security affiliates conducted pool operations with the stocks of parent banks; all of this was the evidence needed to push ahead with the enactment of the legislation.

However, the vast majority of research into this process since has found that there was no such evidence. Kroszner and Rajan suggest that, when one considers the delinquency rate from the period, Universal banks were much stronger as a result of the combination and did not present an excessive risk. In addition, the quality of the bonds that the large banks offered defaulted less frequently than purely investment bank-developed bonds did, according to Puri. One of the major proponents of this view is George J. Benston, and more specifically in his 1990 book The Separation of Commercial and Investment Banking. Benston suggests that as the data from the time does not point towards a flaw in the Universal Banking model, ‘financial stability is more likely under universal banking than specially banking, principally because universal banks are more diversified…’ Benston goes on to make a number of other points regarding the superiority of universal banking as a model, one being that as long as antitrust laws do their job there will be no cartelisation as a result of universal banking, although some of these suggestions are hard to swallow. We will return to that in a moment, but this concept of cartelisation is important. Benston notes that the enactment of the Glass-Steagall Act actually precipitated cartelisation, in that the commercial banks were aided in removing unprofitable securities arms, and then their competition for customers’ deposits was immediately eliminated by the Act. This is interesting, and is potentially supported by the fact that after just two years, Senator Glass recognised that the law ‘was an overreaction to an extreme situation’. Yet, we must take great care with this viewpoint. It is offered by those on the economic right, and comes from a school that was instrumental in deregulating the sector prior to the Financial Crisis (proponents such as Professor Charles Calomiris will argue that Universal Banking was not at fault for the Financial Crisis, with his and many of his supporters arguing that federally-backed mortgage institutions Fannie Mae and Freddie Mac were actually at fault).

Another viewpoint into the reasoning behind the Glass-Steagall Act is in relation to the ‘House of Morgan’. The banking empire established by the legendary J.P. Morgan forms one half of an epic battle that saw the US legislative arena caught in the middle. According to Rothbard, Morgan and the Rockefeller Family, led by John D., would grow within their respective fields but the families would come to blows as the competition heated up within the all-important banking sector. Rothbard suggests that the Rockefellers sought to lobby and secure the loyalty of certain politicians in order to dismantle the House of Morgan once and for all and, with the Morgan’s decision to opt for commercial banking rather than its stalwart investment banking arm, Rothbard suggests that aim was finally achieved. The entire story, which revolves around the development of the Federal Reserve and the sheer dominance of the Morgan empire, is worth studying but it all leads us back to the Glass-Steagall Act. It is apparent, for whatever reason, that the Act was a coerced movement based upon political and environment-altering manoeuvrings. If we accept that to be true, then it calls into question the legislative process of the time and, one may reasonably argue, the legislative process in general. It also casts a shadow on the reverence paid to the Act by Cicilline. It will be best left for another post, but the deregulation of the Act and its provisions in the 1990s is not so straightforward either (we should not be surprised), so the reality is that it is extremely dangerous to use something which has not been analysed properly as the basis for a future legislative or regulatory agenda.

The Glass-Steagall Act did, on the face of it at least, work. However, there are so many elements to consider a. in its construction and b. in its effect, that it becomes very difficult to say whether it can be heralded in the way that Cicilline speaks of the Act. For the technology industry, and the social importance of its leaders, it is vital that some control is exerted over their operations. In that sense, Cicilline is absolutely right. However, the arguable effect of the Glass-Steagall was to cartelise the banking industry which, if we connect history lineally, is a direct cause of the concentrated banking arena we witness today in the US (and this then has a global effect). There needs to be impartial studies undertaken on the potential effect of separation within the technology industry because the penalty for not doing so, if we use the banking industry as the example, would be massive for society. A technology industry that is more cartelised than it is now is not beneficial for society at all – the legislative body must take great care in this particular arena, and now is not the time for romanticising the past.


Keywords – Technology, Legislation, Banking, Finance, U.S., @finregmatters

Sunday, 17 February 2019

Understanding the Oligopoly Concept

On a number of occasions here in Financial Regulation Matters we have discussed the credit rating and audit industries. They have taken up a number of posts on account of their negative and impactful behaviour, and in most of the posts we attempt to conclude as to why they a. act in such a manner, b. are allowed to continue acting in such a manner, and c. what may be done to alter that behaviour. Often, we conclude by discussing the oligopolistic features of their industry and implying that those dynamics are the fundamental answer to all three aspects. However, the word oligopoly is sometimes defined within the posts, but often it is not elaborated what the concept is and why it is so impactful within these financial industries that are so crucial. In this post we will dissect the concept of an oligopoly and examine why the two identified industries are absolutely defined by the concept.

