So Much Auditor Litigation Makes For Strange Bedfellows

Every one of the Big 4 (and the next tier) has a handful of lawsuits on their desk related to their audits of the banks and other financial institutions that failed, were taken over in the dead of night, or bailed out by their respective central banks. That’s in addition to the various fraud and Madoff related suits. It may or may not have been better for them to have warned us with “going concern” opinions earlier.  We’ll let the judges and juries decide, if any of the cases are actually tried.  Most often they settle and the audit firm pays, but not as much as you would think.

Deloitte has been party to settlements, left and right, lately, but they’re no more prone to settlements.   After all, per Adam Savett of Risk Metrics (by way of Kevin La Croix of D&O Diary), “jury trials in securities class action lawsuits are extremely rare” :

“As reported on the Securities Litigation Watch blog (here), only 21 cases (prior to Vivendi) have gone trial since the 1995 enactment of the PSLRA. Only seven of the 21 cases (including the Household International case) that have gone to a verdict involved conduct that occurred after the PSLRA was enacted.”

Jury trials in accounting malpractice cases are even rarer. It’s just that Deloitte has more than the average share of subprime-related litigation and as a result is suffering from the double whammy of both losing clients due to the crisis and having those former clients sue them.

What’s interesting about the current flood of lawsuits is the heightened probability Deloitte – and the rest of the Big 4 – will end up on both sides of lawsuits with their former and current audit clients.

Take the Merrill Lynch litigation.


Deloitte is a co-defendant with Bank of America (in place of Merrill Lynch) on lawsuits stemming from Bank of America’s “Deal From Hell” to buy Merrill Lynch for $50 billion, arranged in 48 hours, and agreed to on September 15 of last year.   In January of this year, Merrill Lynch announced settlement of a suit filed in October 2007 related to the earlier period where Merrill Lynch experienced significant losses due to write downs of CDOs and other subprime related assets. Deloitte was a defendant and may also have to contribute to that $475 million settlement.  Kevin La Croix described it as,

“…unquestionably the largest subprime subprime securities lawsuit settlements so far, and [ ] certainly suggest[s] the enormous stakes that may be involved in the mass of subprime and credit crisis-related litigation cases that remain pending.”

There’s a hearing tomorrow, October 13th, in the case of  Bank of America NA (as successor by merger to Fleet National Bank) v. Deloitte & Touche LLP in Boston’s Suffolk County Courthouse. It will be taped by Courtroom View Network and available exclusively to re: The Auditors subscribers on Wednesday.

It must be quite uncomfortable, I’m sure, for Deloitte to be sued by Bank of America when generally they have been taking the same side in things, standing up for each other, not tearing each other down, or making each other cry.

This case tells the story of DVI, a now bankrupt “specialty” finance firm in Pennsylvania:

“DVI’s inaccurate and often illegal accounting practices hid its financial troubles long enough to land $150 million in loans with Fleet National Bank, which was acquired by Bank of America during its $47 billion acquisition of FleetBoston Financial Corp. in 2004.

In a 187-page report reviewing the fraud that took place at DVI between 1995 and 2003, the examiner also raised questions about Deloitte’s role as DVI’s auditor. Specifically, the report claims Deloitte was partly aware of DVI’s issues well before the firm imploded in 2003 and that Deloitte “aggravated the circumstances surrounding and leading to DVI’s” demise.”

This case is interesting to me for a couple of reasons:

1) The strange bedfellows situation I described earlier.  Deloitte has also been on the same side as Bank of America in Parmalat litigation, for example. I think we will see more and more of these potential conflicts and compromises in independence for the Big 4+ firms because of the flood of subprime/financial crisis/bankruptcy suits.  Although this is only a $50 million dollar suit, one that the firms would have brushed off as immaterial in the past, how many does it take to add up to a real problem when the Big 4 firm is still the auditor of a co-defendant bank, and then is placed in an adversarial relationship with their client or former client?

