WASHINGTON (Legal Newsline) - A federal judge in Washington has found accounting giant PwC liable to the Federal Deposit Insurance Corp. for failing to catch the multibillion-dollar fraud that took down Colonial Bank, even as she rejected similar claims by the bank and its holding company because they were complicit in the fraud.

The 92-page decision issued last week by U.S. District Judge Barbara Rothstein raises the question of how the FDIC, which stands in the shoes of Colonial Bank as receiver for the failed institution, can collect from PwC for a fraud when the bank itself is barred.

Rothstein ruled that the Alabama bank and its holding company were barred from recovering money over the fraud because their employees perpetrated the crime or knew about it.

Rothstein departed from precedent by raising the FDIC to a higher status as plaintiff than the bank, said Michael J. Dell, a partner with Kramer Levin who doesn’t represent either of the parties in the case.

“I would think PwC will win on this issue on appeal,” Dell said. Court-appointed trustees like the FDIC have the legal authority to sue on behalf of the estate of a failed business, but they also inherit that institution’s legal status, he said.

In this case, Rothstein explicitly rejected Colonial’s arguments it was entitled to damages over the fraud while leaving open the possibility she will order PwC to pay the FDIC anyway.

“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,” PwC said in a prepared statement. The accounting firm “intends to appeal that novel ruling at the earliest possible opportunity.”

Colonial failed in 2009 after bank employees were drawn into a fraud scheme engineered by Lee Farkas, the former chairman of mortgage lender Taylor Bean & Whitaker. It started when Taylor Bean began racking up large overdrafts in the account it used to fund mortgages and Colonial employees devised a scheme to hide them from regulators and auditors. Farkas and several Colonial employees went to prison over the fraud.

It was known to top managers in the mortgage department, who circulated an email providing false explanations to give PwC auditors if they discovered it.

Farkas also got an assist from Bank of America, which as custodian for mortgage securities allowed Taylor Bean to effectively double-sell the loans, stripping Colonial of more than $900 million in collateral and triggering its demise. Rothstein ruled that BoA represented an ”intervening cause” of those later losses and barred the FDIC from recovering on claims relating to the double-selling scheme.

The judge did rule for the FDIC on claims PwC didn’t follow professional standards. The accounting firm would have uncovered the fraud in the early days had it pulled individual mortgage documents to verify that Taylor Bean was putting up collateral for its loans. Instead, the accounting firm assigned a college intern to evaluate the $589 million account and failed to heed clear warning signs of fraud, the judge ruled.

Because of these missteps, the judge ruled, PwC is guilty of breaching its professional duties to the FDIC and Colonial. She denied the claims of Colonial and its holding company, however, under the legal doctrine of in pari delicto, under which the party to a crime can’t collect damages stemming from it.

The judge, who sits in Washington but was assigned to hear this case from the Middle District of Alabama, also applied Alabama law to find that Colonial surrendered its right to collect from PwC because its employees actively interfered with the auditing firm’s efforts to uncover fraud.

The case now proceeds to the damages phase, where it is unknown how much Rothstein will award the FDIC for professional negligence. By holding the FDIC eligible to collect on claims the bank is barred from pressing, however, the judge has entered new territory.

PwC argues it can’t be ordered to serve as insurer for a fraud neither it nor state and federal banking regulators uncovered. If the judge’s ruling stands, it very well may be stuck with that role and on the hook for hundreds of millions of dollars in damages. That could mean higher costs for future clients of auditing firms, as they are forced to add the cost of a huge potential liability into every assignment.

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