Is Andersen’s Number Up?

Arthur Andersen LLP is fighting for its life – and so far the battle is going badly. The Big Five professional services firm is working around the clock to strike a deal with the U.S. Justice Department before Thursday to resolve possible criminal charges. (These relate to the destruction of documents concerning Enron, its energy trader client that went bankrupt last year.) Simultanously, it is trying to reach a settlement with the Securities and Exchange Commission over accounting irregularities. Andersen is also negotiating a sale of some or all of its operations to KPMG, Deloitte Touche Tohmatsu or another rival. And if that isn’t enough, the firm is trying to staunch a stream of client defections; those who have already left include Merck and Federal Express, among dozens of others. All in all, March has been a terrible month for the accounting giant – and it isn’t over yet. Events are moving forward every hour.

When the dust finally settles, will Andersen avoid collapse? Experts at Wharton and elsewhere say the chances of Andersen’s survival – at least in its present form – are slim. The reason, they argue, goes beyond the legal and financial issues and strikes at the heart of an accountant’s responsibility to users of financial statements. Andersen, like other accounting firms that audit publicly held companies, is perceived as a public guardian. After its involvement with Enron – which went bankrupt after it became clear that the company’s profits were illusory and some Andersen executives played a role in concealing Enron’s true financial condition from the public – Andersen’s reputation may be tarnished beyond repair. And when an accounting/auditing firm loses its reputation, it loses everything.

Andersen’s top priority now is to reach a settlement with the U.S. Department of Justice. According to the Washington Post, federal prosecutors have told Andersen that they plan to levy obstruction of justice charges against the firm for failing to prevent document shredding after company officials learned that Enron’s accounting procedures were the subject of lawsuits and a federal inquiry. The Post also reports that prosecutors have set a March 14 deadline for Andersen to agree to enter a guilty plea, although Justice Department officials are continuing to meet with Andersen lawyers arguing against criminal charges.

Simultaneously, newspaper reports point out that Andersen has approached all the other Big Five firms about a possible merger or sale, but is holding serious merger discussions with just two: KPMG and Deloitte Touche Tohmatsu. On Wednesday, the Financial Times of London reported that KPMG, the world’s third largest audit firm, with revenues of $11.7 billion, has emerged as a possible buyer for Andersen. If KPMG takes over Andersen (revenues: $9.3 billion), the combined entity would become the world’s second largest professional services firm with some $20 billion in annual revenues. (The largest is PricewaterhouseCoopers, which has revenues of $22.3 billion.) Ernst & Young, which was also in the running as a possible buyer, said on Wednesday that it would not pursue a merger with Andersen as long as it faces litigation over Enron.

Before an acquistion deal can go through, though, the buyer will need reassurance that the benefits outweigh the possible liabilities. In that respect, at least some of the facts are not in dispute, as evidenced by a mea culpa recently issued by Andersen Managing Partner and CEO Joseph F. Berardino. He admitted that “people in our firm made serious errors in judgment in destroying documents. What was done was not in keeping with the values and heritage of this firm. It was wrong. There’s no other word for it.”

But in a case like this, with so much at stake, an acknowledgement of responsibility may not be enough and yet may also be too much, according to Wharton accounting professor Robert W. Holthausen. “It’s a difficult balancing act, especially for a company that’s always been known as a high-quality firm,” he says. “If errors have been made, it may be in the best interests of a company’s reputation to come clean and admit them. But at the same time, such admissions may become ammunition for lawsuits.”

That should be a concern for Andersen, which reportedly offered $750 million to resolve all the claims related to the Enron audits. According to the Wall Street Journal, that offer was rejected as “insufficient” by attorneys assigned to lead the shareholder litigation against the CPA firm. The likelihood of tremendous legal and financial liabilities could also delay or block any merger between Andersen and another firm. In addition, the direct dollar damage from Enron-related suits could cripple or even bankrupt Andersen, despite its estimated resources of $1 billion from the sale of its consulting arm, another $250 million of insurance coverage from a captive insurance company, and $160 million of additional insurance coverage the company is believed to have procured from a third-party insurance firm.

While sorting out these issues in court may take years, Andersen is already beginning to feel the pain as clients leave in droves. Since Enron’s collapse, the accounting firm has lost such high-profile clients as Federal Express, Delta Air Lines, Freddie Mac, SunTrust Banks Inc. and Merck & Co. At least 25 firms have abandoned the company in recent weeks, according to Auditor+Trak, an Atlanta-based information service that tracks movements in businesses’ use of auditors. The Wall Street Journal on March 13 put the number at 34.

“This is the time of year when decisions (about audit engagements) are made,” notes Wharton accounting professor David Larcker. “What happened with Enron could have conceivably happened with any of the Big Five, but Andersen was the one that got caught with it. Now some high-profile companies like Merck are nervous about having Andersen’s name appear on their financial statements.” 

Considering that each of the Big Five firms has had a share of regulatory and shareholder lawsuits, some people might conclude that Andersen’s black eye could trigger a larger client stampede, away from all the Big Five and into the arms of the so-called international second-tier, like BDO Seidman. But Holthausen, for one, discounts that possibility.

If that is true, the Big Four firm that buys Andersen could still end up with many of its remaining clients. The acquistion, however, could face two key issues. First, as is usually the case when any two large organizations in an industry merge, regulators are likely to scrutinize the anti-trust aspects closely. And second, notes Robert E. Mittelstaedt, Jr., vice dean of executive education at Wharton, the acquirer will need to take into account the fact that Andersen is organized as a partnership rather than as a corporation. “This is significant, because it means the partners could be personally liable in some form or another even if Andersen is acquired by another firm. That could be a huge distraction and also a financial problem in the future,” he says.

Bankruptcy offers one possible solution to the first problem. According to Holthausen, if Andersen declares bankruptcy, this might make it simpler for one of the other Big Four to acquire its business. “Generally, anti-trust concerns are waived in the event of a bankruptcy,” he explains. “So if Andersen declares bankruptcy, this might pre-empt any regulatory concern about anti-competitive mergers.”

As for the second factor, an answer may lie in the fate of Laventhol & Horwath, an international second-tier firm — known at one time as the seventh-largest firm, right behind the then-Big Six — which declared bankruptcy in November 1990 under a crush of lawsuits that totaled $1 billion by some accounts. “Laventhol was organized as a general partnership, which meant that each partner was responsible for the firm’s debts,” says a former Laventhol partner, who requests anonymity and is now a partner in a regional CPA firm. “Under our court settlement, each partner had to contribute about $100,000 and we were then free to try to continue doing business with our former clients.”