Rise and fall of the management audit

Corporates owe their historical success to regulation, but this success is vulnerable to the ceaseless efforts to offset corporate liability.

by Christopher McKenna for World Business
Last Updated: 23 Jul 2013

When Marvin Bower, the management consultant who refounded McKinsey & Co in the late 1930s, was a student he wrote two articles that anticipated his subsequent career. In the first, Bower considered how businessmen could institutionalise the emerging market for "plans for reorganising, consolidating, and refinancing companies".

He wrote this before he was aware that professional firms, then called 'management engineers', already existed to solve these problems. His second article, in 1931, may have been even more prescient. His concern for the liability of board membership echoed that of James McKinsey, who had written two years earlier about the potential risks faced by executives.

Both their articles, however, were soon overshadowed by the publication of Adolf Berle and Gardiner Means' book, The Modern Corporation and Private Property, in 1932. Berle and Means, both Harvard-trained colleagues at the Columbia Law School, argued that the historic trustee relationship between shareholders and corporate boards had been corrupted by the divorce of ownership from administrative control.

In the two years that followed, US legislature drew on Berle and Means' book in the radical reshaping of US financial market regulation, particularly the Securities Act of 1933, which required that "any financing be preceded by the exercise of due diligence".

Corporations responded to the regulatory requirements of this New Deal legislation by hiring accountants, investment bankers and consultants to certify that their boards' actions were both legal and prudent. Management consultants, who had previously concentrated on selling advice, took over the production of bankers' surveys from commercial bankers. These surveys became known as management audits and served as an independent, external confirmation of management's judgment, complementing the financial audits by accountants and the valuation reports by investment bankers.

In the early 1940s, however, corporate boards began to employ an even more straightforward device to offset their potential liability from shareholder lawsuits: liability insurance. Following legislative changes that permitted the reimbursement of corporate officers for legal fees, directors' indemnity insurance, or directors' and officers' (D&O) liability insurance as it came to be known, soon became a de facto corporate policy.

With the introduction of insurance policies, the use of professionals as a hedge against legal liability faded away except where US federal and state laws explicitly mandated their use. Management consultants returned to selling advice as their primary product and the subject of D&O liability insurance soon faded from public view. Corporate executives were generally well protected from litigation by the 'business judgment rule'.

This presumed that in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the belief that the action taken was in the best interests of the company. Thus, dissident stockholders challenging executives' actions could not base their claim on the economic outcome, but instead had to challenge the legal presumption that the board of directors had acted in good faith.

In 1985, however, a ruling that the board of directors of the Trans Union Corporation had failed to exercise "informed business judgment" in approving the acquisition of the company in 1980 by billionaire Jay Pritzker, whose family built the Hyatt Hotel chain, led to a full-blown crisis. The Delaware Supreme Court overruled the lower Chancery Court, determining that despite the fact that Pritzker's offer was significantly above the stock market price, the board members were "grossly negligent" in approving the sale of the company.

Corporate lawyers seized on the court's criticism of Trans Union for not seeking outside advice, even though the justices said that external studies were not essential "to support an informed business judgment".

Jonathan Macey and Geoffrey Miller explained in the Yale Law Journal that as a practical matter the decision virtually guaranteed the increased "use of investment bankers and lawyers in corporate decision-making".

It was not only investment bankers and lawyers who benefited, since one of the key pieces of evidence used by the dissenting judge to show that the Trans Union board had exercised "informed business judgment" was the fact that less than two months earlier, "the board had reviewed and discussed an outside study of the company by the Boston Consulting Group". As a lawyer told the Wall Street Journal, "this decision underscores once again the critical need for the retention of independent experts". The court had resuscitated the dormant logic of the management audit from the 1930s.

The decision led to a national crisis in corporate liability insurance.

