Big Four Auditors and Jury Trials: Not In The U.S.

Deloitte has settled a shareholder case against the firm stemming from their role as auditor of Bear Stearns, one of the early financial services firms to fail, be force sold or nationalized during the financial crisis of 2008-2009. Deloitte was dangerously close to having to answer for its actions – or rather inactions – at a trial. For the Big 4 audit firms in the United States, trials over auditor liability are unheard of.

Rare birds in modern times.

Deloitte’s audits “were so deficient that the audit amounted to no audit at all,” the [Bear Stearns investors] plaintiffs argued in court papers.

That was Reuters describing the rationale behind the decision of US District Judge Robert Sweet back on January 23, 2011 to allow a case against executives of Bear Stearns and its outside auditor, Deloitte, to go forward. I wrote in Forbes:

In Ernst & Ernst v. Hochfelder, the Supreme Court held that actions under Section 10(b) of the Exchange Act and Rule 10b-5 require an allegation of “`scienter’—intent to deceive, manipulate, or defraud.” The “scienter” requirement, necessary to sustain allegations against the auditors in a securities claim under Section 10(b), is notoriously difficult to meet in an auditor liability case.

If there’s anything of substance in a claim against auditors the case usually settles before the facts are made public. New Century Trustee v. KPMG is an early crisis mortgage originator case, cited several times in the Bear Stearns decision. However, those facts will never be heard in open court. In spite of – or perhaps because of – very particular examples of reckless behavior by the auditor documented by the bankruptcy examiner, the case was settled...since Ernst, most courts have concluded that recklessness can satisfy the requirement of “scienter” in a securities fraud action against an accountant.

That standard requires more than a misapplication of accounting principles. Plaintiffs must prove that the accounting practices were so deficient that the audit amounted to no audit at all, or “an egregious refusal to see the obvious, or to investigate the doubtful,” or that the accounting judgments which were made were such that no reasonable accountant would have made the same decisions if confronted with the same facts.

The plaintiffs’ attorneys In Re: Bear Stearns Companies, Inc. Securities Litigation successfully pled recklessness equivalent to “scienter” and more. They knocked the requirements for recklessness to prove “scienter” out of the park. The Complaint identified as a red flag the fact that Deloitte knew or should have known, absent recklessness, the risk factors inherent in the industry, such as declining housing prices, relaxation of credit standards, excessive concentration of lending, and increasing default rates.

The Securities Complaint has alleged that JPMorgan discovered in the course of one weekend the overvaluation of assets and underestimation of risk exposure in Bear Stearns’ financial statements. JC Flowers & Co., a leverage-buyout company, had also reviewed Bear Stearns’ books the same weekend and made an unsuccessful proposal to buy 90% of the Company at a similar price between $2 and $2.60 per share. These allegations support an inference of Deloitte’s scienter.

They’re specific enough about who, what, why, and when to nail “particularity”. The misstatements with respect to valuation and risk were adequately alleged with sufficient specificity and established as material. They showed how Deloitte, like the Bear Stearns executives, caused losses.

But there will be no trial. Investors led by the State of Michigan Retirement Systems settled with Bear Stearns executives for $275 million – which will be covered by insurance –  and auditor Deloitte will pay, in cash, an additional $19.9 million.

To put Deloitte’s settlement in perspective, I looked at the firm’s audit fees for Bear Stearns from 2003-2006. (Fee information for 2007 is not available since the firm was bought, under duress, by JP Morgan in 2008 and the proxy focuses on that transaction, not the typical disclosures.) Deloitte earned $110 million dollars, more than 5X this settlement amount, in just the last four years at Bear.

In addition, the settlement is chump change in comparison to the hundreds of millions Deloitte will earn performing the “independent” foreclosure review at JP Morgan under April 2011 OCC and Fed consent orders. Deloitte is focusing in this engagement on the harm to foreclosed borrowers from mortgages and securitizations made by Bear Stearns EMC, now a part of JP Morgan, and Washington Mutual, another Deloitte audit client that was force bought.

In addition to the relatively low cost for Deloitte of disposing of the case there’s also the “WTF” factor to consider. You have to go outside of the US to see a trial of a Big Four audit firm to know what I’m talking about. Australia’s Centro case against PwC or Canada’s Nortel case where Deloitte partners testified can tell you everything you need to know about why the Big Four will settle every time. Rather than have a jury and the public hear and see the pathetic state of the audit profession, its inability to stop executives who want to cheat, and its unwillingness to acknowledge liability as a firm when it screws up, audit firms will reach into seemingly bottomless pockets and pay up. If only we knew, or the PCAOB or SEC were checking to see, how long any one of the firms can keep doing this.

Even though the Bear Stearns attorneys overcame motions to dismiss and requests by defense for summary judgment and made a great argument for Deloitte’s culpability in the fraud on the basis of “no audit at all”, Deloitte can pay a lousy $20 million and escape scrutiny for its part in allowing one of the most significant failures of the financial crisis.