2) The language around this case reminds me of the one I wrote about recently with regard to the deepening insolvency theory. Although the news reports consider this case a potential bellwether for the firms in terms of responsibility for identifying fraud risk at their clients and acting on it, I see it as bigger than that.  The audit firms already have a responsibility to identify risk of fraud and adjust their audit procedures accordingly, assuming those procedures will uncover the fraud if it exists.  What we really need are judges who understand and acknowledge this responsibility and requirement and also hold audit firms accountable when they keep their clients on life support for the sake of their fees.  That’s an unconscionable fraud that’s being perpetrated by the auditors on the company’s shareholders, creditors, employees, vendors, and customers.

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24 replies
  1. ExDeloitte
    ExDeloitte says:

    Ha! Should be funny to watch. I commend Deloitte’s spin (I mean, marketing) team, which works hard to earn its keep.

  2. huh?
    huh? says:

    so the rest of the world didn’t see this coming, but yet the auditors are supposed to see the future….. they audit as of the balance sheet date….12/31…. this deal happened in the fall. Alot can happen in 10+ months…. there are so many stupid people out there that don’t understand the auditors role…. they have no clue.

  3. Dan
    Dan says:

    I don’t count myself in the ‘stupid’ column…and my colleagues don’t either. I’ve been in Big 4 and second tier firms and know that they’re really just another business, driven by profit goals.

    I do understand the role of the auditors, and I also recognize that too many auditors are just doing their job and following a program to complete the audit within a tight budget, with minimal understanding of internal controls and the overall business.

    Let’s not forget that audits are big revenue for the firms, and the client CFO is often a good friend of the audit partner. And yes, independence takes a hit. I’m not talking about the majority of businesses here-the small and mid-sized companies that incur increased scrutiny because of the public distrust factor. I’m referring to large companies and their Big 4 and second tier firms, who have lost the trusted advisor status and firms that are begging to keep their clients. After all, the partners need to get the latest high-end foreign ride (but they’re hurting in this economy too).

  4. Philip J. Fry
    Philip J. Fry says:

    @ 2 –

    For years the business model for the investment banking business has been issue low-yielding short-term debt, buy high-yielding long-term assets, and make your money on the spread. The mismatch in maturity between assets and liabilities creates liquidity risk but also drives their profitability. Liquidity risk and capital requirements didn’t just emerge spontaneously in 2008 (remember Drexel?), all of the I-banks knew the risk involved with such leveraging but chose to take the risks anyway for the sake of profit. All of which is perfectly OK for a bank to do, after all, they’re in the business of taking risks.

    Auditors, on the other hand, aren’t in the business of taking risks. They’re in the business of assessing risks and speaking up when management is endangering shareholder wealth, and they didn’t do that. So I don’t buy the excuses of Big 4 apologists who say it’s not the job of the auditor to spot trouble brewing. Either their armies of subject matter experts don’t know a thing about what their doing or they looked the other way, either way they can’t just wash their hands of it when their clients crash and burn.

    This was not some flash flood that suddenly emerged in 2008, the clouds were building for years, long before the report date of 12/31/08.

  5. huh?
    huh? says:

    Phil- It is easy to say that it was easy to spot with the blazing light of hindsight. If it was so obvious then why didn’t all of these hot shot fund managers just short all of the bank stocks and make billions? I have read your posts on this board. Most of them are no accurate.

  6. Anonymous
    Anonymous says:

    Phil – Auditors are not “in the business of speaking up when management is endangering shareholder wealth.” They’re in the business of opining on a Company’s financials and ensuring they properly disclose risks (to the extent required under GAAP). It’s the responsibility of the Board to remove management if they are endanging shareholder wealth.

    Also, if it’s a public company, there are disclosures of the risk management is taking. Let’s take Merrill for example. In the 12/31/2007 10-K, they disclosed:

    “We may incur additional material losses in future periods due to write-downs in the value of financial instruments…” “Our business and financial condition may be adversely impacted by an inability to borrow funds or sell assets to meet our obligations…”

    If a shareholder wants to ignore the risks disclosed in a 10-K, that’s fine.

