The Government Accountability Project (GAP), a 30 year old nonprofit public interest group that promotes government and corporate accountability and is the leader whistle blower protection organization in the United States, recently published a report on the role of the auditors in the unlawful privatizations in Sri Lanka. Highlighted in the report is the misconduct of auditing firms PricewaterhouseCoopers (PWC) and Ernst & Young (E&Y) who forfeited their reputations Sri Lanka Insurance Corporation (SLIC) privatization.
The GAP report states that the principal assets of an auditing firm and of chartered accountants are their reputations and their integrity. It is a firm’s reputation for accuracy and independence that makes it valuable to governments, investors and the public. In the sale of SLIC, a privatization transaction nullified by the Supreme Court of Sri Lanka on June 4, 2009 for unlawfulness and misconduct, two auditing firms PWC and E&Y forfeited their reputations. Both firms lent their expertise to a transaction that illicitly converted a public asset into private wealth for unscrupulous individuals/organizations.
The privatization of SLIC was a transaction that took place on two parallel tracks. The report states that one occurred before the public an the other transpired behind the scenes, orchestrated by politicians, auditors and private firms seeking to benefit at the public’s expense. Documents are now available that illustrate clearly, with dates, names and amounts of money, the invisible and illicit manipulations behind this privatization transaction, together with the pivotal role played by PWC and E&Y.
Unauthorized preparation for the sale of SLIC
The GAP report states that the privatization of a public enterprise in Sri Lanka requires the approval of the Cabinet of Ministers even to begin. Nevertheless, just before July 20, 2001, the Public Enterprises Reform Commission (PERC), on its own initiative, drafted a concept paper that set out a plan to privatize SLIC. Based on this paper, PERC Chairman P.B. Jayasundera formed a Core Group to consider the transaction. From time to time, Jayasundera had served as a senior policy advisor to E&Y, the auditors of SLIC, who should have been independent of PERC and consequently, of Jayasundera.
The Core Group consisted of five people including the Chairman of SLIC and Deva Rodrigo, Senior Partner of PWC. This group was to deliver a recommendation about the sale to Jayasundera, Chairman of PERC. It should be noted that the appointment of the SLIC Chairman as the Chairman of the Core Group is precluded by public finance regulation.
The report states that on September 3, 2001, the Core Group delivered its conclusions to Jayasundera, in his capacity as PERC Chairman, recommending the privatization of SLIC. On Janaury 21, 2002, Minister Milinda Moragoda who was the Minister in charge of PERC, appointed a Steering Committee to oversee the transaction. The Steering Committee also included the Chairman of SLIC, Jayasundera himself and Rodrigo of PWC. Rodrigo, therefore, was a member of the Core Group, the Steering Committee and the consulting firm ultimately involved in the privatization of a valuable public asset, SLIC.
Court documents show that E&Y had cooperated from the very beginning in the accounting work required to move ahead with the divestiture without Cabinet approval. Records reveal that E&Y had quoted a fee of US$81,000 to restate the SLIC Audited Accounts n the basis of International Accounting Standards. According to the documents, Cabinet did not authorize any restructuring of SLIC until April 3rd 2002. Prior to this date, the Steering Committee had already called for bids to provide the financial services necessary for privatization, had evaluated the bids and had shortlisted PWC.
The GAP report states that it is not surprising PWC was shorlisted as Rodrigo was on the Steering Committee and the Core Group and was fully informed about the amount the government was prepared to pay for financial services. In other words, a PWC partner was an adviser to both the contractor and the potential contractee in this transaction. E&Y was also shortlisted and this firm too, held privileged information from both sides of the transaction. GAP states that both firms should have been disqualified because of their access to the accounts of SLIC and the funding parameters of the contract, but they were not.
PWC subsequently signed a contract with the government for a tax-free total of US$1,065,000. While the contract was signed by PWC Indonesia, court documents and public announcements concerning the sale of shares in SLIC shows that PWC Sri Lanka acted jointly with the company’s Indonesia franchise and provided key personnel to the project. A PERC internal audit report prepared by SJMS Associates, Chartered Accountants, read: “Mr. Deva Rodrigo, partner of PWC, was one of the members of the Steering Committee that selected PWC as the financial advisor, the conflict of interst was not considered.”
