Something unexpected just happened… A tiny piece of earth was lobbed into a very deep, regulatory black hole.
The Senior Judge of the United States District Court for the Western District of Washington, Judge Barbara Jacobs Rothstein, ruled last week that the accounting giant PwC was liable for failing to uncover a multibillion-dollar fraud that sank Alabama-based Colonial Bank in 2009.
Allowing the FDIC to try and collect the $2.5 billion Colonial’s demise cost the FDIC’s insurance fund puts the accounting industry on notice – especially Deloitte, Ernst & Young, KPMG, and PricewaterhouseCoopers, who collectively audit companies that account for 98 percent of the value of U.S. stock markets. Auditors may be liable for inadequate or fraudulent audit reports they typically rubber stamp with gold-stars.
Unfortunately, it’s only a shovelful of earth that probably won’t hit the bottom of the deep regulatory hole accounting giants swim freely in. Still, there’s a potential here for a ripple effect that could end up changing the broken system that allows this level of fraud to happen under auditors’ noses.
First, Just the Facts
Catherine Kissick, the head of Colonial Bank’s mortgage lending department, aided and abetted an insane fraud perpetrated by Colonial’s biggest mortgage banking customer, Lee Farkas, the former chairman of bankrupt mortgage lender Taylor, Bean & Whitaker.
Kissick “bought” hundreds of millions of dollars in mortgages from TBW that they didn’t own or had previously pledged to other lenders. She also allowed the failing business to freely “sweep” money from Colonial accounts into a TBW overdraft account, to keep insolvent TBW afloat in the financial crisis.
Taylor, Bean & Whitaker collapsed. Its chairman, Lee Farkas, was sentenced to 30 years in prison. Six other TBW executives went to jail for their roles in the scheme, and Catherine Kissick was sentenced to eight years for fraud.
Deloitte, TBW’s external auditor, settled with TBW’s bankruptcy trustee for an undisclosed sum in 2013.
Colonial Bank collapsed in 2009 when it was discovered there wasn’t any collateral behind the loans it made to TBW.
That’s the straight and narrow view of what happened, and it’s incriminating enough. But now it gets even more complicated.
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Loopholes Standing in the Way of Justice
The FDIC, which “stands in the shoes of Colonial Bank as receiver for the failed institution,” is suing PwC (Colonial’s outside auditor) for not uncovering the TBW scheme in its regular audits of the bank. By law, the bank itself is barred from suing or recovering any money because the bank’s own employees either perpetrated the fraud or knew about the crime.
PwC, in its defense, claimed the FDIC, acting on behalf of Colonial, couldn’t sue because it was the same as the bank suing it. But Judge Rothstein ruled that, while Colonial Bank and its Alabama holding company were barred from recovering anything, the FDIC’s case had enough merit to go forward.
According to Michael J. Dell, a law partner with Kramer Levin who isn’t representing any party in the case, Judge Rothstein departed from precedent by “raising the FDIC to a higher status as plaintiff than the bank.” Dell said, “I would think PwC will win on this issue on appeal.”
Specifically, Dell acknowledged, while court-appointed trustees have the right to sue on behalf of the estate of a failed business, they also inherit that institution’s legal status.
Even before PwC faces trial in the case, it’s claiming: “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.”
In a prepared statement PwC said it, “… intends to appeal that novel ruling at the earliest possible opportunity.”
So the little piece of hope thrown into the regulatory black hole that might hold accounting firms responsible for evergreen audits, the same way rating agencies rubberstamp credit ratings of companies that pay them to tell investors they are safe and sound, might never see the light of day.
History Repeats Itself
That’s not because the case is not going to trial – it is. It’s just that PwC will settle long before any judge or jury hears all the facts and must render a verdict.
PwC and the other “Big Four” accounting firms all had clients that failed, were bailed out, or were effectively nationalized during the crisis.
All of them were sued. Not a single one of those cases went to trial but were settled instead.
Ernst & Young LLP paid $99 million to investors and $10 million to the New York attorney general’s office for its role as auditor of Lehman Brothers Holdings Inc.
KPMG settled for an undisclosed amount for its audit of the mortgage originator and fraudster New Century and paid $24 million for its audits of insolvent Countrywide Bank, which was sold to Bank of America.
Deloitte settled its exposure as auditor of Bear Stearns for $19.9 million, and as auditor of failed Washington Mutual contributed $18.5 million to a settlement with investors for its negligent audits.
The chance of PwC being held accountable now is exactly between slim and none. Why? Because accounting firms, like rating agencies, are “protected” businesses.
On Monday, I’ll tell you exactly who protects them, and what will happen next in this shady saga.