An indictment against Ernst & Young? Maybe not . . .

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Washington Post Staff Writer
Tuesday, December 21, 2010; 11:19 PM

If you are going to screw up, make sure that you are working at a company that regulators aren't going to let fail. That's the lesson not only for big financial companies but for the Final Four big national accounting firms as well.

That, I suspect, accounts for the way New York Attorney General Andrew M. Cuomo is suing Ernst & Young for its alleged role in helping Lehman Brothers produce misleading financial statements before it collapsed two years ago.

People are baying for criminal indictments of big names for their roles - make that alleged roles - in the financial meltdown and ensuing horrible recession. But Cuomo isn't seeking to indict E&Y, the nation's second largest accounting firm. Instead, he is seeking damages - based on the fees it got from Lehman - that E&Y or its malpractice insurer or whoever ends up writing the checks can cover.

This gives Cuomo chops for seeming to go after E&Y without him running the risk of putting the firm out of business. In the accounting world, you see, being criminally indicted pretty much puts you out of business as customers and partners flee, and you lose some of the licenses that allow you to do business. And I don't think any sentient regulator wants to run the risk of E&Y going out of business.

Call it the Arthur Andersen Effect. Andersen, you might recall, was indicted and convicted in 2002 for its role in the collapse of Enron. Just being indicted destroyed the firm, because partners and clients fled. By the time Andersen won on appeal, it was a husk of its former self, and what had been the Big Five accounting firms had become the Final Four.

Having the Final Four dwindle to the Terminal Three would increase an already unhealthy concentration among the nation's accounting firms, says Emilie Feldman, an assistant professor at the University of Pennsylvania's Wharton School.

Five years ago, I wrote a column based on her then-unpublished paper that said having the Final Four absorb Andersen's business would have violated antitrust guidelines had it involved a sale rather than a collapse.

So I asked Feldman - disclosure: her family and mine are close friends - to calculate the effect of the demise of E&Y. The answer: It would be even worse than the collapse of Andersen. "The increased concentration would clearly violate the guidelines," she told me.

By Feldman's math, a collapse of E&Y and assumption of its business by the Terminal Three would add 733 points to the Herfindahl-Hirschman Index, which antitrust experts use to measure business concentration. The industry is already so concentrated that any increase of more than 50 points would violate guidelines and bring on an investigation.

Andersen's collapse, she said, increased the index by 455 points. Her paper, "A Basic Quantification of the Competitive Implications of the Demise of Arthur Andersen," was published in 2006 in the Review of Industrial Organization.

I'm not saying that E&Y doesn't deserve to fail, or that its partners shouldn't be punished severely. What I am saying is that Cuomo seems to be handling E&Y litigation more intelligently than the federal government handled Andersen.

The logical way to deal with Andersen's Enron role would have been to split the firm in two - a good firm with an accounting business that could be recapitalized with new money and a bad firm that would have been allowed to fail and take the partners' money down with it. That would have produced serious consequences for Andersen and its partners, but we still would have five big national accounting firms rather than four.

We sure don't want to go down to three. You can bet that the Securities and Exchange Commission and the publicly traded companies that hire big nationally recognized accountants don't want to lose E&Y either.

Hence, Cuomo's suit with a bark far bigger than its bite. E&Y almost surely will settle, lest it have its dirty laundry aired at a trial, which it could lose.

So my bet is that E&Y gets whacked, fined and punished - but gets to stay in business. You don't have to be Citi or Bank of America to be too big to be allowed to fail.

Allan Sloan is Fortune magazine's senior editor at large.

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