WASHINGTON (Legal Newsline) - A federal judge has put a damages trial on hold in the Federal Deposit Insurance Corp.’s multibillion-dollar lawsuit against accounting firm PwC over 2009 failure of Colonial Bank Group, saying she was behind schedule on determining the threshold question of liability.

In an Oct. 31 order, U.S. District Judge Barbara Rothstein said her “original estimate for issuing the liability order was unrealistic.” She canceled all pending dates for future bench trials and said she’d hold a status conference within two weeks of issuing her anticipated order on liability.

Rothstein heard testimony in a four-week bench trial that ended Oct. 23, in which the FDIC argued PwC was responsible for failing to uncover a long-running fraud involving Alabama-based Colonial and its largest customer, Taylor Bean & Whitaker.

Colonial failed in 2009 after the fraud was discovered, and both the chairman of Taylor Bean and several Colonial executives went to jail for perpetrating the scheme to hide a ballooning cash shortfall at the mortgage origination firm.

The lawsuit, if it proceeds to verdict, would represent a key test of the limits of auditor liability for fraud. The FDIC, along with trustees for bankrupt companies, are increasingly suing accounting firms over their failure to uncover fraud that leads to large losses. Accounting firms argue they can’t serve as insurers for losses caused by the crimes of others, but have settled most of the cases so far for undisclosed amounts.

The multi-phase litigation over PwC’s responsibility for the collapse was supposed to proceed to a damages trial on Nov. 27. PwC could still face a jury trial, though one that was scheduled has since been canceled, over the same issues due to a quirk of Colonial’s engagement letters with its auditors that in most years precluded a jury trial, but allowed for one in the audit years 2006-07.

The fraud was engineered by Lee Farkas, the former Taylor Bean & Whitaker chairman, with the help of executives within Colonial’s mortgage-lending group. It started when Taylor Bean began racking up large overdrafts in the account it used to fund mortgages until it could sell them to Colonial and other financial institutions.

Colonial employees covered the overdrafts up by “sweeping” cash from Colonial accounts into TBW’s account overnight. The overdraft had grown to $220 million by 2005 and was known to top managers in the mortgage department, who circulated an email providing false explanations to give PwC auditors if they discovered it.

Not only did PwC fail to uncover the fraud in audits from 2002 to 2008, but it went undetected by state and federal regulators, Colonial’s internal audit team staffed with more than 100 CPAs, and Ernst & Young, which was hired shortly before the bank collapsed to perform a forensic investigation specifically on whether money was improperly being funneled from Colonial to TBW.

The fraud was ultimately discovered by FBI agents who were investigating Taylor Bean’s proposed $300 million capital injection into Colonial as it was failing, to make sure Colonial wasn’t actually lending the money that would be used to prop it up.

“That none of these actors was able to find the fraud shows that it was particularly well concealed,” says PwC, in a 178-page post-trial filing summing up its arguments in the case. “The fraudsters used their high positions at TBW and Colonial Bank, and their extensive knowledge of the Bank’s systems and internal controls, to mask the fraud and manufacture false evidence.”

PwC says it shouldn’t be required to insure the FDIC against losses caused by others, and can’t be found liable under Alabama law because of Colonial Bank’s failure to provide accurate financial information and its employees’ interference in efforts to detect fraud.

The FDIC, in its own filing, says PwC should have done random samples of TBW mortgages but never pulled a single one. Its accounting expert testified at trial that there were numerous additional procedures the auditors could have performed that would have detected the fraud.

PwC argued any samples of mortgage files would hardly be random, since a Colonial executive who later pleaded guilty to fraud controlled the data room where they were stored. As evidence Colonial employees interfered with PwC’s efforts to uncover fraud, the accounting firm cited internal emails in which employees in the mortgage department were instructed to give auditors only the information they requested and “never volunteer extra.”

Before the liability trial began at the end of September, 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.

PwC, like most big accounting firms, is a private partnership that likely can pay only a tiny fraction of the billions of dollars in damages the FDIC is seeking. It settled a similar lawsuit over its alleged responsibility for the bankruptcy of Taylor Bean last year in mid-trial. In March of this year, it settled a $3 billion lawsuit over the collapse of commodities broker MF Global, also mid-trial, for an undisclosed amount.

Neither PwC nor the FDIC will comment on the pending litigation.

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