Ready or not, here I come, you can’t hide
Gonna find you and take it slowly…

Related News:  On February 28 the US Justice Department fined Deloitte & Touche LLP $149.5 million for alleged fraud against the government related to its role as the independent outside auditor of Taylor, Bean & Whitaker Mortgage Corp. The company, a mortgage loan originator that failed in 2009, was alleged to have fraudulently sold fictitious loans insured by the Federal Housing Administration. Deloitte issued audit reports for TBW’s fiscal years 2002 through 2008. The DOJ alleged TBW’s financial statements failed to reflect its severe financial distress and knowingly deviated from applicable auditing standards, according to Justice Department. Deloitte, therefore, allegedly failed to detect TBW’s fraudulent conduct and materially false and misleading financial statements, a violation of the False Claims Act, Justice said. The settlement makes no determination of liability and Deloitte neither admitted nor denied the allegations.

The settlement says (emphasis is mine):

In conducting its audits and issuing its opinions on TBW’s consolidated financial statements, Deloitte failed to detect the fraudulent conduct at TBW and that TBW’s financial statements were materially false and misleading. The United States contends that those failures occurred because Deloitte did not conduct its audits in conformance with GAAS, and Deloitte’s audit deficiencies included failures related to the financing arrangements that TBW personnel used to perpetrate the fraudulent scheme referenced in Paragraph C above. 5.

The United States further contends that if Deloitte had conducted its audits of TBW’s financial statements in conformance with GAAS, Deloitte’s audits would have detected TBW’s fraudulent conduct, and would have revealed that TBW’s financial statements were materially false and misleading, either of which would have resulted in the termination of TBW’s participation in the Direct Endorsement Lender program, and would have prevented the United States from incurring losses on FHA- 4 insured mortgages that TBW continued originating and endorsing after the issuance of Deloitte’s reports. E.

Deloitte denies the United States’ allegations…

There was no complaint, only a pre-suit civil settlement of an investigation against the audit firm. No individuals were named.  It was also not a qui tam, meaning there was no whistleblower.

I wonder if this is more than Deloitte paid the Trustee on behalf of investors in 2013. That settlement amount was confidential. According to Reuters, Deloitte “failed to detect fraud at one of the biggest private mortgage companies to collapse during the U.S. housing crash.” The original claim against the firm was a catastrophic $7 billion. The complaint said, “Deloitte missed this fraud because it simply accepted management’s conflicting, incomplete and often last-minute explanations to highly-questionable transactions.” Deloitte avoided a trial that was to start in Miami October 21, 2013.

This is not the first time in recent years that Deloitte has been fined for False Claims Act alleged fraud. Two years ago its consulting arm paid $11 million to settle claims of cheating the federal government.

This is the first time any US regulator fined or sanctioned either Deloitte or PwC for their audits of Taylor Bean & Whitaker or Colonial Bank.

Judge Rothstein has scheduled the damages phase of the FDIC v PwC case for Colonial Bank to begin on Tuesday, March 20. It’s expected to last up to three days.

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On December 28, 2017, U.S. District Judge Barbara Jacobs Rothstein handed down a decision from her bench trial in the case of the failure of Colonial Bank from fraud, a complex combination of allegations brought against PricewaterhouseCoopers LLP and fellow accounting firm Crowe Horwath LLP by the bank’s holding company and the FDIC, as the receiver for the failed Alabama bank.

Both the FDIC and the bank holding company sued the two audit firms for failing to detect the long-running fraud at Colonial related to its largest client, Taylor Bean & Whitaker Mortgage Corp.

A story from 2014 in The Wall Street Journal by Patrick Fitzgerald gives some context:

The collapse of Colonial, which had $25 billion in assets and $20 billion in deposits, was the biggest bank failure of 2009. The regulator estimates Colonial’s failure will ultimately cost its insurance fund $5 billion, making it one of the most expensive bank failures in U.S. history. The FDIC, however, hadn’t made a point of targeting the professional firms who advised the failed banks until filing the original Colonial lawsuit in 2012.

When the case was first filed in November of 2012, Alison Frankel of Reuters On the Law column noted that I had wondered almost two years before when the FDIC would get around to suing some auditors over crisis-era bank failures:

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.

When the case was filed I wrote about it for Forbes.  At the time I wrote:

Maybe the FDIC likes its advantage as a regulator, too. The FDIC complaint has more details about what PwC didn’t do in its audits than the securities litigation complaint. Several allegations made in the FDIC complaint are supported by knowledge of the audit choices PwC made, or did not make, that most likely came from the workpapers, PCAOB inspection findings pertaining to Colonial, and the reluctant but compelling cooperation of PwC itself.