  7. Philip J. Fry
    Philip J. Fry says:

    @ 5 –

    Not sure what other posts you’re referring to where I’ve been inaccurate. I tend to speak from my own experience regarding things I’ve seen in my career, including this issue.

    In addition to working for the Big 4 I used to work for a big investment bank, in their liquidity risk management group, to be specific. That particular bank was one of the many that made headlines last fall for its spectacular fall from grace. So I’m speaking about things I have some knowledge of and when I say that even low level nobodies like myself were aware of the risk of funding long-term investments with short-term commercial paper. And if a grunt like me knew the risks then you can bet the audit partner who certified our financials knew about them too. I’m not talking about market timing and predicting a bank collapse, I’m talking about witnessing the tripling of the bank’s balance sheet over the course of several years, all of it reliant on short-term funding. That’s a huge risk that anybody who has ever worked in a corporate treasury department is well aware of.

    So I ask you this, is it really hindsight to say that this scenario presents a significant risk? Do you really think that the audit partner on this engagement for several consecutive years didn’t notice these risks? More likely, he knew the fallout of issuing a qualifed opinion and didn’t want to deal with the repercussions so he issued the standard rubber-stamp unqualified opinion to make his client happy.

    So, tell me where exactly do you see the inaccuracy in my observations?

  8. Philip J. Fry
    Philip J. Fry says:

    @ 6 –

    Allow me to clarify using more precise language. The auditor is REQUIRED to assess whether or not uncertainty exists as to whether a company will continue to be a going concern, and if any doubt exists the auditor MUST reflect this in the audit opinion, not merely as a footnote dislcosure.

    Considering that Merill’s 12/31/08 financials fully reflected the losses that ultimately brought down the firm as an independent company I don’t believe the boilerplate language in the 10-K lives up to this standard.

  9. #9
    #9 says:

    There is a difference. Read the rule. You don’t understand and are just contributing to the perception problem the profession has.

  10. Anonymous
    Anonymous says:

    There’s a difference between saying there’s a risk to a business model and if X, Y, and Z happen, the business will fail vs. saying there’s such a high probability that X, Y, and Z will happen 7 to 8 months later that it warrants a going concern opinion. I think everyone knew investment banks relied on short term lending and that if they couldn’t get if they wouldn’t be able to continue operating. What I don’t think people knew was that it was going to completely freeze up in September 08. I think most people thought the lending environment was getting tougher and as a result, spreads would narrow, not that the banks would be completely unable to roll over debt.

    The losses didn’t bring merrill down (as you said, they were already reflected). It was a freeze up in liquidity. And it’s not just banks that do this. Manufacturers, retailer, etc rely on short term lending to fund their operations. If you’re saying relying on rolling short term credit to function is an indicator of a going concern issue, then a whole host of companies should have received going concern opinions at 12/31/2007. While some have indeed gone belly up, there are plenty of other who haven’t (but may have in the credit market of late 08 if they had a going concern opinion since it would have effectively shut off their funding). Just having a “what if” risk to a business doesn’t create a going concern. Now, if you were signing an opinion on a Company who relied on short term credit in September ’08, that’s another story. But saying anyone who had liquidity rik at 12/31/07 should have gotten a going concern opinion? Give me a break

  11. Anonymous
    Anonymous says:

    @BBC – do you really think any doubt and substantial doubt are equivalent statements? Seems to me one is an incredibly stringent criteria — the auditor must have zero doubt… I would think that given prediction of the future is hard there would always be doubt. The other implies some measure of what is substantial. Now we get tricky — what is substantial to one may not be substantial to another.