The term oligopoly roughly derives from the Greek words oligoi – meaning ‘few’ – and polein – meaning ‘to sell’ – with the essential meaning of a few sellers being helpful. The term itself will usually link one’s thinking to the concept of a Monopoly, meaning one seller, and then a duopoly, meaning two sellers. The actual coining of the term stems from the esteemed French mathematician Augustin Cournot who, in 1838, wrote Researches into the Mathematical Principles of the Theory of Wealth. Friedman discusses how within this noted work, Cournot introduced the theory of an oligopoly, but that ‘its most astounding characteristic is its complete originality. Usually, such a field of study develops through a series of stages, one shading into another, at the hands of a succession of writers’. Friedman notes that, before Cournot, there was no development of the theory. Before this development, Friedman notes how the word ‘monopoly’ was used to describe all variants – monopoly, oligopoly, and duopoly. The theory established by Cournot is particularly technical and is described in detail here. In order to simplify the concept, it is useful to think of the issue of having a number of sellers within a specific marketplace as being constrained by two ‘end-points’: collusion and an oligopoly. For example, in the marketplace the sellers could collude with each other to determine the price of the product(s) sold within that marketplace. However, as collusion is illegal in most economies, the result would be not only the potential of criminal investigation, but also the lack of a bind between the sellers based upon the illegal status of the agreement. So, in opposition to this, it has been noted that in an oligopoly the sellers will adjust their output ‘independently of the other firm’s output to maximise its profit’. Admittedly, the economic theory does become complicated and operates firmly within the comfort zone of Economists, but the essential sentiment is that the companies within the oligopoly have the ability, on account of them all essentially selling the same product, to analyse the strategy of their counterparts and develop their own strategies accordingly – the element binding them all together is the aim to maximise their profits. In that same sense then, undercutting your oligopolistic partner would not serve to maximise your profits, which preserves the status of the oligopoly itself.

However, there are other factors which affect an oligopoly and deviating from Economics for a moment will help us illustrate this better. If we use the financial services sector as a lens, then the audit and credit rating industry provide perfect examples of both oligopolies, but also what variables preserve that oligopolistic structure. In the excellent Corporate Power, Oligopolies, and the Crisis of the State, Professor Luis Suarez-Villa discusses what he labels ‘corporatocracy’ – ‘the overwhelming power of corporate interests over governance and society’ – and that oligopolies are absolutely crucial to the development of that power dynamic. In relation to this dynamic, he states that ‘corporatocracy is as important to oligopolies as water is to marine life – one cannot exist without the other’. Suarez-Villa is not hesitant when it comes to affirming his views on the power dynamic, and his view on the role of the oligopolistic vehicle is never as clear as when he states that in those ‘markets that neoliberal ideologues have fervently advocated for are mostly dominated by corporate oligopolies. Oligopolies that wield immense power over most everything we do, in most sectors of the economy, and that influence most every aspect of public governance’. So, for Suarez-Villa, the influence of corporate oligopolies is abundantly clear if one cares to look. At first glance, the viewpoint expressed above seems almost conspiratorial, belonging within the realm of ‘conspiracy theory’. However, not only is the Professor’s work meticulously researched – as we would expect – but there are examples all around us. Just two examples are the credit rating and audit industries.

