Ernst & Young (EY) and Moody’s Under Attack as Gatekeepers’ Failures Continue to be Revealed with Wirecard

The Wirecard scandal has made for an engrossing account of corporate failure since the news emerged that the German financial payments processing company had been inflating its accounts. Now that the company has collapsed – the first time that a member of the German Dax index has failed – the ramifications are starting to be revealed. The EU is now investigating the role played by BaFin, the German regulator tasked with regulating the company, whilst the FCA in the UK has ordered the British arm of the company to freeze all of their customers’ accounts. Now that the aftermath is continuing to fold, the focus is now rightly turning to why the alarm bells were not sounded earlier by those both paid and expected to do so.

 

Of particular concern has been the auditing conducted by Ernst & Young (EY), and the credit rating conducted by Moody’s. With investors standing to lose out considerably because of this collapse, the performance of these gatekeepers is a massively important issue. Unfortunately, for the two concerned, the information that is slowly-but-surely being revealed does not make for comfortable reading.

 

Starting with Moody’s, there has been some criticism from industry professionals today regarding their role. During last Friday (19^th June) Moody’s had downgraded the company’s rating by six notches, before removing the rating altogether on Monday. This came after EY refused to sign off on the company’s accounts, with Moody’s declaring that it had decided to withdraw ‘because it believes it has insufficient or otherwise inadequate information to support the maintenance of the ratings’. The decision to downgrade prompted Wirecard to seek new financing strategies, although those plans will not be needed now the insolvency process is underway. However, as Gene Phillips of PF2 helpfully pointed out yesterday, the wording attached to Moody’s downgrading of Wirecard reveals a crucial issue for credit rating agencies more generally. It was not until June 2^nd that Moody’s downgraded Wirecard, which came less than a year after it had rated the company Baa3 – or, investment grade – citing that despite a number of challenges ranging from competition to its size relative to its US counterparts, the company had a strong market position in Asia and Europe, was diverse, had scalability, and a sound financial profile. Now, less than a year later, the agency stated that it would first place the company on review of a downgrade (on the 2^nd June) based on ‘ongoing uncertainties around the allegations regarding fraudulent accounting practices and concentration risks on third party acquirers’. In defence of Moody’s, Wirecard was hovering just above the cut-off for investment-grade, and there were a number of warnings attached to the rating, especially concerning governance. Yet, there is a sentence in the attached dialogue that will prove to damning for the agency: ‘The company’s strong and swift expansion led to some instances in its Asian operations where a lack of corporate control resulted in periodic restatement of booked revenues. Management had immediately taken meaningful measures to avoid such issues in the future. Considering the opinion of external auditors, we assumed that these events have been isolated, regionally concentrated events’. We now know that this ‘assumption’ was a dramatic error, with the sequence of events now being shown to have been quite the opposite from what had been believed by the agency.

 

Therefore, the question to ask is likely a simple one: what purpose do the rating agencies actually serve if they are assuming critical issues such as those highlighted above? A number of societally important investors are bound to invest only in instruments which agencies deem to be of investment-grade, but we now have the admittance that one of the major agencies was assuming key information to be case, when in fact deeper investigation would, or at least should have revealed greater issues and affected the creditworthiness of the firm in question. One might well argue that this is an issue of disclosure, and that the rating agencies are not either a. set up or b. supposed to uncover fraudulent activities – the argument being that this is the role of the auditor. Perhaps that is the case, and it is why we shall turn our attention to EY next. However, the continued usage of the rating agencies’ products must continue to critically analysed because it is clear that there are important issues that need to be considered when understanding the usefulness of a rating, like how much of it can be relied upon to be objectively true? How much is assumed? Why and when would an agency make critical assumptions, and when would it not? It is questions like these that lead prominent critics to suggest ratings have very little to no value. I argue that they do, but not in the traditional sense, in that they serve more of a signalling purpose required for the functioning of the financial system, and not much else. But, to admit to assuming key material information, irrespective of whether it came from an auditor or not, is telling. Important journalistic investigations conducted by the FT had demonstrated, at least enough to inject doubt into the picture being painted, that more caution should have been afforded to the allocation of an investment-grade rating, with all that entails. Other examinations, like that conducted by Sigma Ratings, demonstrated quite clearly that much greater caution should have been afforded when assigning this particular rating. Why that caution was not afforded is solely for Moody’s to answer; saying ‘we assumed’ is not enough.

 

Yet, Moody’s will receive some criticism for the Wirecard scandal but, for the gatekeepers, the majority of the criticism will rightly be reserved for EY. The audit firm had provided clean audits for Wirecard for a number of years. However, despite journalistic investigations and whistleblowers raising the alarms, together with internal investigations (which were ultimately mothballed), the auditor continued to give clean audits. It was revealed today that they actually went further, and not only turned a blind eye but actively did not perform as they were supposed to. Billions of Euros were said to be housed in Wirecard’s Asian arms, but rather than investigate this and perform the due diligence that is expected of a Big Four auditor, the FT revealed that EY failed to even request the bank statements from a bank in Singapore where Wirecard had claimed it had more than €1 billion. EY has not commented on these allegations yet, but other auditors and expert onlookers have. One auditor said ‘the big question for me is what on earth did EY do when they signed off the accounts?’, whilst another said that obtaining independent financial information is akin to one of the fundamentals of auditing. A Professor of Accounting declared, quite rightly, that is was ‘not sufficient’ for an auditor to accept account confirmations from third parties, but a head of a rival auditor went even further when they suggested that ‘it is beyond the realms of reality that EY wouldn’t have had [the bank balance confirmations] unless they did a very poor audit’. If it is the case that this is just extremely poor auditing, EY will be in trouble. However, if it is the case that EY had the information it needed to know that Wirecard did not have the money it said it had, and still signed off on key audits, then EY will be in serious trouble. It is elements such as these which are causing people to liken this collapse to the collapse of Enron, at least in terms of the damage it will do for the auditing sector.

 

As investors, regulators, and politicians line up to blame and punish, the gatekeepers stand in a particularly vulnerable position. This will be added to Moody’s’ long list of instances where they have fallen short, but for EY it could be extremely problematic. Akshay Naheta, a SoftBank executive who was involved with SoftBank’s investment into Wirecard last year, neatly summed up why this is potentially such an impending issue for EY; ‘I’m totally baffled by the lack of competence and responsibility displayed by E&Y… as an organisation that is meant to protect all stakeholders – creditors and shareholders – in companies, both public and private, they have materially failed in their fiduciary duties’. Auditors have a massively important role in the efficient running of the economic system, and their unique position between the company and the outside world is one which will, inevitably, lead to some failures which are usually massive in scale. According to Moody’s account, their whole system relies upon the auditor-company relationship too, which only adds weight to the philosophical importance of that relationship. However, is it too much for just a few auditors to bear? Are there too many engrained conflicts of interest within that relationship? The dynamics of that relationship were considered at length after the Enron/WorldCom scandals but, like most instances of reform-laden eras with regards to gatekeepers, the economic cycles brought around other issues which caused audit-related concerns to become of less importance. The rules implemented after those scandals, most notably concerning the enforced division of the major auditors away from their commercial consulting arms, were overridden by the industry not long after. The cyclical nature of reform and regulation must be brought to an end, with rules designed to increase the effectiveness of the said gatekeeper within the financial system needing to be consistently applied, not just for the economic cycle (mostly because we do not seem to have so-called ‘Quiet Periods’ any more!).

 

Keywords – Wirecard, Moody’s, EY, Audit, @finregmatters