    Seems to me this difference is as huge as the difference between criminal and civil court rulings — criminal requiring beyond the shadow of a doubt and civil requiring the decision be supported bythe perpondence of the evidence. Civil is quite subjective…criminal is such a high standard that decisions err on the side of not convicting. Look at OJ — criminally innocent, civilly guilty… whether you agree with either decision, that was the case and it is about different standards to measure guilt.

    So, are you saying auditors are to meet the any doubt criteria — how can anyone do that when they are predicting the future (which by definition is entirely in doubt).

  12. Philip J. Fry
    Philip J. Fry says:

    @ 11- I’ll give you that much. At 12/31/07 you could say that a reliance on short-term funding wasn’t enough to trigger the going concern opinion, but what about all those 12/31/08 unqualified opinions that were issued in the midst of the credit crunch?

    Let’s turn back the clock to March 2009, six months after the death of Lehman and the near death of Merrill, right around the time that the 12/31/08 financials were being issued. Wall Street was still in the grip of the credit crisis, Citigroup’s share price fell below $1 and rumors were circulating that Morgan Stanley would be the next bank to fall. Liquidity was still a serious problem for every bank and even the mighty Goldman Sachs had to turn itself into a commercial bank in anticipation of the day when it might need to go begging the Fed for emergency cash.

    At that time I would say there was “substantial doubt” about many banks. Hell, based on the stock price of Citigroup and Morgan Stanley at the time the market had effectively issued its own going concern opinion about both banks. Do you really think the audit partners on those engagements were free of substantial doubt? Or did they just wimp out and take the path of least resistance?

  13. BBC
    BBC says:

    @12 & @10 – I was being sarcastic (thought it came through more clearly) – I don’t think Philip understands

  14. Anonymous
    Anonymous says:

    @ Phil – I believe Morgan had also converted to a bank holding company to gain access to liquidity from the Fed. And in March, the Federal government had already shown it was willing to dump money into certain key banks, such s Morgan, Goldman, and Citi, regardless of how dismal their results were (cough… Citi..cough). So if I were a partner on any of those engagements I probably wouldn’t have had much of an issue. I think the dismal share price wasn’t due to the market saying these banks would fail, but rather the fear that the common shareholder would be completely dilluted by more government cash. Having a viable way to raise cash, even if it is incredibly dillutive to your current shareholders would help support the fact that you are a going concern.

    Now if I was auditing a smaller regional bank who the gov’t had proven they don’t really care about…. that would be another case entirely, and I think you may see more lawsuits arising over those audits as those banks continue to fail through the rest of 2009.

  15. Philip J. Fry
    Philip J. Fry says:

    @ 14 – I understand when someone is arguing semantics while overlooking the substance of an argument. I just chose to ignore you.

    @ 15 – I’m not so sure that shareholder dilution was the only factor driving down share prices. I think there was real doubt, especially in the case of Citi and Morgan, that these companies could survive without either de facto nationalization (Fannie, Freddie) or forced acquisition (Bear, Merrill). Was disaster a forgone conclusion? Or course not. Was it a serious possibility that raised a lot of doubt in the minds of the market about the survival prospects of these firms? I think so.

    Morgan did become a bank holding company to get access to Fed cash. However, in the summer of 2008 Lehman also had access to the Fed window and that didn’t keep them alive.

  16. Joe Delvine
    Joe Delvine says:

    I don’t understand how D&T got pulled into this suit as they were not consulted during the weekend from hell. Due deligence did not really exist as this entire ordeal was 2 CEOs and their related BODs working a weekend…In retospecty, both CEOs should have stayed on the golf course and all would have been good.

  17. fm
    fm says:

    @Joe Delvine

    Actually I’d like to know whether Deloitte, EY, PwC or KPMG were at the table during these weekend dealmaking sessions or consulted when their respective clients were bailed out, forced to fail, bought suddenly by others etc. Does anyone know? Since valuation of assets held by the banks/investment bank was key to establish a purchase price or windup cost I’m wondering if they were consulted or why not. I’ve had a potential post about this sitting on my list and have not heard anyone else talk about it until now.

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