Starting with the credit rating industry, this author discusses in meticulous detail the development of the industry from its non-commercial beginnings (with the Baring Brothers banking empire’s move into the antebellum [pre-war] United States), to the commercialised beginnings with the social reformers Lewis Tappan in the 1840s (via a failed venture in the 1830s). After enjoying a monopolistic situation in the first few years, Tappan would be joined in the marketplace by John Bradstreet, and his entrance was predicated upon methodological advances that served to quantify the process of credit rating. Henry Poor would develop his company based upon extensive knowledge and research of the rail roads, and John Moody would develop his company on the basis of a clearly defined Manual in the early 1900s. Once the split between credit reporting and credit rating – the former being concerned with a qualitative analysis of debt, and the latter concerned with presenting alphanumerical ratings – occurred at the turn of the turn of the 20th century, very little has changed. The merging of Standard Statistics with Poor’s company in the early 1940s gave birth to the modern-day Standard & Poor’s, and alongside Moody’s the duopoly was developed and has maintained ever since. The development of Fitch Ratings from 1914 has done little to dent the dominance of the Big Two, but is substantial enough to declare the modern industry as representing a pure oligopoly – the Big Three control more than 90% of the market between them. There are two elements which allow the oligopoly to continue irrespective of external pressure, and those elements are also witnessed in the auditing industry. The first is that all of the rating agencies, essentially, sell the same product. There are slight differences in the underlying methodologies behind the credit ratings, but essentially it is exactly the same offering (particularly with the Big Two). This serves limit competition because there is little use on 15 companies all doing the same thing. This leads us to the second and by far the most important issue, and that is the purpose and usage of the products being sold. It is often found within corporate oligopolies that it is the consumer that maintains the oligopoly, not regulation or legislation which is often criticised as protecting the oligopoly. For instance, the modern economy is defined by dispersed investors – say, institutional investors like a pension provider – and those investors have a number of competing pressures affecting them at any one time. Their managers must take certain investment decisions, but their principals, the pension holder, will want to a. know what the manager is doing and how they are performing, and b. constrain that management if there is a need to. Now, the pension holder would find it massively inefficient to review every financial decision the management take in detail, and if that were the process it would be so laden with inefficiency it would make the act of investing counter-productive in terms of profiteering. So, it is in this gap – what is called ‘informational asymmetry’ – that the credit rating agencies exist. They provide easy-to-understand and easy-to-assimilate information on what are often extraordinarily complex financial actions. That asymmetry is resolved, theoretically, by the rating agencies. If we return to the dynamic mentioned above then, the consumer of the ratings would therefore be disadvantaged if there were 10 leading rating agencies, because which one is best to follow? Which one is most accurate? Which one can be trusted? With Moody’s and S&P demonstrating reputations spanning more than a century, that reputation breeds trust. Yet, this is all very theoretical and we shall see shortly why.

The audit industry is remarkably similar to the credit rating industry. It is led by the ‘Big Four’ – PricewaterhouseCoopers, Deloitte, Ernst & Young, and KPMG, and their histories go back longer still. However, whilst the rating agencies’ function is central to the capital markets and their development, auditors are arguably central to the economy as a whole. In any interaction within the business sphere, trust is a central component. Even with reputation, how can one really trust in another? What happens if a traditionally trustworthy entity suddenly changes course? It is within this truly-foundational asymmetry that auditors sit. The modern day auditors fulfil a number of crucial roles within the marketplace, but acting as the primary ‘check-and-balance’ within business and within a host of transactions makes the existence of auditors crucial. So, even more so with auditors, what would the effect be of increased competition? The auditors are constantly facing ‘competition probes’ and suggestions that competition needs to be increased, but the reality is ‘increased competition in audit markets impact audit quality negatively’ – calling for increased competition within a perfect oligopoly displays a fundamental misunderstanding of an oligopoly. The consumers of audit ‘products’ would be fundamentally disadvantaged by an increase in competition, as the ability to trust in the auditor’s decisions would be compromised, thus making the whole process inefficient. We can see here that these two examples demonstrate the core constituents of oligopolistic characteristics – a market that competes on price but one which contains actors which can easily match their strategies to their competition’s based upon the selling of the same product, and a consumer base that would be actively disadvantaged by an increase in competition, thus preserving the oligopoly and preserving the cycle.

Any regular reader of the blog will know that this story cannot finish here. We have covered almost every negative action taken by the credit rating agencies since before the Financial Crisis, and we are kept abreast of negative developments within the audit industry. We will not go back over them here, but what can be easily seen just by keeping up to date with the business media is that these two industries consistently transgress (misbehave), even despite record penalties and massive regulatory action. We see the rating agencies receive over $2 billion in fines between Moody’s and S&P, a record figure, and then continue to transgress via methodological failings that favour the issuer over the investor. As for auditors, their misbehaving has shown absolutely no restraint, with almost every member of the Big Four taking up column inches in the business media on an almost daily basis (this is no exaggeration). A statement from Suarez-Villa seems absolutely relevant here and can, in terms of providing a juxtaposition, give us the answer why these industries continue to misbehave. Very early in the book Suarez-Villa declares that ‘the relations of power that oligopolies represent are largely ignored by the public today – lost in an avalanche of reports that are largely pro-corporate, and that view corporate interests as beneficial to most everyone’. So, according to this viewpoint, the public are not aware of the power of the oligopoly. However, and much more importantly, the oligopolists are aware of their position and subsequent power, and that is the primary reason why we see repeated transgressive behaviour. It does, admittedly, sound like a severe over-simplification, but the reality is that these industries transgress merely because they can, and it is extraordinarily lucrative to do so. Yes there are a number of criminological, philosophical, biological, anthropological, and many other perspectives that we could apply to why actors within these industries transgress, but what is for sure is that the oligopolistic vehicle is what fundamentally allows them to do so.

