WASHINGTON (Legal Newsline) - Auditors are paid to make sure a company’s books are accurate. Fraud artists specialize in misleading auditors. So should an auditor pay for the damages caused by a fraud artist?

That’s the question that may be decided in a trial beginning in federal court in Washington, D.C., during a trial that began Monday, over whether Big Four accounting firm PricewaterhouseCoopers is responsible for $2.5 billion in losses by failing to uncover a long-running fraud at Colonial Bank, an Alabama bank that failed in 2009. The law in this area is surprisingly murky.

The fraud was engineered by the former chairman of Taylor Bean & Whitaker, Colonial’s biggest mortgage banking customer, with the help of a top executive within the bank. It went undetected not just by PwC, but another outside accounting firm hired to conduct internal audits, state and federal banking regulators and even a third accounting firm that conducted a forensic audit after Colonial grew suspicious about Taylor Bean.

None of that deterred the Federal Deposit Insurance Corp., which is among the regulators that missed the fraud. It is suing PwC for the money it lost in the bank’s collapse. And in rulings including an order issued last week, U.S. District Judge Barbara Jacobs Rothstein has rejected most of PwC’s defenses.

Due to quirks in the underlying contracts between PwC and Colonial bank between 2002 and 2009, the accounting firm first faces a bench trial before Rothstein, and then a second jury trial scheduled for January.

PwC argued unsuccessfully the legal doctrine of in pari delicto – legal Latin for “in equal fault” – bars the FDIC, which is standing in Colonial’s shoes, from collecting money for crimes its own employees committed. The accounting firm also argued that Alabama is one of four states that prevents plaintiffs that are themselves negligent from suing third parties for damages stemming from their negligence.

There’s no question Colonial was negligent. Its internal auditors failed to discover an audacious fraud in which, Catherine Kissick, the head of its mortgage lending department, “bought” hundreds of millions of dollars in mortgages from Taylor Bean that Taylor Bean either didn’t own or had pledged to other lenders. Kissick, who was sentenced to eight years for the fraud, also allowed Taylor Bean to “sweep” Colonial’s money into an overdraft account to keep it from going broke.

PwC says Colonial had other problems, including failed investments in Florida real estate that hastened the bank’s collapse.

“The failure of the bank had nothing to do with auditing or accounting,” said Matthew Brewer, an attorney with Bartlit Beck representing PwC at trial. “The bank had its own failed strategies that over time caused it to suffer and fall apart.” 

PwC also says it adhered to Generally Accepted Accounting Standards, under which auditors must make a reasonable attempt to verify the financial statements of their clients. Auditors aren’t insurers under GAAS, however, and auditing standards assume even a “properly planned and performed audit may not detect a material misstatement resulting from fraud.

“If you’re trying to lie to me, it’s very difficult for me to get around that,” said Steven Kachelmeier, chair of the accounting department at the University of Texas McCombs School of Business. “Where it becomes especially difficult is when there’s collusion involved.”

Public policy should prevent companies from profiting from frauds their own employees committed, PwC says. The reasoning behind in pari delicto was summed up by U.S. District Judge Richard Posner in a 1982 decision: “If the owners of the corrupt enterprise are allowed to shift the costs of its wrongdoing entirely to the auditor, their incentives to hire honest managers and monitor their behavior will be reduced." 

Judge Rothstein rejected most of PwC’s arguments, saying there was room for the FDIC to prove that the fraud was so blatant, and PwC’s audits so deficient, that the bank’s failure wouldn’t have occurred but for PwC’s negligence. To that extent, the lawsuit is similar to a routine slip-and-fall case: Had you paid the slightest attention to the water your employee spilled on the floor and mopped it up, I wouldn’t have fallen and broken my knee. 

Will it work? The law in this area has been evolving, and PwC has already settled numerous cases, including ones involving Colonial Bank. It recently settled during trial a $3 billion lawsuit by the receivers of bankrupt MF Global, after failing to convince the judge to dismiss the case on in pari delicto grounds.

In that case, the plaintiffs said PwC facilitated former MF Global Chairman Jon Corzine’s disastrous strategy of buying levered positions in European sovereign debt."

Until Arthur Anderson was driven into liquidation over its role in the failure of Enron Corp. in 2002, “there was a pretty strong demarcation” between the auditor and its client over fraud, said Kachelmeier, the UT accounting expert. “Any responsibility to uncover fraud lay with the client.”

That changed with Enron and other scandals of the era like Worldcom and HealthSouth, he said. Auditors are now expected to take a more assertive role in verifying their clients aren’t lying to them, including “brainstorming sessions” at the beginning of an assignment in which the audit team identifies risk areas and strategies to ensure the quality of information obtained from them.

The problem comes when there is collusion between the client and an outside company that also provides corroborating evidence that transactions are legitimate. Taylor Bean verified the mortgages Colonial was buying were legitimate, for example, when in fact it had fraudulently borrowed against them from others.

“The cornerstone of auditing is don’t take the client’s word for it – corroborate with another source,” Kachelmeier said. “Well if the other party is in on it with you, we’re asking a lot of auditors to try and uncover that level of fraud.” 

The FDIC says PwC’s oversights were unreasonable and the audit firm failed to verify that Colonial’s internal controls were sufficient, as required under Sarbanes-Oxley. If PwC had reported the truth about the transactions, the plaintiffs say, “Colonial would not have continued such transactions with TBW and would have avoided over $1 billion in losses for which PwC should be held accountable.” 

One thing that is virtually certain in this case: The FDIC won’t recover $1 billion, or anything close to it. Accounting firms like PwC are private partnerships with slim assets and reportedly little in the way of insurance. The firm’s previous settlements have all been confidential but it is unlikely they exceeded tens of millions of dollars apiece. As insurers against business losses, accounting firms are hardly the equal of an Aetna. 

“If auditors had to pay the nominal value of the claims being brought against them, there wouldn’t be a Big Four,” Kachelmeier said.

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