Emboldened by the judgment, US corporate lawyers launched a barrage of class-action lawsuits against public companies with the result that between 1984 and 1987, the number of lawsuits rose by a factor of five and the associated monetary judgments rose by 750%. Naturally, D&O insurance premiums soon skyrocketed. The problem, however, was that for some corporations there was no available supply at any price. As the New York Times reported, despite significantly reduced coverage and premiums rates that rose as much as 10-fold, "in certain industries - such as steel, petroleum, and electronics - there may be a problem simply finding an insurer".

As the work performed by lawyers, accountants and investment bankers became a shield against these lawsuits, the leading professional firms' own potential liability began to mount and the cost of their liability insurance also skyrocketed. The leading accountancy firms were particularly susceptible to shareholder lawsuits and by the 1990s, the only strategic response open to them, short of abandoning their near monopoly over corporate audits, was to push for legislative reform.

They targeted two areas: the longstanding problem that professionals were subject to "joint and several liability" and the SEC Rule 10b-5 that held professionals liable for "aiding and abetting". The top firms warned legislators that without significant legal changes, they would have to reduce risk by avoiding what they considered high-risk audit clients.

They argued, in effect, that the state should protect the implicit right of every large company to be audited by one of the six accounting firms.

Congress bowed to the pressure of corporate boards, professional firms and, presumably, the lure of substantial contributions to their election campaigns. Between 1988 and 1996, the US public accounting profession donated more than $17 million to political campaigns, with donations peaking during 1994-96 when Congress was drafting and debating liability legislation.

Relief came first from the Supreme Court and then from Congress. In 1994, the Supreme Court overturned all previous judicial precedents by ruling that professionals were not liable for "aiding and abetting" under SEC Rule 10b-5.

A year later, Congress passed the Private Securities Reform Act of 1995, which abolished "joint and several liability" in favour of proportional liability for professional firms. The American courts had granted the leading professional firms the means to escape the professional liability that had been transferred to them by corporate boards since the mid-1980s.

More trouble, however, was in store. Struggling during the late 1980s and early 1990s to keep their audit practices profitable, the giant professional firms pioneered a new business model that allowed them to subsidise loss-leading corporate audits through more profitable IT consulting assignments.

Although Arthur Andersen had pioneered the development of a consulting practice, the other large accounting firms soon followed, either through internal expansion of their consulting divisions or by acquiring existing consulting firms, or both.

In 1984, for example, Touche Ross acquired Braxton, one of the 10 largest management consulting firms in the US at the time, and in 1985 both Price Waterhouse and Coopers & Lybrand bought consultancies. By 1992 the revenue from non-audit work within the top six firms reached $6.2 billion, surpassing the fees ($5.3 billion) from corporate audits.

In their drive to expand into consulting, however, these firms unwittingly caused more problems than they solved. Their consulting assignments created the appearance of a conflict of interest that endangered the accounting profession's entrenched support among government regulators.

In the late 1990s, this issue came to a head when Arthur Levitt, chairman of the SEC, decided that the leading auditors were no longer truly independent from their corporate clients because they had become so reliant on consulting revenues. Levitt publicly petitioned Congress to separate accounting and consulting.

Under pressure from the SEC , the big firms began to separate their accounting and consulting businesses. In retrospect, the scale of this transfer is remarkable because, by 1998, the top five firms employed more than 65,000 consultants and billed more than $12 billion annually. By 2003, four of the five consulting firms had new names and new owners.

Of course, one professional service firm, Arthur Andersen, did not successfully navigate this transition. In the short interval between 1998 and 2002, Enron went bankrupt, dragging down with it Arthur Andersen, its corporate auditor. The resulting public fiasco rapidly turned into the worst crisis in corporate governance since the 1930s. Worst of all was the fact that far from a strange anomaly, the Enron/Andersen debacle was clearly a consequence of the professional liability crisis that hearkened back to the mid-1980s.

As a result, Congress took up the question of financial regulation at the end of 2001 with a determination not seen since the 1930s, culminating in the passage of the Sarbanes-Oxley Act of 2002 "to protect investors by improving the accuracy and reliability of corporate disclosures".

