PwC faces 3 major trials that threaten its business

Philip Merrill’s notes:

1) Do Auditors need to be seasoned professionals in the businesses they audit?

2) Or, CPA’s that have to take the customers word for accuracy in financial statement representation including notes.

By Francine McKenna

Published: Aug 15, 2016 12:32 p.m. ET

The Big Four global audit firms go to court all the time but are rarely put on trial.

PricewaterhouseCoopers LLP, the U.S. member of the global professional-services giant, is currently facing not one, not two, but three significant trials for allegedly negligent audits. An unfavorable verdict in the trial currently playing out in a Florida state court could inflict a significant monetary wound. That, combined with a possible unfavorable judgment in another trial scheduled for federal court in Alabama in February of 2017, and a third in a Manhattan federal court within the next year, may be fatal.

The case against PwC brought by the Taylor Bean and Whitaker bankruptcy trustee is quite unusual, said Tom Rohback, an attorney with Axinn Veltrop & Harkrider. That’s because it is one of the few cases from the credit crisis seeking to hold auditors responsible for crisis-era losses to actually go to trial.

“Beyond the $5.5 billion sought, the case is unusual because the plaintiff is the trustee of the entity that committed the fraud and is suing not its own audit firm but the audit firm of the institution it defrauded,” he said. “

Settlements preferred

In the U.S. the Big Four audit firms have, in recent history, almost always settled because of the fear that one catastrophic jury verdict could shut them down for good. In addition, trials show the public just how often auditors fail to detect fraud. Settlements prevent the public from hearing that in open court and typically put partners’ pretrial testimony under confidential court seal forever.

‘The trial has the potential to influence public perception of auditors, as well as strategies used by the plaintiff lawyers that try cases against them, regardless of the eventual verdict.’

Tom Rohback, Axinn Veltrop and Harkrider

The bankruptcy trustee for Taylor Bean & Whitaker Mortgage Corp., once the 12th-largest U.S. mortgage lender, sued PwC for $5.5 billion in damages in 2012 after the bank went bankrupt in August 2009. Federal regulators, not the bank’s auditor, Deloitte, uncovered a $3 billion fraud involving fake mortgage assets. The bankruptcy trustee for Taylor, however, alleges that PwC was negligent in not spotting the fraud from its perch as auditor of Colonial Bank, which bought the allegedly fake mortgages that Taylor Bean had originated and that made Taylor Bean’s losses worse.

Beth Tanis, the lead attorney for PwC from the firm King & Spalding, issued a statement at the beginning of the trial: “PricewaterhouseCoopers did not audit or perform any other services for Taylor Bean. With regard to the services performed for Colonial Bancgroup, one of the targets of Taylor Bean’s fraud, PricewaterhouseCoopers did its job,” said Tanis. “As the professional audit standards make clear, even a properly designed and executed audit may not detect fraud, especially in instances when there is collusion, fabrication of documents, and the override of controls, as there was at Colonial Bank. We are confident that a jury will understand the applicable rules and standards in this case and decide accordingly.”

A spokeswoman for PwC declined to provide further comment.

Six Taylor Bean executives went to jail for their roles in the fraud. The bank’s former chairman, Lee Farkas, was sentenced to 30 years in prison. Taylor Bean auditor Deloitte settled with the trustee for an undisclosed amount in 2013.

The bankruptcy route

Colonial Bank, a Montgomery, Ala., institution with $25 billion in assets, also filed for bankruptcy in 2009. The Colonial Bank bankruptcy trustee and the Federal Deposit Insurance Corp. brought a lawsuit in 2012 against PwC for negligence as the auditor of Colonial Bank, claiming $1 billion in damages. That case is scheduled to go to trial in February.

The FDIC’s suit was its first against an auditor for a financial-crisis-era bank fraud or failure. Crowe Horwath LLP, Colonial’s outsourced internal audit firm, is also named in the Colonial suit. (Remember Arthur Andersen internal and external auditor for Enron?)