Credit rating agencies are beginning to fall away from public view a decade on since the Financial Crisis, mainly because their transgressions are now ‘limited’ in their scope. For auditors, the situation is very much different and they beginning to experience scrutiny like they did at the turn of the 21st century with their conduct surrounding Enron. This is leading auditors to defend their oligopolistic position, with some putting in measures like the clear separation of auditing and consulting service provision, and some even claiming that the perceptive role of auditors is wrong and should be altered. Yet, the reality is, there is no cure. There is an abundance of reform proposals, and an abundance of commentary that supplements criticism with calls for disbandment of the industries etc. However, this does not take into account the reality of the oligopoly and it is suggested here that any reform proposal that does not take that fully into account is bound to fail. Criticism and critical reform proposals are to be encouraged, but it is vital they are directed to the most realistic and therefore potentially most efficient route to altering the transgressive nature of these industries – and that route is by fundamentally considering the dynamics of oligopolies and then taking the appropriate action.


Keywords – business, audit, accounting, credit rating, regulation, oligopolies, @finregmatters

Saturday, 2 February 2019

Auditors and the ‘Expectation Gap’


We have only looked fleetingly at the story of Grant Thornton – The British-founded ‘professional services’ company that is now regarded as one of the largest firms outside of the traditional ‘Big Four’ audit firms – and its connection to Patisserie Valarie. As the chain sits currently in administration and is ‘set to be sold off piecemeal’, the role of Grant Thornton in auditing the chain just before it collapsed has brought the auditor firmly into the spotlight. Grant Thornton’s CEO is currently facing questions from MPs and, as part of his response, he has told the House of Commons Committee that there was an ‘expectation gap’ between what is expected of audit firms and what they do in practice. In this post, we will review the story and analyse the developments, but focus more on this concept of an ‘expectation gap’ existing in relation to the auditing industry, which is particularly centralised within the financialised society we live in.

Patisserie Valerie entered into administration last week, with the chain saying that 70 of its stores would immediately close. The Financial Times is reporting that, due to its ‘unreliable accounts’, even businesspeople who specialise in purchasing collapsed companies are avoiding the wholesale purchase and are instead looking to purchase only ‘chunks’ of the failed business. KPMG, the auditor undertaking administration responsibilities has provided very limited information so far and it has been suggested that the chain’s financial figures, dating back almost six years, may not be reliable; the newspaper continues by including a quote from an unnamed source that states: ‘it’s been a very long time since I’ve seen a fraud like that. I couldn’t bid on it’. As a result, there are a number of investigations currently underway. The FRC are investigating the associated auditors under the ‘Audit Enforcement Procedure’, the SFO has opened an investigation into an unnamed individual, although it is also conducting a wider investigation into the collapsed chain. However, it is currently David Dunckley who is facing the questions. Dunckley stated that ‘we are not doing what the market thinks. We are not looking for fraud and we are not looking at the future and we are not giving a statement that the accounts are correct. We are saying they are reasonable, we are looking at the past, and we are not set up to look for fraud’. MPs responded angrily, with Peter Kyle MP responding ‘if an audit is not picking up on [fraudulent] behaviour, what is the point of audit in the first place?’. It is worth mentioning that representatives of other firms did not agree with Dunckley’s assessment, with BDO saying ‘you look for material frauds’ and Mazars saying ‘what the public expect is to be able to rely on a set of accounts’. A rival auditor was quoted by The Financial Times attacking Dunckley’s testimony, stating that ‘our worry is that he has damaged the audit profession as a whole’. The question is, is the public perception of the audit industry inherently damaged anyway?

