PwC Dodges A Bullet (For Now) With Refco

The Wall Street Journal reports on the bankruptcy examiner’s conclusions regarding the culpability of several players in the Refco collapse. Its Law Blog comments again specifically about the damning criticism of Chicago law firm Mayer Brown Rowe and Maw.

I’m more interested in the comments about the various accounting firms involved with Refco throughout the years. Only Deloitte seems unscathed and PwC dodges a bullet, as the examiner lets them off the hook on a technicality.

First the Arthur Andersen/Grant Thornton connection… It seems that Refco had been audited by Arthur Andersen, until their collapse when the partner on the account walked almost virtually across the street to Grant Thornton. (Andersen was on Monroe Street and Grant Thornton is headquartered in the Insurance Exchange, on Jackson Street, right next door to the Chicago Board of Trade.)

I’ve mentioned before that I suspect this happened more than a few times and is the reason why so many legacy Andersen clients eventually had issues, even though their books were given a “fresh set of eyes” when a new firm took over their audit after AA’s demise. In fact, the same partner and team from Arthur Andersen often opened up shop at the client under a different firm. That’s, of course, the reason why so many Andersen partners (and their staff) made out ok after the collapse. They had clients and relationships and no worries of non-compete agreements. They shopped their portfolio to the highest bidder and, in some cases, such as with Refco, seemed to bring a much larger and more complex client to Grant Thornton than they had ever had before.

How else would Grant Thornton dream of having the expertise and critical mass to service a client such as Refco if they hadn’t received the injection of the original Arthur Andersen partner and his team? Unfortunately, this partner also brought Arthur Andersen style auditing to the engagement and to Grant Thornton. As we saw in so many other cases, it wasn’t about the principles. It was about the pesos.

The FT’s Jeremy Grant made a good point, with the help of one very special “specialist.”

“The Refco filing contains many of the pre-IPO warnings about “risk factors” that are standard in such filings. But the two warnings from the auditor and the unusual reference to Mr Bennett raised eyebrows among some accounting specialists. “I found [this] odd, since specific people are usually not named in a firm so large,” said one Chicago-based auditing specialist who declined to be named. Refco said that the first deficiency was based on “the need to increase our existing finance department resources to be able to prepare financial statements that are fully compliant with all SEC reporting guidelines on a timely basis”.

The second exposed “our lack of formalised procedures for closing our books”.

The specialist noted that the filing highlighted the fact that Refco was “a global company in the financial markets that goes public but cannot close its books and suddenly has to invest in significant automation and outside support to provide adequate reporting to regulators and investors at the time of an IPO”.”

And how did PwC avoid getting the finger pointed at them by Mr. Hochberg of McKenna Long?

Well, it wasn’t for lack of trying to join the party that was Refco in its prime. It was well reported that PwC was instrumental in helping Refco to address these financial reporting and accounting deficiencies. They needed significant help in getting ready to meet public company financial reporting requirements at the time of their IPO. PwC spent more than a year with Refco and must have given them some advice on how to do what was required. PwC was also auditor of Refco Public Commodity Pool, LP until September 15, 2006 when they resigned.

So shouldn’t PwC also have to answer for their involvement with this company?

Per Mr. Hochberg’s report, PwC’s potential culpability could not be pursued by his investigation because of a conflict. McKenna Long and Aldridge, Mr. Hochberg’s firm, has PwC as a client in a case regarding a government contract. They disclosed this conflict to the judge and then Mr. Hochberg unilaterally decided not to continue investigating his own client, PwC. The judge “did not direct the Examiner to continue his investigation.”

Sounds like Mr. Hochberg won a stay of execution for his firm’s client, PwC, by default. But why wasn’t this issue identified when McKenna Long did their conflicts check before accepting the engagement as bankruptcy examiner? Or maybe it was identified and they knew how to diplomatically, and apparently legally, make sure their client, PwC, would not be investigated. Poor dumb reporters thinking that substance would be the judge in whether every firm that had been involved would have to answer to the examiner.

I call “saved by a technicality” and encourage the case against PwC to also be pursued by creditors.

From page 350 of the report:
PRICEWATERHOUSECOOPERS, LLP
The Examiner included PricewaterhouseCoopers, LLP (“PwC”) as part of his initial investigation. Review of PwC’s activities also was significant to evaluating the roles of the other professionals, especially in relation to the LBO and IPO. During the initial stages of the investigation, however, it came to the Examiner’s attention that the Examiner’s counsel, MLA, had one open matter on behalf of PwC being handled by MLA’s Denver, Colorado office related to a government contract. This other legal work did not relate to Refco, the Refco Examination, or the Refco Bankruptcy Cases. The MLA partner in charge of this file did not work on the Refco Examination. Nonetheless, the Examiner brought this issue to the attention of the Court, and consulted with counsel for the U.S. Trustee, counsel for the Debtors, counsel for the Creditors Committee, and counsel for the RCM Trustee.

Based on those consultations, the Examiner decided to discontinue any investigation of possible claims against PwC. Upon disclosure to the Court of the Examiner’s recommendation, the Court did not direct the Examiner to continue his investigation.

Refco Report Sheds Light On Collapse
Independent Examiner Says Law, Audit Firms Could Face Liability
Law firm Mayer, Brown, Rowe & Maw and several major accounting firms, including Grant Thornton LLP, may be liable in connection with the 2005 downfall of commodities and derivatives trading firm Refco Inc., according to the findings of a new report by a Refco bankruptcy examiner.
“The report from an independent examiner appointed by a U.S. bankruptcy court overseeing Refco’s bankruptcy proceedings alleges that Mayer Brown executed a series of fraudulent transactions that, when discovered in the fall of 2005, led to one of the swiftest downfalls of a firm in Wall Street history. The report says Refco debtors, which incurred some $1 billion in losses, could bring claims against accounting and tax firms Grant Thornton and Ernst & Young LLP for professional negligence or aiding and abetting fraud.
The report, the result of an inquiry by law firm McKenna Long & Aldridge, which is acting as independent examiner, comes nearly two years after Refco collapsed.

At the heart of the Refco collapse are a series of what are called round-trip loans. Refco used these loans — between related entities and outside investors — to shift bad debts off its books starting in 1997 or 1998 and lasting through 2005, according to the report.
The loans — ranging from $50 million to $720 million — typically were unwound days after the reporting period or audit. The disclosure of these loans when a new employee stumbled on them in 2005 triggered the firm’s collapse and, later, the indictment of its top executive on criminal-fraud charges.

Despite what the examiner characterized as failings in the audits, the report says the examiner was “unable to reach a definitive conclusion” on whether Andersen or Grant Thornton “knowingly aided and abetted” the breach of fiduciary duty that occurred at Refco…”