Grey matters ethical dilemma: Brought to account – the CISI verdict

A research partner in a boutique advisory firm finds herself facing a difficult decision. A major client’s planned flotation looks overvalued – but no one will listen to her

John has spent most of his working life in the City of London. He now fills a number of non-executive roles, but for 20 years before he stopped full-time work, he was a senior director of an investment bank. Recently, he was surprised to receive an email out of the blue from Jean, asking if he could meet up for 30 minutes. Jean, whom he had not seen for several years, had been an analyst who had worked in the Mergers & Acquisitions team in his old bank and he had also known her as a college friend of his daughter.

Jean explained that about 12 months ago, she had left the bank to join a boutique advisory firm, where she is the research partner. The firm is currently working on bringing to market a new client, and success in this transaction is crucial if it is to have any credibility. The client was an outsourcer that specialised in taking routine clerical tasks, in both the private and public sectors, applying its skills in organisational and operational management to re-engineer and automate, reducing costs by labour saving and relocating to lower-cost regions or overseas. Standard contracts generally ran for ten years, and the client’s business model involved high costs in the first few years, as jobs were reorganised and/or new equipment was bought.

On a strict comparison of costs and profits, new contracts were generally unprofitable for the first three or four years, then substantial – often indecent – margins could be made in later years. As the client was growing rapidly, the number of loss-making contracts was on this basis much greater than the profitable ones.
All six partners had borrowed heavily to set up their firm and success for the client is crucialJean went on to explain that, despite this, the client’s accounts showed relatively large and rapidly growing earnings. The key to this apparent anomaly was that the client capitalised not only assets but also a proportion – in her view, too high a proportion – of actual running costs. The accounts were not sufficiently transparent. Effectively, profit was being recognised too early, and the client was dependent to a greater degree than outsiders might appreciate on a rapidly growing stream of new business and future cost saving, which was not yet certain. Jean had looked at this in considerable detail and was quite quickly able to satisfy John that her concerns were justified, and that the anticipated share price on launch was not sustainable if the market were aware of the practices that Jean described.

Jean said that the client’s management was controlled by three strong individuals: the chairman, the chief executive, and the chief financial officer (CFO). The three had worked together in a large multinational and had built the business originally with a private equity house over a good number of years. Each of them had a major financial commitment to it, and all, including the chairman, would benefit significantly from a successful flotation. Jean had raised her concerns with the CFO, who had initially taken steps to persuade her that she was wrong, but increasingly was showing clearly that he and his two senior colleagues regarded Jean’s attitude as one of disloyalty and had begun to question her commitment and, more worryingly, whether they had perhaps made a mistake in choosing her firm.

Jean had discussed the accounting treatment with the client’s auditors, an ambitious, mid-sized firm that had grown rapidly, in good part stimulated by the growth of the client. The audit partner said he understood Jean’s concern but that the matter was one of interpretation. The client had always delivered in the past, and he saw no reason to challenge the current position. The chair of the client’s audit committee, also the senior independent director, is senior partner of the client’s long-standing and quite small firm of solicitors. Jean had tried to raise the subject with him and had received little better than a brush-off.

Jean told John that she had followed the client for some time and was confident that her analysis was sound. Although she had shared her concerns with one of her partners, who is the sponsor of the issue, he had said that he was confident in relying on the client’s audited accounts and the assurances of the firm’s executive that its accounting treatments and projections were all soundly based.

Jean feels that she is in a difficult position. All six of the partners in the boutique, in order to set up the firm, had borrowed heavily to fund the business until it became established, and so success with the client transaction is crucial to all of them. Jean is perhaps fortunate in that she has no dependants beyond herself and her husband, while she is aware that her partners all have children and significant external commitments, such as school fees and large mortgages, to meet on a regular basis. Consequently, she feels reluctant to make too big a fuss, although her real inclination is to say that she feels that the risk involved in continuing with the client flotation is too great for the boutique.

John offers Jean a number of possible courses of action to discuss with her partners/the client to help remediate the position, but says that at the end of the day, Jean may be faced with deciding that she:

  • should accept that the accounting treatments in question are an art not a science and that having raised her concerns, she should allow the flotation to continue
  • should seek to persuade the sponsoring partner of her concerns, and if he remains unreceptive, should insist that the matter is aired with all the partners
  • has no credible option other than immediate resignation
  • must immediately report the matter to both the accounting regulatory authorities and the FCA.
The CISI verdict
The dilemma was published in the Review digital edition, with members invited to register their favoured response from the above four options and leave supporting comments in a survey on the CISI website.

This was not one of the more popular dilemmas, possibly indicative of lower levels of interest in corporate finance matters, albeit that the type of dilemma illustrated is
one that practitioners will be familiar with: a conflict between the need for valuable fees and personal integrity.

Interestingly, no one felt that the issue was an immediate resigning matter, with the great majority of respondents (84%) supporting the view that Jean should seek to persuade the sponsoring partner of her concerns, failing which she should insist that the matter is raised with all the partners. This is the CISI's preferred option.

A number of readers felt that the matter should be reported immediately to both the accounting and financial regulators. While this may be considered a ‘safety first’
action, it does expose all of the partners to the risk of damaging action by one or possibly both regulators, without giving Jean’s fellow partners the opportunity to
take remedial action. Accordingly, it would represent a last resort, rather than first action.

There was only one vote for allowing the float to continue on the basis that accounting treatments are an art, not a science. This was possibly from a reader who is a supporter of the John Cleese school of accountancy, or more recently, the
Autonomy/Hewlett Packard debacle!


Published: 11 Mar 2015
  • Opinion
  • People
  • Integrity & Ethics
  • The Review
  • integrity
  • Grey Matters

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