KPMG Partners Lucked Out -- Thanks to Enron and Arthur Andersen
There's one group of people who should be giving thanks daily for the Enron scandal: the partners of KPMG, one of the Final Four accounting firms. That's because the fallout from Enron is what allowed KPMG to extract a favorable settlement from the Justice Department last week. The firm agreed to fork over less than a year's profit in return for not being indicted on a zillion counts of cheating the government by peddling sleazy, dishonest tax shelters for six years.
The government didn't dare file criminal charges against KPMG because an indictment alone would have driven it out of business, leaving us with too few big accounting firms to go around. KPMG was in this strong bargaining position because of the collapse of Enron's accounting firm, Arthur Andersen, which the government foolishly indicted on criminal charges three years ago.
Even though the indictment was on narrow grounds and the government ultimately lost the case, a criminal indictment is guaranteed to send any major accounting firm to the big ledger in the sky. Partners and clients flee when there's an indictment, and some states yank licenses. The Securities and Exchange Commission's rules of practice ban convicted firms, which means that almost no board of directors is going to ask shareholders to approve hiring an indicted firm. The right approach would have been to wipe out the partners' capital and pursue criminal charges against individual miscreants, while letting Andersen reorganize its auditing practice. Indicting the firm was the wrong approach, because it set off an uncontrolled collapse.
Absent Andersen, no sensible person is going to risk indicting any of the Final Four, which would leave us with the Last Three. "We . . . recognize the importance of avoiding collateral consequences wherever possible," Attorney General Alberto R. Gonzales said at last week's news conference.
Andersen would have failed even without a criminal indictment, and it deserved to. It had shelled out major money to settle its screw-ups at Sunbeam and Waste Management. Settlements for its Enron, Global Crossing, Qwest and Baptist Foundation of America disasters would have wiped out the remainder of its capital. But forcing Andersen out of business rather than allowing the honest remnant to reorganize has produced an unhealthy lack of competition among big accounting firms.
In an unpublished paper, Emilie R. Feldman, a doctoral student at the Harvard Business School, makes a compelling case that the Final Four firms absorbing Andersen's business would have violated antitrust guidelines had it involved a sale rather than a collapse.
Feldman (disclosure: her family and mine are close friends) says having the Final Four absorb Andersen's business added 455 points to the Herfindahl-Hirschman Index, a tool that antitrust mavens use to measure business concentration. Any increase bigger than 50 points would have violated the relevant guidelines, she says.
In other words, a collapse brought about by the Justice Department prosecutors allowed the Final Four to acquire at no cost business that the Justice Department antitrust enforcers would never have let them buy. You have to love it.
To be sure, the penalty imposed on KPMG isn't chopped liver. It's $456 million, which is real money. But it's less than it seems to be, even though the deal forbids KPMG from deducting any of the money from taxable income.
KPMG wouldn't help me put the $456 million into context. So I consulted the folks at Inside Public Accounting, an industry trade journal. And you don't need a CPA to see that this deal is one of the bargains of the year.
The journal's publisher, Martha Sawyer, says that KPMG generated $3.8 billion of revenue in the year ended Sept. 30, 2004. She estimates that between 35 and 48 percent of that was pretax profit, which works out to at least $1.33 billion, an average of $787,000 per partner. But remember that the penalty is after taxes. So we'll assume an unrealistically high tax rate -- 40 percent -- for KPMG's partners. This would leave after-tax profit of about $470,000 per partner. The $456 million is about $276,000 per partner. So KPMG's partners are paying less than a year's profit to avoid being destroyed by a criminal indictment. Pretty slick.
The firm and the government say none of KPMG's payments will be covered by insurance. But the settlement calls for the government to get 50 percent of the first $288 million of insurance proceeds, should KPMG get any. (KPMG would keep anything above $288 million.) The settlement, the first $256 million of which was due last week, may end up costing KPMG less than the stated $456 million by the time it finishes paying next year.
So it's time for KPMG's partners to thank the gods of greed for creating the Enron scandal. Because if we hadn't had Enron, we might not have KPMG.
Sloan is Newsweek's Wall Street editor. His e-mail is email@example.com