The same article discusses how the audit industry, or at least three of its biggest players (PwC, EY, and KPMG) would be ceasing providing ‘consulting services’ to FTSE 350 audit clients by the end of 2020. We have discussed this issue of ‘consulting services’ before, primarily in relation to the conflict-of-interest issue that similarly occurs within the credit rating industry when they provide ‘ancillary services’ for those who they rate (the sole focus of the author’s first book), but it is worth asking whether this is enough to rebuild the public’s trust in this particular sector. Though there are clear historical cases of auditors’ failures, including Enron and WorldCom, the auditors will be quick to label these as ‘legacy issues’. However, if we focus more recently, we can see that the auditors, and this spread between them and not just one particular auditor, have consistently failed in their remit. Recently there has been a number of scandals involving auditing failures, including: Patisserie Valerie; Carillion; Conviviality; Rolls-Royce; BT; Mitie Group; BHS; Sports Direct; Ted Baker; and Quindell. It is bordering on the remarkable that there is even a question over the competency of these massive global firms; it is clear there is something inherently wrong with the operations of these companies.

It is difficult to pinpoint where that problem lies however, and that is assuming there is just one problem. Reviews of the associated regulators have found that, in the case of the FRC, the regulator is ‘built on weak foundations’, whilst it has been suggested by a number of observers (chief amongst which is Professor Prem Sikka) that the auditing and consulting arms of the auditors should be fundamentally split. In this author’s first book cited above, there was a discussion on the auditing industry and that fed into the calls to enforce the splitting of these two arms within the credit rating industry, and make the splitting of the arms irreversible. This suggestion was based on the fact that, after the Enron and WorldCom scandals, the US-led Sarbanes Oxley-era provided an environment where, essentially, the largest auditing firms were pushed to divest from their consultancy arms. Although the credit rating agencies (S&P in particular) went on to acquire a number of components from this divestment, there was a fundamental issue in that the Sarbanes Oxley-led divestment was done with the sentiment of encouragement, rather than enforcement. The auditors did divest, but they did so on their terms, with short periods being declared as to when they would not conduct consultancy services from that point. Inevitably, in the run-up to the Crisis, the auditors had rebuilt these consultancy arms that were directly identified as being crucial to the Enron-era degeneration in standards, and since the Crisis these consultancy arms have continued to grow. Now, with PwC, EY, and KPMG telling regulators that they will divest, it appears the same thing will happen again; the auditors will respond to public demand, but wait for the news cycles to oscillate away from the industry and then rebuild. This tremendously cyclical arrangement is continuing unabated, and many seem happy for this to be the case because it resolves an issue now, and not fundamentally.

Another aspect is that the so-called ‘Big Four’ are an oligopoly, and that is a vital understanding. The theory of the marketplace is that the firms will compete on quality and price, and what will result is an efficient sector that is affordable to the customer. However, in an oligopolistic marketplace, those elements do not exist. When one firm takes a certain action, the other members of the oligopoly will usually, and it is argued here that they must, take the very same action – this is represented clearly with the firms stating that they will stop providing consultancy services to FTSE 350 companies who they provide audit services to as well (KPMG started this sentiment and the others followed). So, if we accept this oligopoly-based theory is the truth, and it surely is, then the options available to regulators are extraordinarily limited. They cannot seek to encourage competition to disturb the hegemony within the oligopoly because an oligopoly is defined by a lack of competition. Also, increasing competition has the potential of perceptively reducing quality within the sector, and even though it may sound paradoxical, many customers would not want a potential reduction in quality even though the sector is clearly fraught with inefficiency – customers know what they are getting with the Big Four and, crucially, the validation received from the Big Four still carries value with external elements, such as investors. Whilst the value exists, the oligopoly will also exist, as is the theory of oligopolies (a great book on Oligopolies can be found here by Luis Suarez-Villa). With that in mind, the current situation is unlikely to change. What will probably happen, and it is strongly suggested here that the following is almost guaranteed to happen, is that the auditors will respond to external pressure in a manner that placates that external pressure, after which they will perform, for a while, in a manner that removes scrutiny from the sector. Once that scrutiny passes and moves onto another sector, the audit sector will re-develop the very same practices and the cycle will simply continue. If one is uncertain about the direction of a certain sector, it is usually wise to look backwards. The cyclicity within the marketplace is abundantly clear to see, if one cares to examine it within that set of parameters. If one is looking for a political victory, in the here and now, then it will be easy to overlook such a trend. It will be worth noting the current stage where it has been identified that the mix of auditing and consulting arms are one of the fundamental keys to auditor failings, and see how long the industry-led impediments on that combination actually last; it will likely be not very long at all.


Keywords – audit, regulators, business, patisserie Valerie, law, economics, @finregmatters