Restrictive bank covenants keep the Big Four on top

Vince Cable’s appointment as business secretary means there is a glimmer of hope for change

Buried in the 81-page credit agreement for US-based healthcare provider
Amedisys is a 22-word stipulation that highlights a problem some fear is
threatening the stability of the global economic system.

“Audited consolidated balance sheets of the group members… [must be] reported
on by and accompanied by an unqualified report from a Big Four accounting firm,”
the phrase reads.

The simple banking covenant, contained in the $400m (£270m) agreement,
prevents Amedisys choosing an auditor apart from a Big Four firm, effectively
locking out smaller auditors from picking up major work.

Amedisys’ case is not isolated. In 2006, Coffeyville Resources’ $1bn
agreement was dependent upon the use of auditor KPMG or “the other Big Four
independent certified public accountants of recognised national standing”.

Research by Grant Thornton’s US branch, conducted earlier in the year
identified more than 450 restrictions applying to at least 220 companies in the
Russell 2,000 index. While widely available on the public record in the US, in
Europe these covenants are the stuff of rumour and myth, widely spoken of, but
rarely produced.

Yet one European example from Spain, according to BDO International chief
Jeremy Newman, states: “The parent company, although not legally obliged to do
so, undertakes to submit its individual and consolidated annual accounts to an
annual audit by one of the four most solvent and internationally renowned audit
firms (the Big Four).”

The Big Four have long kept quiet on the subject, until last month. In a
joint submission, the Big Four – along with the next two largest firms, Grant
Thornton and BDO – officially acknowledged, for the first time, the existence of
restrictive covenants in the UK.

“These contractual limitations can distort the market for audit services,”
the firms said in their joint submission to the Organisation for Economic
Co-operation and Development.

The covenants’ existence, smaller auditors claim, stifle competition in the
top heavy audit market. In the wake of the banking crisis, fears the Big Four
have become “too big to fail” have grown more acute.

If a Big Four auditor collapsed, it’s feared contractual obligations would
limit companies from appointing a non-Big Four replacement. This requirement,
combined with strict conflict of interest barriers, would leave major companies
flailing, with no auditor legally able to provide assurance on their accounts.

With no auditor, companies could then fail to meet listing requirements
across the world.

Grant Thornton estimated that in the event of a Big Four collapse, 20% of the
7,200 largest businesses in the G20 would be left stranded, according to a
letter the firm sent to the International Organization of Securities Commissions
in January.

The UK’s financial reporting regulator, the Financial Reporting Council
(FRC), encourages companies to disclose “contractual obligations to appoint
certain audit firms”. Recent FRC research revealed only a few make disclosures
and of those none said their choice of auditor was restricted. The FRC added:
“It is unclear how many of those which were silent on the issue are subject to
some form of restriction from lenders or others.”

The body said it learned of one case where a loan agreement specified a
higher interest rate if the company chose a non-Big Four auditor.

Most UK banks dismiss the issue. Lloyds said it will not comment on “our
suppliers”. Barclays Capital also declined to comment, while HSBC said it does
not stipulate the use of a Big Four auditor.

“We would always recommend that our customers use an auditor that is
appropriate to the size and complexity of their individual business,” a HSBC
spokeswoman said.

All three banks are members of the Loan Market Association, which defines an
“auditor” as one of either PricewaterhouseCoopers, Ernst & Young, KPMG or
Deloitte or “any other firm approved in advance by the majority lenders.”

According to Newman the suggestion of a Big Four auditor is tantamount to a
restriction. “There is no doubt that this is an obligation a company would be
foolish to ignore,” he said in a blog published last week.

There’s optimism within the audit profession that change may be on its way.
The appointment of Lib Dem Vince Cable as business secretary brought the glimmer
of hope the government may make changes.

Before being elected Cable said: “There is a second tier [of audit firms],
the BDO Stoy Haywards, who are desperate to get into this stuff. Why they’re
impeded, I don’t know. But I have asked the Office of Fair Trading (OFT) to look
at this, and they have agreed.”

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