Nov 2 (Reuters) - Way back in February 2011, the crackerjack
blogger Francine McKenna of re: The Auditors asked an
interesting question in a column for Forbes: Given the
widespread failures of small and regional banks in the financial
crisis, why hadn't the Federal Deposit Insurance Corporation
brought any lawsuits against the audit firms that signed off on
reports that turned out to be materially misleading? McKenna
noted that two private lawyers had predicted such suits were
coming in a column for the Legal Intelligencer, but said so far
none had been filed. By then the FDIC was actively pursuing
directors and officers of failed banks, but auditors seemed to
be off the hook.
That's no longer true. On Wednesday the FDIC, as receiver
for the Colonial Bank of Montgomery, Alabama, sued
PricewaterhouseCoopers and Crowe Horwath in federal court in
Montgomery, claiming that they committed professional
malpractice and breach of contract by failing to detect that two
Colonial employees helped the notorious (and defunct) mortgage
lender Taylor Bean poke hundred-million-dollar holes in
Colonial's balance sheet. (PwC was the external auditor and
Crowe Horwath performed internal audits.)
"All the time that (Taylor Bean) was carrying out an
increasingly brazen and costly fraud against Colonial, PwC and
Crowe never realized that many hundreds of millions of dollars
of bank assets did not exist, had been sold to others, or were
worthless," wrote the FDIC's counsel at Bailey & Glasser and
Mullin, Hoard & Brown. "Missing huge holes in Colonial's balance
sheet and serious gaps in internal control, PwC and Crowe
continued to perform auditing services for Colonial without ever
detecting the (Taylor Bean) fraud. Had they performed their
auditing work in accordance with applicable professional
standards, they would have learned of the TBW fraud in time to
prevent additional losses suffered by Colonial."
Specifically, the complaint asserted that two Colonial
mortgage lending employees permitted since-convicted Taylor Bean
officials to divert money from Colonial without the bank
receiving collateral in return. Taylor Bean allegedly stole
almost $1 billion from Colonial in 2008 and 2009 by promising to
supply it with mortgages that it actually sold to other banks.
Colonial, according to the FDIC complaint, was seized by Alabama
banking regulators in 2009.
You probably recall that auditing firms are frequently the
beneficiaries of an old common-law doctrine called in pari
delicto, which holds that one wrongdoer can't sue another for
the proceeds of their joint misconduct. Depending on how broadly
state courts have interpreted the doctrine (New York offers a
particularly broad reading), in pari delicto generally blocks
companies that engaged in fraud from suing their auditors for
failing to uncover or expose it.
The FDIC seems clearly to be anticipating an in pari delicto
defense. The complaint acknowledges that the two Colonial
mortgage lending employees, Catherine Kissick and Teresa Kelly,
were not only aware of the Taylor Bean scheme but actually
facilitated the illegal diversion of cash. They knew full well
that Taylor Bean's chairman was a "pathological liar and fraud"
who stole from his own company -- yet were so enmeshed in his
scheme that they subsequently pled guilty to aiding the fraud.
Typically, since the actions of employees are imputed to the
corporation, that would make Colonial a wrongdoer right
alongside Taylor Bean -- exactly the scenario in which in pari
delicto would protect its auditors.
But the complaint paints the Colonial lending officials as
rogue employees who acted in their own interest but against the
interest of the bank. "At no time did this fraud benefit
Colonial," the complaint said. "Rather, the fraud perpetrated
was against Colonial, harmed Colonial, was to the detriment of
Colonial and resulted in Colonial lending (Taylor Bean) many
hundreds of millions of dollars that were secured by worthless
or non-existent loans." If the FDIC can show that Kissick and
Kelly were explicitly acting for themselves and against the
interests of the bank, in pari delicto may not shield the
auditors.
PwC is represented by Elizabeth Tanis of King & Spalding,
who took issue in a statement with the FDIC's assertions. "The
Colonial Bank executive who spearheaded the fraud on the
Colonial Bank side has testified that her actions were motivated
by a desire to prevent loss to the bank and to save an important
client relationship. She further testified that (Taylor Bean)
was paying Colonial Bank $20 million to $30 million per month in
interest," Tanis said. Moreover, Tanis said, auditors can't be
expected to have uncovered a fraud that was "so well-concealed
that neither the FDIC nor the OCC discovered it, even when they
performed targeted exams of the mortgage warehouse lending
division, where the fraud occurred."
A Crowe Horwath representative sent an email statement: "The
FDIC's claims are without merit, and Crowe stands behind our
work and the people who performed it."
(Reporting By Alison Frankel)
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