The Act revisited the original New Deal legislation, strengthening and updating "accountability by public companies in the areas of financial reporting, disclosure, audits, conflicts of interest and governance". In particular, it forbade accounting firms from offering management consulting services to any corporate client with which they also served as an auditor.

However, the legislation increased the legal obligation of directors to monitor internal management decisions. Just as the corporate failures in the late 1920s had led to regulations promoting oversight by management consultants during the 1930s, the transfer of legal liability from corporate boards that began in the 1980s and eventually climaxed in the corporate governance crisis of the early 2000s, persuaded regulators to compel corporations to employ outsiders to perform routine management audits. Thus, having failed to prevent the corporate governance crisis, management consultants were nevertheless once again touted as the best solution to rising corporate liability.

But what, you might ask, does any of this have to do with the problems that executives currently face? The immediate answer is that anyone who deals with the complicated regulatory requirements of Sarbanes-Oxley should understand that these regulations are not a novel development, but the repetition of a long-standing regulatory cycle that will most likely result in corporate directors increasing their use of professionals as a hedge against their rising liability. We are now at the beginning of the third cycle of corporate liability within the last 75 years.

If the past provides any guidance for the future, it seems likely that this cycle will result initially in a concerted attack on regulatory oversight and the attempt to shift liability on to both business professionals and insurance providers before a prominent corporate scandal emboldens American legislators, yet again, to try to hold corporate board members personally responsible for corporate malfeasance.

Even for those lucky enough to escape the immediate regulatory requirements of Sarbanes-Oxley, the changing use of outside advisors as a shield against corporate liability is a powerful reminder that a central function of business professionals is to provide an external audit of internal decisions. Those who truly understand the value of professional advisors rarely scoff at the very real value of someone telling you what you presumably already know.

The underlying historical lesson, however, may be less obvious - almost all markets are themselves by-products of government regulation, whether explicit or not, that can rapidly disappear as political support declines.

Although Andersen and Enron were both entrepreneurial organisations, at their core both depended on government regulation and legislative politics to maintain what was otherwise an inherently unstable market for their primary products.

Enron, Andersen and McKinsey owed their historical success to market regulation. As such, their continued success was particularly vulnerable to political change and the never-ending effort to offset corporate liability on which the leading professional firms had always depended.

THE CYCLE OF LIABILITY 1920s: The first management consultants sell advice on best practice to large organisations.

Cycle One 1930s: The Securities Act (1933) requires that "any financing be preceded by the exercise of due diligence". Companies hire more accountants, investment bankers and consultants to certify that their boards' actions are legal and prudent. Management consultants produce bankers' surveys or audits to serve as independent external confirmation.

1940s: Legislative changes permit the reimbursement of corporate officers for legal fees, directors' indemnity insurance, or directors and officers (D&O) liability insurance. Management consultants return to selling advice on best practice.

Cycle Two 1980s: The Delaware Supreme Court rules that the directors of the Trans Union Corporation had failed to exercise "informed business judgment" in approving the acquisition of the company by Jay Pritzker. The new interpretation of the law resuscitates the dormant logic of the management audit from the 1930s and management consultants return to due diligence.

1990s: Enron goes bankrupt, dragging down with it Arthur Andersen, its auditors. Management consultants return to selling advice.

Cycle Three 2000s: The Sarbanes-Oxley Act is passed to "protect investors by improving the accuracy and reliability of corporate disclosures". It forbids accountancy firms from also offering consultancy services to the same client. Management consultants are once again seen as the answer to the issue of rising corporate liability and are hired for due diligence.

- Christopher McKenna is a lecturer in strategy at Said Business School, a Fellow of Brasenose College and a founding member of the Clifford Chance Centre for the Management of Professional Service Firms, University of Oxford. This article is an edited extract from his book, The World's Newest Profession: management consulting in the 20th century (Cambridge University Press, 2006).

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