Tanis, in her opening statement at the trial on Aug. 9, said that no one at Taylor Bean relied on PwC’s audit of Colonial Bank, even though Colonial was Taylor Bean’s biggest mortgage buyer.

“There will be no document showing you that these directors or anybody else at Taylor Bean ever received these Pricewaterhouse audit reports, actually read these Pricewaterhouse audit reports and relied on them,” she said.

Largest Banking Regulatory Fines (2008 – 2015)

Bank

Date

Fine Amount

Description

Bank of America

August 2014

$16,650,000,000

Settlement to resolve allegations of misselling mortgage-backed securities. The … Show More

Bank of America

February 2012

$11,820

Part of the National Mortgage Settlement; $8.6bn paid as relief to borrowers, $3 … Show More

Bank of America

January 2013

$11,600

Settlement resolving repurchase requests of faulty mortgage sales. Bank agreed t … Show More

Bank of America

March 2014

$9,330

Settled charges of misleading investors over mortgage backed securities.

Citigroup

July 2014

$7,000,000,000

Settled charges of misleading investors over mortgage backed securities. $4bn pa … Show More

JPMorgan Chase

November 2013

$13,000,000,000

Part of $13bn settlement; $4bn paid as relief to consumers, $2bn paid as civil penalty

Wells Fargo

February 2012

$5,350

Part of the National Mortgage Settlement; $4.3bn paid as relief to borrowers, $1 … Show More

JPMorgan Chase

February 2012

$5,290

Part of the National Mortgage Settlement; $4.2bn paid as relief to borrowers and … Show More

JPMorgan Chase

October 2013

$4,000

Part of $13bn settlement; settles federal and state claims by FHFA.

JPMorgan Chase

October 2013

$4,000

Settlement over securities laws violations in connection with mortgage-backed se … Show More

Bank

Date

Fine Amount

Description

Data collected from the Financial Times on May 20, 2015.

See more details ›

Taylor Bean’s employees, customers and creditors, who all lost something when the firm went bankrupt, were relying on Colonial Bank to operate as an honest business partner that was accurately reflecting its financial obligations to Taylor Bean, a point emphasized by Steve Thomas, the attorney for the Taylor Bean trustee, in his opening statement on Tuesday.

Thomas told the jury that PricewaterhouseCooper’s failure mattered, because many people were counting on it to do its job. “PwC was lending credibility to Colonial’s financial statements. PwC’s failure mattered because Taylor Bean and Whitaker, and others, relied on PwC to do its job,” he said.

‘PwC was lending credibility to Colonial’s financial statements. PwC’s failure mattered because Taylor Bean and Whitaker, and others, relied on PwC to do its job.’

Steve Thomas, attorney for Taylor Bean trustee

PwC and the other Big Four accounting firms all had major clients that failed, were bailed out or were effectively nationalized during the crisis. None of those cases went to trial. 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 its exposures early, and within a week of each other in 2010 settled for an undisclosed amount for its audit of New Century, another big mortgage originator, and paid $24 million for its audits of Countrywide Bank, which was distressed when it was sold to Bank of America BAC, +0.74% .

Deloitte settled its exposure as auditor of Bear Stearns for $19.9 million. Bear Stearns was bought for a relative pittance by J.P. Morgan JPM, +0.61%  during the crisis. Deloitte was also the auditor of Washington Mutual and contributed $18.5 million to a settlement with investors for its negligent audits. Deloitte went on to earn hundreds of millions of dollars reviewing J.P. Morgan’s exposure to foreclosure fraud claims for Bear Stearns and Washington Mutual mortgages it inherited as part of those purchases.

The litigation hit

Those settlements pale in comparison to the total of $6.5 billion that Taylor Bean and Colonial Bank trustees are looking for from PwC. On Aug. 5 U.S. District Judge Victor Marrero in Manhattan rejected PwC’s request to dismiss MF Global’s lawsuit alleging professional malpractice that contributed to the October 2011 bankruptcy of the brokerage firm once run by former New Jersey Gov. Jon Corzine. That suit is seeking $1 billion in damages, bringing the total potential claims PwC is facing over a very short period to $7.5 billion.

