The Trusty Servant

I was going to say

quomodo ceciderunt robusti
How are the mighty fallen

But, I was thinking of KPMG, not James Crosby, forced to resign from the FSA this morning. I spent 5 years with KPMG long ago, when it was known as Peats, so whilst I tend to regard it with affection, I also remember the difficulties.

These thoughts were prompted by the rather tangled tale set out in Paul Moore’s detailed statement to the Treasury Select Committee. He qualified as a barrister and later became a partner in KPMG’s “Financial Sector Practice” in London. KPMG in Edinburgh were HBOS’ auditors. In 2002 HBOS recruited Paul Moore from KPMG as Head of Group Regulatory Risk. He became the FSA Approved Person for Control Functions 10 (Compliance Oversight) and 11 (Anti Money-Laundering).

He was sacked by James Crosby without compensation in November 2004, apparently for drawing the board’s attention to the risky nature of the group’s lending. Like many barristers he has a gift for clear exposition

there must have been a very high risk if you lend money to people who have no jobs, no provable income and no assets. If you lend that money to buy an asset which is worth the same or even less than the amount of the loan and secure that loan on the value of that asset purchased and, then, assume that the asset will always rise in value, you must be pretty close to delusional

Crosby’s choice as replacement was a woman who had primarily been a sales manager and had never carried out a role as a risk manager of any type before.

All this seems depressingly familiar. A sales type naturally prefers another dynamic upbeat sales type as watchdog rather than someone with “negative waves” (the tank repair guy in Kelly’s Heroes, a rather apposite movie in some ways).

The interesting part is that to cover himself Crosby got an “independent report”. It turns out that the independent report was by KPMG (para 2.20).

Horrible sinking feeling.

Conflicts of interest. The legal position is that auditors are appointed by the shareholders to whom they report. But, of course, this is a polite fiction. They are appointed by the CEO. Back in my day this gave rise to immense angst. The procedure was that after trivial issues had been got out of the way there would be a meeting between the audit manager and the finance director. If necessary, this got escalated to the audit partner and the CEO/chairman. The meeting negotiated changes thought necessary by the audit team to give “a true and fair view”.

Of course, the FD/CEO/Chairman knew that the accounts had to end up “unqualified”. But they could apply a lot of pressure to bend the audit team’s position. The implicit threat was that (1) there would be less non-audit work for the audit firm (sometimes worth substantially more in fee income than the audit work); and (2) that the audit firm might be changed. [These days (1) is somewhat less of an issue because of separation between the audit and consultancy arms. So HBOS' auditors were KPMG Audit Plc.]

The defence against this pressure was a welter of detailed professional standards and best practice models within the profession and the firm, the integrity of the individuals concerned, and the threat of litigation.

The threat of litigation could arise if the accounts were wrongly signed off and the company subsequently got into financial difficulties, because then aggrieved creditors/shareholders would probably sue the audit firm on the deep pocket principle. This threat was obviously only effective for really major issues.

Partners tended to divide into “social partners”, probably known these days as rainmakers following US jargon, and “technical partners”. But both kinds had a clear appreciation of the value of retaining happy clients. The result was that pressure also got directed downwards. If you raised an unwelcome issue with a “difficult” client then a manager would put pressure on you. Are we really sure about this? What about X?

Of course, this could be beneficial. Young audit staff were not always correct in their challenges. But it could be tricky when there were no obvious precedents. I remember having fairly tough arguments with my manager about foreign exchange profits, which back in 1977 were much less clearly understood than today, so that there was far less detailed professional guidance or expertise available within the accounting profession to help one’s understanding or strengthen one’s resolve.

Returning to Moore’s memo, we read in 3.13:

[The HBOS CFO] (along with others apparently) strongly reprimanded for raising issues relating to a “cultural indisposition to challenge within certain parts of the firm” when reporting to the Group Audit Committee. I said – “I would not want the Committee to be under any illusion as to how strong the tensions were as GRR carried out its oversight work and I have to say that there have been some behaviours which I would consider to be unacceptable.” The KPMG Audit Partner told someone who reported back to me that he thought I had a “death wish” following this meeting.

Not encouraging.

Then 3.21:

As I stated above in section 2 above, a supposedly “independent report” by HBOS’s auditors said HBOS were right but failed even to interview key witnesses.

Let us not jump to conclusions. Sacked employees are often less than accurate in their recollections. But I wonder when someone will get around to asking KPMG a few questions. The sooner the better really. Not long after I left, audit firms like KPMG started to get visits from their US firms’ General Counsels. The US leads the way in litigation, so a General Counsel is a key figure in a US audit firm. These guys started pointing out the importance of careful file review at the close of an audit.

Prior to that point the naive UK firms had thought fat files were better because they showed more diligence and hard work in checking. Not in a court. The snag was unanswered questions or anything that might be interpreted as giving rise to unanswered questions. Stray facts or statements which a lawyer could point to and say “Why did you not follow that up?”. What was needed were clear, unqualified statements, supported by detail of what was checked. Of course, it is hard to argue with that.

Equally files started to be rigorously reviewed. Have we a legal obligation to keep this? Hard to argue with that too.