June 20, 2005

Egads! The Big Three?

Lots of news about KPMG pleading for its life due to the tax shelters it sold in the 1990s and its subsequent alleged obstruction of justice activities (see these court opinions that illustrate how aggressive KPMG was in the lawsuits filed against them over the tax shelters, much to the judiciary’s chagrin, and last week’s apology from KPMG for this aggressive posture). In my mind, it’s pretty clear that the corporate world cannot live with only three major audit firms, as the independence rules often forces companies to hire at least two – if not three – of the Big 4 to perform the various audit and non-audit services they need.

In this blog, a venture capitalist notes how he testified last Friday before the SEC’s Small Business Advisory Committee that “the formation of a fifth or sixth major national auditing firm would provide small companies with a better alternative that what exists today while helping to restore the balance of negotiation between auditing firms and their clients.”

Of course, creating additional national audit firms is no easy feat. To see how far the auditing profession would have to change to create them, read this recent article that indicates that the 5th largest firm presently has no Fortune 500 clients – and only two of the Fortune 500 companies use an auditor other than the Big 4.

The problem with relying on smaller audit firms to conduct public company audits is reflected in a recent Glass Lewis study. The June 2nd study reveals that smaller audit firms have an error rate of about three times that of the larger audit firms – and small public companies have a much higher restatement rate than that of large companies. Overall, the restatement (i.e. error) rate in financial statements audited by smaller audit firms is high – and thus commands a higher price for capital. So I believe we are just plain stuck with the Big 4 for the time being.

So the question remains: how does the market (or regulators) ensure that these “too big to fail” entities don’t cross the criminal line? One thought is for audit firms to have a board of directors, with independent directors to oversee management and ensure that the appropriate culture and behavior is instilled. The use of an oversight body should help protect audit firms from these “death penalty” type of situations – and ultimately protect investors as well as clients.

Probably a crazy notion if you thought of this governance framework in the law firm context. But one crucial difference between a law firm and an audit firm: a lawyer’s role is to serve as an advocate for clients; an auditor’s role is more about getting clients to conform with applicable regulations. Let me know your reactions to this dilemma.

Fred Cook Speaks from Stanford Directors’ College

Hopefully, each of you will be able to watch to Fred Cook’s groundbreaking video webcast tomorrow on “Fred Cook Speaks to Directors.” Fred’s speech should have a major impact and keep our momentum going in the area of responsible compensation – and we urge that all directors should view this video live or by archive.

I have seen a draft of Fred’s presentation (we call Fred the “Dean” of compensation consultants) – and you will not be disappointed as it contains some fresh thinking. Plus, this video event enables you to get a taste of what it is like to attend Stanford Directors’ College, which is quite pricey to attend live since it caters to directors.

Managing D&O Departures and Arrivals

We have posted the transcript from the webcast, “Managing D&O Departures and Arrivals.” This was one of my favorites, as I tend to like the governance stuff the most.

SEC Commissioner Goldschmid to Hang Around

Urged by Democratic Senators, who reportedly are scared what Commissioners Atkins and Glassman would do if he left without a replacement, Commissioner Goldschmid (a Democratic appointee) has agreed to stay at the SEC, at least through the end of the summer. Goldschmid’s tenure arrangements at Columbia University requires that he rejoin the faculty soon.

Some Senators are trying to get the Bush Administration to name a replacement for Goldschmid – as well as re-up Commissioner Campos, the other Democratic appointee whose term expires soon – as part of a package deal with Chris Cox’s Chair confirmation. No word yet as to what President Bush intends to do.