By Jerri-Lynn Scofield has worked as a securities lawyer and a derivatives trader.
One so-called unintended consequence of the financial crisis and the inadequate Dodd-Frank reforms has been to consolidate or maintain the status quo within different types of financial players, rather than encourage competition. So, for example, the U.S. banking sector is more concentrated now than before– too-big-to-fail institutions are even bigger, and many smaller regional players have been forced to merge.
Additionally, despite much sound and fury promoting greater competition in the market for credit ratings, no alternative to the “issuer pays” business model–with all its embedded conflicts of interest– has emerged. As a recent SEC report documents, rating agency performance remains woeful, in part due to persistent conflicts of interest. But so far, no new entrants have made significant inroads into the combined market share of Standard & Poor’s, Moody’s Investor Services, and Fitch Ratings Inc., which the SEC estimates together issued 96% of the more than 2.4 million credit ratings outstanding as of end-2014.
For the biggest accounting firms, concentration began even earlier, during George W. Bush’s administration, when the big five became the big four. In the wake of the Department of Justice’s (DoJ) pathetic enforcement record on corporate fraud during the Obama administration–particularly regarding financial institutions–it’s worth remembering this wasn’t always the case. During Bush’s tenure, federal prosecutors successfully prosecuted–and jailed–corporate executives from Adelphia, Enron, and WorldCom, among others.
The decision to pursue a criminal charge against Arthur Andersen for Enron-related activities caused the accounting firm’s bankruptcy. This ultimately led former Obama Attorney General Eric Holder to follow his previously enunciated “Holder doctrine”, under which the DoJ opted to seek civil settlements and monetary penalties for corporate transgressions rather than individual or corporate criminal claims. The ostensible reason was to avoid triggering a major corporate bankruptcy, which would inflict significant collateral damage, on employees and otherwise. Further, in the case of a too-big-to-fail banks, it was argued, dire systemic consequences might follow. (In September 2015, Deputy Attorney General Sally Quillian Yates authored memo announcing a significant tightening of individual accountability for corporate wrongdoing. So far, surprise, surprise, no major upsurge in prosecutions has occurred.)
Now, big four auditing firm PricewaterhouseCoopers (PwC) faces potential exposure to three significant legal actions for allegedly negligent audits. And depending on the outcome of this ongoing litigation, the big four might become the big three. Statutes of limitations considerations dictate that, these will probably be among the last lawsuits brought as a consequence of actions arising from the financial crisis.
The first action kicked off earlier this month in the Circuit Court for the 11th Judicial Circuit of Florida before Judge Jacqueline Hogan Scola, and could itself potentially inflict a knock-out blow on PwC. As reported by CVN, which is producing a live webcast and gavel-to-gavel recording of the trial, attorneys for the Taylor Bean & Whitaker Mortgage Corp.’s bankruptcy trust accused PwC of performing negligent audits that contributed to Colonial Bank’s multibillion collapse during the mortgage crisis. Taylor Bean & Whitaker was one of the largest U.S. mortgage lenders before a 2009 raid by federal agents led to its subsequent bankruptcy declaration.
Plaintiffs seek to recover $5.5 billion in damages from PwC for allegedly failing to detect a multiyear fraud carried out by Taylor Bean executives involving funds deposited in Colonial accounts from problematic mortgage loans (e.g., that were either non-existent or had previously been bought by other investors). PwC audited the accounts of Colonial’s mortgage lending division. The bankruptcy of Colonial’s largest customer, Taylor Bean, led the Federal Deposit Insurance Corp. (FDIC) to shutter the bank in what was the sixth largest banking failure in U.S. history.
“Year after year, Pricewaterhouse didn’t do their job, they didn’t follow the rules and they failed to detect the fraud,” said Steven Thomas of Thomas Alexander Forrester & Sorensen LLP in his opening statement, as recorded by CVN. This action presents the jury with the question– to what extent is an auditor responsible for detecting potential fraud?– an answer that has yet to be conclusively settled legally.
The Florida action brought against PwC is noteworthy in that it has proceeded to trial. PwC was not unique in seeing the demise of clients during the financial crisis. In fact, all the major accounting firms saw some clients fail or receive bailouts. Yet unlike PwC, these other accounting firms have successfully avoided trials and instead pursued settlement strategies. One reason for their taking such positions is no doubt the costs of litigating complex financial claims. Another is the unwillingness to expose to public view the unpalatable process of financial sausage-making that constitutes the auditing process. Settlement records are generally sealed and not made public.
Those firms that opted for settlement have capped their liability at a fraction of PwC’s potential exposure. MarketWatch reports that Ernst & Young paid $99 million to investors and $10 million to the New York state attorney general’s office for its role Lehman Brothers’ auditor. KPMG also opted for quick settlement, and in 2010 settled for an undisclosed amount for its audit activities for major mortgage originator New Century. KPMG also shelled out an additional $24 million for auditing the accounts of Countrywide Bank, prior to when Bank of America made a distressed acquisition.
MarketWatch also noted that Deloitte also opted for settlements. JP Morgan purchased Bear Stearns at a fire-sale price in March 2008 and Deloitte subsequently settled its exposure as Bear Stearns’ auditor for $19.9 million. For its role as Washington Mutual’s auditor, Deloitte contributed $18.5 million to a multi-party settlement. Deloitte subsequently earned hundreds of millions of dollars reviewing J.P. Morgan’s exposure to foreclosure fraud claims for the Bear Stearns and Washington Mutual mortgages it acquired when it purchased these institutions.
If it survives the Florida action, PwC is facing two further trials, including an action brought by the FDIC and docketed for federal court in Alabama in February of 2017. Federal district judge for the southern district of New York Victor Marrero allowed the second to proceed when on August 5 he denied PwC’s motion for summary judgment in a $1 billion lawsuit filed by the administrator winding down MF Global. (Jon Corzine, CEO of that firm, was former CEO of Goldman Sachs, as well as a former U.S. Senator and former New Jersey Governor.) The Wall Street Journal noted that the judge determined the administrator “has presented sufficient evidence to create a material factual dispute” as to whether PwC’s accounting advice contributed to MF Global’s 2011 bankruptcy. PwC separately settled a claim concerning the adequacy of PwC’s audit of MF Global’s pre-failure internal controls for $65 million.