The report states that the entire privatization process was de facto well down the road, manipulated by Moragoda and Jayasundera, with assistance from PWC and E&Y, by the time the official bodies – the Cabinet and the Technical Evaluation Committee (TEC) – were even informed, much less involved. In fact by July 9, 2002, PERC had already placed advertisements in the international media calling for expressions of interest in the proposed sale of up to 90% of the shares of SLIC. At this point, as far as the public was aware, Cabinet was still considering retaining a minority stake in the company and a Cabinet Appointed Tender Board (CATB) had not yet been appointed.
Expressions of interest, however, were placed in only two international media outlets. The announcements instructed those interested to submit EOI’s by mail or fax to PWC Indonesia and PWC Sri Lanka. The TEC had not approved either advertisement. According to regulation, EOI’s are to include the details of the bidding companies’ ownership structure and profile, audited financial statements for the previous three years and relevant operational capabilities. This information is required in order that the evaluation committee may establish the capabilities and bona fides of bidders.
Proposals are to be deposited before a specified times and date in a sealed box and opened in public. Instructing bidders to submit proposals directly to PWC was a serious violation of practice and procedure, leading to, at the very least, a lack of transparency in the handling of the bids.. In effect, this step shows that once the reputation of PWC was put in the services of an irregular process, the subsequent steps necessary to complete the illicit divestiture of SLIC fell into place.
Manipulation of Accounts
The GAP report states that when the Share and Sale Purchase Agreement was signed, it included a provision to adjust the ‘purchase consideration’ according to differences in SLIC account updated by E&Y from March 31, 2002 to April 11, 2003.
Steering committee minutes make clear that the intention was to compute the purchase price adjustment on the basis of a comparison of audited accounts for SLIC on March 31, 2002 and April 11, 2003. International accounting standards required E&Y to restte the current assets and current liabilities of SLIC on the two dates based on independently audited accounts. In fact, E&Y failed to compute the purchase price adjustment before handing over absolute possession and management of SLIC to the purchasers on April 11, 2003. This decision, taken unilaterally with no safeguard in place to protect the interests of the government, led to the non-conclusion of this transaction and opened the door to a demand from the purchasers for a refund from the government of Rs.2.1 billion.
At some point in the proceedings, the GAP report states that E&Y surreptitiously and retrospectively reclassified the working capital of SLIC in such a way that it appeared that the government owed a substantial sum to the purchaser after the transfer of ownership on April 11, 2003. Documents available strongly suggest that the reclassification of the Net Working Capital occurred after the ‘freeze letter’ dated October 9, 2002 sent by PERC to SLIC. This letter is routinely sent during a divestiture process to prevent changes that would have a material impact on the evaluation and price of the enterprise being privatized.
Documents before Court reveal that in 2004, PERC had questioned E&Y about this retrospective and surreptitious reclassification of the SLIC investment portfolio by Rs.3,000 million but had not received any explanation from E&Y. Documents also show that the normal Annual Audited Accounts of SLIC audited by E&Y as of December 31, 2001 and December 31, 2002 presented the current assets and current liabilities separately on the balance sheet. Consequently, the GAP report says it is not clear why these classifications had been omitted in the un-audited accounts of SLIC as of the relevant dates March 31, 2002 and April 11, 2003, signed by E&Y. When questioned about this discrepancy, E&Y requested and obtained 17 extensions to compute the increase in the net working capital of SLIC and adjust the purchase consideration. In the end however, E&Y did not even produce the calculations requested although the firm was obliged to do so. In effect, it is clear that E&Y was working from un-audited accounts produced by management. This is an extremely uncommon practice and the auditors should have refused to carry out the assignment based on unverified figures.
The conduct of Milford Holdings, the purchaser, since the Supreme Court’s voiding of the sale shows an awareness of the dimensions of this manipulation of accounts by its perpetrators. Whereas initially Milford Holdings had sent the government a letter of demand, contending that it had paid too much for SLIC, the company subsequently reversed its position radically. The GAP report states that in the face of disclosures made in Court, Milford Holdings pleaded with the Supreme Court not to annul the transaction. In order to maintain ownership of SLIC, Milford offered to withdraw its demand for a refund from the government in the amount of Rs.2.1 billion based on its claim that it paid too much, and increase the amount it paid for its shares, acknowledging that the unadjusted purchase price was too low.
