If an accounting firm fails to detect massive fraud that busts the state’s third largest bank, can it be held liable?
Accountable, maybe, yet not liable. You could fire them, sure. But sue them?
At least that’s the way things seemed until a recent court decision that marks the first time an audit firm has been found liable for not detecting fraud.
The legal marathon that recently broke through this legal limit includes accounting giant PricewaterhouseCoopers, the Federal Deposit Insurance Corp., Alabama’s now-defunct Colonial Bank and bankrupt mortgage lender Taylor, Bean & Whitaker, and it appears to be nearing the finish line after nearly a decade.
PricewaterhouseCoopers is the defendant in a lawsuit brought by the FDIC that sought to hold PwC liable for not detecting fraud during audits of the Colonial Bank — at the time, the third largest bank holding company in the state, with assets of more than $25.6 billion.
U.S. District Judge Barbara Jacobs Rothstein last December ruled that the accounting firm was negligent and said in her 92-page decision, “PwC did not design its audits to detect fraud and PwC’s failure to do so constitutes a violation of the auditing standard.”
Judge Rothstein has scheduled a three-day hearing for March 20-22 in Washington, D.C. to determine damages against PwC, which the judge ruled negligently failed to find a $2.3 billion fraud scheme between Colonial Bank and Taylor Bean.
A trial is scheduled to start April 3 for claims against PwC co-defendant and second Colonial auditor Crowe Horwath, which is expected to last three to four weeks, with the first and last weeks in Washington, D.C. and the middle weeks in Montgomery.
The FDIC has served as the receiver for Colonial since its 2008 failure and sued both PwC and Crowe Horwath, alleging the firms should have learned of the mortgage fraud scheme and should not have signed off on the audits.
Complicating the case is the fact that two executives at Colonial pleaded guilty in connection with the fraud and tried to keep the scheme secret during the auditing process.
Judge Rothstein last year ruled that the defendants in the case — the two accounting firms — could not avoid liability to the FDIC by pointing to Colonial’s involvement in the fraud and said that she believed the Alabama Supreme Court would allow the FDIC to pursue the case.
In a statement, PwC said it “is pleased that the Court properly rejected all of the claims asserted by Colonial BancGroup, as well as several of the key claims asserted by the FDIC. The Court’s ruling recognizes that in addition to those CBG employees who perpetrated the fraud, numerous other employees at Colonial Bancgroup actively and substantially interfered with PricewaterhouseCoopers’ audit. The FDIC was only able to prevail on the claim that it did based on an earlier novel ruling by the Court that immunized the FDIC from imputation-based defenses. PricewaterhouseCoopers intends to appeal that novel ruling at the earliest possible opportunity. PricewaterhouseCoopers is also pleased with the Court’s finding that it did not cause a substantial portion of the damages the FDIC is seeking. PricewaterhouseCoopers looks forward to the damages phase where the FDIC will bear the burden of proof on what remains of their inflated damages claim.”
An attorney who has represented the FDIC in the case said he is not allowed to comment, but another attorney who has been following the case and asked not to be identified, said, “If I were an auditor at a smaller Alabama-based firm or a smaller firm that does work in Alabama, I would be a little nervous about the carte blanch the judge has given the FDIC.”
But accounting professors and financial minds around the state say they don’t see the ruling as much more than a wake-up call.
“The outside fallout is relatively minor, ” says James Barth, Ph.D., Lowder Eminent Scholar in Finance at Auburn University and a Fellow of the Wharton Financial Institutions Center.
“The big firms have been around a long time, and everybody knows now and then they are likely to be sued. If it is a federal regulator, that tends to attract a little more attention than if it is a small firm suing an outside auditor, ” Barth says.
“Accounting firms are sued fairly often for lost assets that have occurred, sometimes because they have deep pockets, sometimes because they may not have engaged in appropriate behavior. I don’t think the fact that PwC or any major accounting firm is sued tells us much at all.
“This is probably not a surprise to most big firms. By and large, it also is the view by some that these auditing firms have deep pockets, and if there are big losses that have occurred, you turn to somebody with deep pockets and blame them for the losses and sometimes you are able to convince the courts.”
According to Don Minyard, Ph.D., CPA, who teaches accounting at the Culverhouse College of Commerce at the University of Alabama, the current standard on fraud goes back to 2002 and the Enron scandal, which led to the Sarbanes-Oxley Act, a federal law that was a comprehensive reform of business practices. The 2002 Sarbanes-Oxley Act focuses on public accounting firms that participate in audits of corporations and was passed in response to a number of corporate accounting scandals that occurred between 2000-2002.
“The standard on fraud has been in place since 2002, ” says Minyard. “It came out of the Enron matter. The standard is, we have to exercise professional skepticism in our audits. There is really no change in our professional requirements. If somebody has not been complying, I would say this is a good wake-up call.”
Minyard says that since the Enron matter some auditing rules on risk assessment were changed. “Auditors always take a risk that the financial statements are not properly presented, ” Minyard says. “When the auditor says the statements are properly represented and they are not, we call that an audit failure. We have always had that risk and we are supposed to be mindful of the risk.”
Barth points out those accounting firms “do not claim to be able to ferret out any fraud.”
“If there is any fraud involved in any transactions that are unaware to the accounting firm, their view would be that they should not be held accountable for any subsequent developments, including the failure of firms.”
An accounting firm, Barth says, can say “we are not in the business of trying to provide opinions of whether there is fraud taking place at an institution when we do an audit.”
Josh Pierce, Robert Hunt Cochrane/Alabama Banker’s Endowed Chair of Banking at the University of Alabama, agrees with Barth that the job of the auditor is “not to look for fraud.”
“When you are auditing, you really are giving your opinion, ” Pierce says. “You are not necessarily supposed to go in and rake the company over the coals.” Pierce says smaller accounting firms “are surely cognizant of what is going on with PwC but they are not dealing with as large or as complex assets as a huge firm.”
Pierce says the consequences of holding small accounting firms liable for not finding client fraud may be more severe than with the larger firms.
“The PwC case is unbelievably complicated, but you can have complicated schemes in small companies. It just might be harder to hide those things, ” Pierce says.
Barth says there has been a growing reliance on smaller accounting firms as auditors. “The big firms still dominate, but if you are a smaller company, you may go to a smaller auditing firm, ” he says.
Barth also points out that financial firms are regulated by government regulators like the FDIC. “Federal regulators have access to funds that other firms don’t have access to. Sometimes you feel like if it is a regulator firm like the FDIC, they can come after you for a long time with a lot of resources, ” he says.
Bill Gerdes is a freelance contributor to Business Alabama. He is based in Hoover.