Ernst & Young: Too big to fail

December 21, 2010: 11:23 AM ET

Don't look for indictments in Andrew Cuomo's case against the accounting firm.  That could kill the business, and no one wants that.

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

Take Ernst & Young, which is a target of New York attorney general Andrew Cuomo 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 unless Cuomo or his successor as AG, Eric Schneiderman, have totally lost their senses, they're not going to indict E&Y, the nation's second-largest accounting firm.

They'll try to get it to agree to fines and penalties, as well they should. But it's hard to imagine them indicting the firm.

Why do I say that? Because in the accounting world, being indicted puts you out of business as customers and partners flee, and you lose some of your 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 may 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, according to 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Five years ago, I wrote a column based on her then-unpublished paper that said that having the Final Four absorb Andersen's business would have violated anti-trust guidelines had it involved a sale rather than a collapse.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-Hirschmann 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 we need to handle E&Y much more intelligently than we handled Andersen.

The logical way to deal with Andersen's Enron role was to split the firm into 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 to Andersen and its partners, but we'd still have five big national accounting firms rather than four.

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

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

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About This Author
Allan Sloan
Allan Sloan
Senior Editor at Large, Fortune

Allan Sloan, who has been writing about business for more than 40 years, joined Fortune in July of 2007. Before that, he was the Wall Street editor for Newsweek for 12 years. His work also appears in The Washington Post. Allan is a seven-time winner of the Loeb Award, business journalism's highest honor, receiving awards in four different categories for five different employers. He is a graduate of Brooklyn College and has a master's degree in journalism from Columbia University. He and his wife live in New Jersey. They have three grown children.

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