At the same time, E&Y, the firm responsible for the retrospective reclassification of assets, has gone silent when questioned about the motive and rationale for the purchase price adjustment. Moreover, E&Y has been unable to confirm that SLIC accounts were prepared in compliance with international accounting standards. Similarly, PWC, which structured the transaction and charged exorbitant fees for doing so, has evaded requests to clarify the issue of the purchase price adjustment.
As consultants to the government, the GAP report states that PWC had a responsibility to protect the interests of the Treasury and the public. The administration of PERC that succeeded Jayasundera attempted to clarify the transaction orchestrated by him in favour of offshore holding companies but has received no cooperation from either E&Y or PWC. Apparently, the report says the two auditing firms were working in collusion with the purchasers’ consortium although they were paid by the government to represent the sellers and the public of Sri Lanka. E&Y, as auditor of SLIC – wholly-owned by the government until April 11th 2003 – owed a professional duty of care to the government. Instead, it appears the firm collaborated with the new purchasers of SLIC, even to the point of adjusting SLIC accounts in favour of the purchasers during the period of government ownership..
The conclusion that the auditors collaborated with the purchasers of SLIC is based on numerous discrepancies in the company’s accounts, particularly in the structuring of the deal. The terms of purchase permitted a net working capital adjustment of the sale price that could not be concluded during the period allowed. In another adjustment certified by PWC, the auditors restated the calculation of SLIC’s net profit before tax for 2001, lowering the figure to approximately 20% of the value previously assigned. Having erroneously restated and dramatically reduced the company’s profits for 2001, PWC then projected this diminished value for the next five years. Subsequently in court, the PWC valuation was shown to be grossly erroneous and the Supreme Court annexed to the judgment, the valuation done by one of the Respondents, the PERC Chairman who succeeded Jayasundera. According to court documents, this ‘discounted cash flow valuation’ of PWC together with other accounting manipulations lowered the value of SLIC from approximately Rs.22 billion to bout Rs.5.2 billion.
In addition, PWC based its valuations of SLIC on the book value of net tangible assets taken from a balance sheet rather than on the market value of these assets which was substantially higher. As a result, SLIC’s balance sheet showed the company’s fixed assets had a value of only Rs.329.3 million on January 31, 2001. Two years later however, a Cabinet memorandum dated March 27, 2003 reads as follows: “SLIC recorded a turnover of Rs.7.8 billion with a profit after tax of Rs.753 million and has net assets of around Rs.5.7 billion after revaluation of fixed assets for the financial year ending December 1, 2002 as per the unaudited draft accounts.” In addition, total liabilities were misleadingly overestimated and the brand value of SLIC, a well-established and profitable insurance corporation in Sri Lanka, was not included in the valuation. In total, in appears that the evaluation of SLIC calculated by PWC was less than 20% of the true value of the company.
Conflicts of interest
The GAP report states that none of the above manipulations would have been possible if this transaction had been carried out transparently by government officials and auditors who truly represented the interests of the public. Most importantly, Deva Rodrigo, a senior partner of PWC, was also a member of the Steering Committee that selected PWC as consultants on the transaction. He supervised their work and authorized payments to them while he simultaneously worked for them himself and received a share of such fees as a Senior Partner, PWC Sri Lanka.
As a firm, E&Y too had a conflict of interest. The report stated that the firm continued to be the auditors of SLIC after the purchasers took possession, management and control on April 11, 2003. At the same time, E&Y was committed to audit SLIC accounts on December 31, 2002 and April 11, 2003 for the government, i.e., the sellers.
The report further states that because of its representation on the Steering Committee, PWC was aware of the misconduct of E&Y. As consultants to the government, PWC had failed to discharge its duties, due diligence and responsibility to protect the interest of the government who was the client of PWC. When questioned by PERC under a succeeding administer by letter dated November 17, 2004 about the retrospective reclassification of SLIC investments on December 31, 2001, PWC failed to provide an explanation. Moreover, PWC failed to ensure that SLIC accounts were audited in accordance with international accounting standards. If PWC were going to attract an international investor for the purchase of shares of SLIC, then PWC itself would need to guarantee that SLIC’s accounts were audited correctly by E&Y.
The report said there has been no action taken by the Institute of Chartered Accountants of Sri Lanka (ICASL) which is a quasi-statutory body to which the government grants funds and appoints nominees and as such, has a legal obligation to pursue allegations of misconduct and fraud. As long ago as August 2005, the ICASL received a complaint about the misconduct of E&Y and PWC in the privatization of SLIC.