What have we learned from the collapse of Lehman Brothers Holdings?
The report issued by a bankruptcy court examiner into the collapse of Lehman Brothers was released last week, sending shock waves through the business world. Aide from many details about high-risk business deals undertaken by the company, what has been most revealing to me is the blame laid on Ernst & Young, Lehman’s outside auditors. One would think that post-Enron, where the once venerable Arthur Anderson was extinguished in the blink of an eye, the remaining Big Four would be a bit more rigorous about their audit engagements. Apparently not.
What came out of the Enron disaster was the Sarbanes Oxley Act (SOX), which among other things imposed increased responsibilities on companies and their auditors to conduct and verify their internal controls. In addition, Congress and the SEC severely limited outside accountants from engaging in non-audit work with the firms they were auditing.
Say hello to the “rule of unintended consequences.”
An interesting thing happened in 2001. That was the year that auditors were prohibited from doing other consulting work for their corporate audit clients. In the case of Lehman Brothers and Ernst & Young, that event seemed to have just the opposite effect in that the auditor’s fees skyrocketed. From 1999 to 2007, the last year auditor fee data was reported to Lehman’s shareholders, Ernst & Young’s fees increased 7 fold from $5.3 million to more than $31 million. While some of the increased revenues can be attributed to the additional work created by Sarbanes Oxley compliance, it remains interesting from a shareholder perspective that the numbers accelerated in such rapid fashion.
The following chart reveals the dramatic climb in E&Y’s fees for the 9-year period. It suggests that, in terms of fees collected from it’s client, the risk of “not biting the hand that feeds you” increased dramatically.
What we see is that, in the case of Lehman Brothers and Ernst & Young, the auditor was able to recoup their non-audit fees in spades. While the apparent conflict of interest that was eliminated by SOX was eliminated, the motivation to rigorously assess the financial dealings of Lehman Brothers may have taken a back seat to the revenues generated from the long-term engagement with Lehman Brothers.
I have no doubt that Ernst & Young officials would rigorously argue that no such conflicts existed. However, when “credible evidence” suggests that “accounting gimmicks” were not uncovered by Ernst & Young to shareholders, investors can only wonder.
So what have we learned here?
Despite SOX reforms, there are still risks to investors from shoddy audit oversight. Auditors are still subject to enormous pressure from unscrupulous clients who try to hide risk from their investors. Long-term engagements by companies of their outside auditors pose real risk to investors.