In August of 2016 PwC faced not one, not two, but three significant trials for allegedly negligent audits.

Its advantage as a regulator, and as a receiver in bankruptcy, seem to have been the cards the FDIC played successfully. That, and getting some help on the case against PwC from the law firm that represented the TBW trustee twice, Thomas, Alexander, Forrester, & Sorenson, in driving settlements with both Deloitte as auditor of Taylor Bean & Whitaker and with PwC for not catching the fraud at Colonial soon enough to stanch the losses at TBW.

On January 4, I published “FDIC win against PwC may finally force auditors to look for fraud” at MarketWatch.  During the TBW Trustee’s trial against PwC, which ended in a confidential settlement once the plaintiff had rested its case, Judge Rothstein’s decision noted that PwC personnel had testified that an auditor did not have an obligation to detect fraud.  Judge Rothstein found that testimony not credible, in particular once the same partners reversed course and admitted their duty during the Colonial trial.

She, therefore, rejected the lawyers’ argument, arguments the firms have tried to make for many, many years, albeit behind the closed doors of sealed depositions and motions, rarely in open court for the public to scrutinize.  The judge found PwC negligent for all the reasons cited in her decision—and in my story—saying that PwC had failed to follow Generally Accepted Auditing Standards.

In January 2013 I spoke at the American Accounting Association Auditing Section Midyear Conference and Doctoral Consortium about a PCAOB document that very few of the academics —those who teach future accounting professionals— had ever heard of.

[The] Appendix [was] published by the PCAOB this past November. It was attached for private reading to a discussion document distributed at the last PCAOB Standing Advisory Group meeting. The agenda item for the meeting was, “Consideration of Outreach and Research Regarding the Auditor’s Approach to Detecting Fraud”.

When I saw the topic on the agenda before the live meeting, I was really excited. But I had missed the words “outreach and research” and thought we were finally going to discuss the auditors’ obligations under PCAOB standards and securities laws with respect to fraud and illegal acts.

The public discussion and the breakout groups, unfortunately, focused on whether the Public Company Accounting Oversight Board (“PCAOB” or the “Board”) should conduct outreach or research regarding the auditor’s approach to the detection of material misstatements of financial statements due to fraud (“financial statement fraud”). I think that’s part of the PCAOB’s mission already with regard to standard setting, inspections, and enforcement of the standards.

The public and the media didn’t see or hear discuss the famous “expectations gap”.
The Big 4 audit firm’s public relations professionals are very good at explaining their position on the “expectations gap”. Set the bar low, tell us what you can’t do, won’t do, or want to make us believe you have no responsibility to do, and maybe everyone will leave the firms alone. Then audit firms can go back to making money the old fashioned way – via a government-sanctioned franchise operating as an oligopoly.

The “We were duped” defense is used over and over again by the audit firms when frauds occur. For example, PwC used it in the firm’s initial reaction to the Satyam scandal.

Sam DiPiazza, Global Chairman on the job when the Satyam scam hit in early 2009 told the Times of India that March:

“What we understand is that this was a massive fraud conducted by the (then) management, and we are as much a victim as anyone.  Our partners were clearly misled.”

PwC begged our indulgence again when in a rambling, incoherent interview with an Indian journalist in the summer of 2010 – more than a year after the fraud was uncovered by the Satyam CEO not PwC—PwC Global Chairman Dennis Nally stated:

“Many times there is an expectation from the investor community that the auditor is in fact fully responsible for the detection of fraud. Now that is not our job, today.”

There is much, much more to this case and the related TBW case, including three PwC auditor independence violations raised at the TBW trial which have never been addressed publicly by the PCAOB and SEC.  I wrote about that issue for the Stigler Center’s ProMarket blog last spring.

Actually, the PCAOB and SEC have also not addressed Deloitte’s work at TBW or PwC’s work at Colonial Bank in any sanction or disciplinary action against the firms or their partners.

TBW and Colonial Bank filed bankruptcy in 2009 after both were raided by the FBI and several executives from both firms went to jail for fraud.  Is nine years later too late?

Please read the whole thing at MarketWatch, as well as Alison Frankel’s excellent explanation of the unique legal principal of in pari delicto that played a major role in why the holding company did not succeed in its claims and that will form the core of PwC’s appeal of the decision.

The damages phase is next as well as a stub trial for a two year period portion in the middle of the audit relationship where the waiver of a jury trial was left out of the engagement letters.  (I know!!!!!!)