Jim Peterson, a former in-house attorney for Arthur Andersen and the author of the book “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms,” has periodically asked the question on his blog: “How big is the ‘worst case’ litigation hit that would disintegrate one of the surviving Big Four?”

Back in September 2006, a report by the consulting firm London Economics to the EU markets commissioner modeled the collapse of a Big Four partnership in the U.K. That model quantified the level, according to Peterson, “of personal sacrifice, beyond which the owner-partners would lose confidence, withdraw their loyalty and their capital, and vote with their feet.”

Peterson’s analysis concluded that critical numbers of partners would defect and put a firm into a death spiral, if they faced a partner-income-distribution reduction of 15% to 20% that extended over three or four years. Peterson extended the figures to the global level to calculate breakup figures for the Big Four. That brought the number down from an optimistic maximum of about $7 billion to about $3 billion.

However, global numbers assume that a Big Four network under deadly financial threat could hold it together and count on the support of its member firms and partners around the world. But that’s not what happened to Arthur Andersen after the bankruptcy of client Enron and an indictment for obstruction of justice in 2001. Instead, Andersen’s non-U.S. member firms flew the coop in 2002, and the firm itself was forced to fold.

Based on the experience of Arthur Andersen, it is unlikely, Peterson told MarketWatch, that PwC’s non-U.S. member firms would pitch in to pay a U.S.-based catastrophic court judgment or a series of them. Peterson’s most recent update of his tipping-point calculation, completed in early 2015, assumes the U.S. firm is left to pay its own way out, as was Andersen’s U.S. firm. The worst-case tipping points for the U.S. practices shrinks from the $3 billion global number down to $900 million for the most financially vulnerable of the four firms.

These numbers matter, according to Peterson, because the loss of another Big Four firm would throw the entire system into chaos.“There is no contingency plan or readiness among the three survivors to stay in an even more risky business or take on the failed firm’s risky clients or outstanding litigation claims,” he said.

The Petrobras angle

The three lawsuits against PwC that are on trial or going to trial in the next year all name only the U.S. firm as a defendant. Another large case names PwC’s Brazil member firm for its allegedly negligent audits and failure to detect a multibillion-dollar bribery and corruption fraud at the state-sponsored oil company Petrobras.

Those plaintiffs, which include the Bill Gates Foundation, could decide to name PwC U.S. as a defendant or eventually require the U.S. firm to ante up to pay a verdict that would otherwise knock out the Brazilian firm, a key cog in its service network for multinational clients.

MarketWatch asked Rohback why PwC would choose to go to trial given the stakes. “Oh, they probably didn’t choose to try the case. They just haven’t hit on a settlement number they can stomach yet,” he said.

PwC has few options at this point, Rohback said. “There’s still time to settle, and they could win it. If they lose, they can ask the judge for a stay in enforcing any judgment until an appeal can be heard.”

Florida law prohibits judgments that would bankrupt a defendant. PwC would probably be reluctant to go to court and open its books to prove it was too poor to pay a judgment. However, in a previous case against an audit firm in Florida tried by Taylor Bean trustee attorney Thomas, the court allowed audit-firm partners to be paid “profits” each year before considering claims of any parties damaged by the firm’s frauds or gross negligence.

Audit firms have no duty to reserve for or disclose serious legal contingencies, since they are partnerships. Thomas had to file a motion to force discovery because he suspected that while the case was under appeal “assets have been or are being dissipated or diverted while such a stay is in place.”

Francine McKenna

Francine McKenna is a MarketWatch reporter based in Washington.

Email Francine at fmckenna@marketwatch.com

New From Credit Suisse: Bonds for Self-Inflicted Catastrophes

Sagacious LLC will help customize a similar program to save op risk regulatory capital at your institution. 