A trial for Crowe Horwath for the FDIC’s allegations related to its role as the Colonial Bank internal audit service provider is also pending.

Oh, and one other interesting thing I should mention…

This is the third case against PwC in just a few years, the second to go to trial, where one of the primary allegations was that PricewaterhouseCoopers LLP, as auditor, gave the client bad accounting advice, in two cases the advice was intended to enable off-balance sheet treatment of liabilities.

Bad accounting advice, from auditor PwC, approved by its National Office, about the assignment of sale accounting—to enable off-balance sheet treatment—was the main allegation in the case by the bankruptcy trustee against PwC for the failure of MF Global, a case that ended in a confidential settlement a few weeks into the trial, just like the one by the TBW trustee against PwC.

In an earlier case that settled right before trial, also for a confidential amount, PwC was sued by the bankruptcy trustee for SemGroup.  In that case too, PwC had flown in experts in derivatives to structure the accounting to meet the client’s needs and stem a liquidity crisis.

SemGroup and MF Global also had a few more things in common besides helpful auditor PwC:

If the SemGroup story sounds a lot like MF Global, you’re not imagining things. MF Global, also a PwC audit client, filed for bankruptcy on October 31, 2010 after its Chairman and CEO Jon Corzine overextended the firm while trading highly risky sovereign debt funded with repo to maturity agreements that left the brokerage firm unable to cover monstrous margin calls from counterparties when the debt of some countries fell in value.

But that wasn’t the first time MF Global’s weak internal controls and poor risk management caused losses. Shortly after MF Global spun out as a public company from PwC audit client Man Financial in 2007, a rogue wheat trader exploited internal control weakness in trading software and caused $141 million in losses at the fledgling public broker-dealer.

PwC is also auditor to Chesapeake Energy, another Oklahoma energy company, where the former CEO set up his own personal internal hedge fund staffed by company employees and used a unique incentive compensation arrangement to engage in undisclosed related party transactions for his own benefit with one of his company’s business partners. He resigned but was never charged with any crimes.

What did PwC do for SemGroup?

Keith Considine and Mark Allan Smith are partners in PwC’s energy consulting practice. According to the pre-trial conference document, they are expected to testify about a special consulting engagement related to SemGroup’s derivatives trading that SemGroup’s management retained PwC’s energy consultants to perform in July 2008.

This is odd for two reasons. First, an auditor risks an independence violation when it takes on a “special consulting engagement” for its audit client.  That’s especially true when the engagement’s subject is an area of the business PwC says itself it was not hired to audit. From the pre-trial conference order document:

SemGroup did not hire the PwC financial-statement auditors to assess the risks the derivatives trading presented or to provide advice as to how to manage that risk as oil prices reached unprecedented highs from late 2007 through mid-2008. SemGroup management, not its financial statement auditors, was responsible for monitoring and evaluating those trading risks.

The engagement is also weird because it was performed in July 2008 a week before SemGroup filed for bankruptcy and two months before PwC resigned as auditor. The bankruptcy examiner’s report, prepared by Louis Freeh who as Trustee also ran cover for creditors with claims against MF Global Holdings, the other PwC trading failure client, explains the purpose of this engagement:

July 15, 2008. Ward stated that PwC representatives arrived in Tulsa and were instructed to review SemGroup’s trading book. PwC’s review was limited to SemGroup’s OTC positions because it was the only ongoing trading liability remaining on SemGroup’s books. PwC reported early in its review that SemGroup was using “strangles” as a trading strategy.

It looks like PwC finally called in the cavalry but it was much too little and way too late.

Read more about the SemGroup case in my post, “PwC Faces A Trial For SemGroup Audit And Its Defense Is Predictably Slick.”

In the Colonial Bank case, PwC audit partners and consultants from its structured product group, with the help of its National Office, created the documentation required to justify sale accounting for some of the mortgage funding loans made by Colonial Bank to TBW. That kept them off Colonial’s  balance sheet.

After the PwC folks successfully “papered” over the transaction to stave off OCC scrutiny of their advice, an earlier complaint in the case says former PwC chairman Sam DiPiazza, now a vice chairman at Citibank and an AT&T  board member, wrote to the team on April 20, 2008:

“To all of you guys—Thanks a great deal for going far beyond to make this happen on Friday. An incredible professional performance. I doubt the client will ever understand what you guys did to make this happen,” wrote DiPiazza.

I think I learned in accounting school that the independence rule is, “The auditor can’t eat what it cooks up for the client,” or something like that.