By ANUPREETA DAS and LESLIE SCISM
May 16, 2016 1:21 p.m. ET WSJ

Credit Suisse Group AG is going to give it a try in the bond market. The bank plans as early as this week to launch unusual new securities that would pay investors relatively high interest rates. The catch is Credit Suisse could take their principal if incidents like rogue trading, information-technology breakdowns or even accounting errors lead to massive losses for the bank, people familiar with the offering said.

The deal is a first-of-its-kind twist on the “catastrophe bonds” that insurers have used for years to lay off the risk of natural disasters like hurricanes. Credit Suisse’s offering covers self-inflicted disasters as well as external events and has been marketed to hedge funds and other big investors.

The insurance feature of the bonds would be triggered if Credit Suisse’s annual operational risk-related losses cross $3.5 billion. Buyers have a level of comfort, however, because it’s a “second-event” bond. The most any single event could contribute to the trigger is $3 billion, meaning it would take more than one event to cross the threshold. The odds of that are remote: Credit Suisse has put them at roughly 1 in 500, the people said.

A Credit Suisse spokeswoman declined to comment.
The appetite for such offerings in the capital markets, as persistently low interest rates send investors searching for higher yields, is encouraging Wall Street companies to test new uses for the structure.

MORE

Heard on the Street: Credit Suisse Takes Out Insurance on Itself
Insurance-industry executives said that they haven’t previously seen a bank attempting to tap capital markets to cover this type of risk. The move has its roots in regulation. Under European bank rules, banks must calculate operational risk and may use insurance products as part of meeting their capital requirements, according to industry participants.

In general, operational risk is the possibility of losses resulting from insufficient internal controls, errant systems or rogue employees. The Credit Suisse offering doesn’t cover market losses from trading that is authorized by the bank, some of the people familiar with the matter said.

Paul Schultz, chief executive of the Aon Securities unit of global insurance brokerage Aon PLC, said an offering like Credit Suisse’s reflects “growing investor sophistication on the underwriting side and a general view that to continue to grow the asset class, investors are going to have to expand from simply writing property risk.”

Zurich-based Credit Suisse, via a Bermuda company called Operational Re, plans to issue a five-year bond of up to 630 million Swiss francs ($646 million) to qualified institutional buyers such as hedge funds, asset managers and firms that pool together capital from pension funds. The bonds are part of a planned package that includes an insurance policy of up to 700 million francs issued by Zurich Insurance Group. Most of the cost of any claim would be paid for by the bonds. The size of the bond offering and the policy limits ultimately will be determined by investor interest, the people said. A spokeswoman for Zurich said the company’s policy is not to comment on current or potential commercial relationships.

The coupon is expected to be in the “mid-single digits,” one of the people said—higher than what Credit Suisse was initially planning, in order to entice investors to buy the novel security.

Credit Suisse last week reported a first-quarter net loss of 302 million francs, compared with a profit of 1.05 billion francs in the same period last year. The bank’s new chief executive, Tidjane Thiam, has been retooling the bank away from its investment-banking business toward its more stable wealth-management unit.

European banks have long used insurance products to meet capital requirements set by regulators or to unload risk from their balance sheets. Before the financial crisis, giant insurer American International Group Inc. sold financial derivatives known as credit-default swaps to major European banks as insurance against losses in their holdings of subprime mortgage assets. AIG’s near collapse in 2008 in the wake of the housing-bubble burst was tied to the massive volume of credit-default swaps it had sold.

As for Credit Suisse’s new bond, the bank can’t call on the money to cover regulatory liabilities or government fines, the people said. Losses from rogue trading, which have hobbled large banks such as Société Générale and UBS Group AG in recent years, could be covered by the insurance provided by the bond, but any fines stemming from it wouldn’t be, they said.

Write to Anupreeta Das at anupreeta.das@wsj.com and Leslie Scism at leslie.scism@wsj.com

Sagacious LLC can customize a disaster bond for your institution.