In the U.S. the auditors will always settle because, in addition to the possibility that one significant judgment may shut one down for good, that one significant judgment is highly likely when partners testify and say really, really stupid things and the firm’s lawyers make outrageous arguments.

As you read this, a judge in Australia is approving a $200 million dollar settlement for investors against Centro and PwC, the company’s auditors. PwC will probably pay about one-third of that. The case went to trial and testimony by the PwC lead partner was extremely embarrassing to the profession as well as damaging to PwC Australia. The defendants stopped the runaway train and settled before the testimony ran head-on into revelations that would spread the ignominy to the rest of the audit firms in Australia and to PwC worldwide.

PwC Australia tried everything during the aborted trial to avoid liability for missing the fact that more than $3 billion of Centro’s short-term debts had been wrongly classified as long-term debt in the final version of the 2006-07 accounts. Earlier testimony in Federal Court revealed that if the debts had been properly classified Centro would have been technically insolvent.

• PwC tried to get the judge removed from its case because he had ruled against executives and directors in a previous case. The Australian reported PwC’s lawyer Cameron Moore claimed,  “Justice Middleton’s earlier rulings on the case, particularly a series of “findings of fact”, could give rise to a perception of bias in the case.”
• PwC filed counterclaims against its client Centro. (This is similar to tactics in India where Price Waterhouse India responded to Mahindra’s Satyam’s suit against the firm for a $1 billion fraud the auditor missed with a suit of its own.)
• PwC claimed during the trial that the $3 billion debt classification mistake did not cause investors losses. The company’s press release about the error caused the losses.
• PwC claimed that lead partner Stephen Cougle was “the auditor”, not PwC the firm, for purposes of the actual audit opinion. The PwC lawyers also argued that the client was Centro, the company and its executives, not its shareholders.
• PwC partner Stephen Cougle testified under oath it was a PwC manager who allowed the error in the financial statements. Cougle denied any responsibility for the errors in the Centro accounts. According to news accounts, the wider business community was appalled at this display of arrogance. According to accounts of the trial in the Sydney Morning Herald:

“He told the judge he does not believe he did anything wrong as lead auditor, and that the mistakes were by junior staff he supervised. The fact that Mr Cougle led that team, which included university-level trainees, some who had only recently graduated, is something that will be taken into account by the judge.

But Mr Cougle has told the court he expected certain things to be done by his PwC staff, and he was disappointed to find out later that tasks they said they were doing were not carried out.

In a heated series of exchanges yesterday, Mr Cougle was asked if he conceded it was his duty to ask the company about the nature of its business and not to delegate that to underlings. He replied that it was ”a team responsibility” and it was not the role of the lead auditor to do every step of the audit.

”Nothing was brought to my attention or came to my attention, in any discussions I had or meetings I had or documents I saw, that brought to my attention that they had not refinanced debt,” he said. ”They just borrowed debt in a very buoyant debt market. Nothing came to my attention.”

Mr Cougle admitted he did not ask Centro if it had any bridging loans, despite receiving in August 2007 alerts from his own firm warning that, considering the volatility then rippling through US credit markets, audit teams should make further inquiries of their clients.”

With such pathetic defense arguments, the Centro shareholders didn’t even need lawyers. They can now back the truck up at PwC Australia and collect the cash – more than 3X what Bear Stearns shareholders are getting from their auditor.

In Canada, Deloitte partners are testifying in a case against three executives of Nortel, accused of manipulating the books in 2003 and prior to claim bonuses. According to Reuters, defense lawyers  “showed the court a string of correspondence between Nortel’s finance team and Deloitte and Touche, its independent auditor for over a century, in which Deloitte raised concerns but ultimately approved of balance sheets featuring a surplus of so-called accruals, or liabilities calculated in prior quarters.”

On the other hand, Deloitte’s lead partner for the Nortel audit had to admit that Nortel was a difficult client whose Audit Committee Chairman “chastised” him, according to The Toronto Star, for “demanding disclosure of a head office accounting entry in 2003 that triggered a surprise return to profit and executive bonus payouts at the now insolvent telecom gear maker. Deloitte & Touche LLC senior partner Don Hathway said Nortel’s audit committee chair John Cleghorn criticized him for delaying a press release announcing the quarterly results and for taking up too much of former chief executive Frank Dunn’s time.”

About a year ago, former Deloitte client Navistar filed suit against Deloittte, more than five years after firing them. It’s not that Deloitte, long time auditor of Navistar – almost 98 years when they were dismissed – didn’t allow the company to get away with a lot in the past, just like Deloitte did with Nortel.  After the Sarbanes-Oxley Law was passed in mid-2002, all the large audit firms did some major cleanup of their complacency over the years, including shedding risky clients, to protect themselves from new liability. To accomplish that with Navistar, Deloitte brought in a former Arthur Andersen partner to replace the good-old-boy who was part of a long line of client approved partners who previously “fit” with Navistar’s culture and modus operandi.

Whether because of his recent experience with Andersen’s failure, fear of personal liability, a “not on my watch” attitude, or possibly a heads up on interest by the SEC in some of Navistar’s accounting, this new partner cleaned house. Many prior agreements between auditor and client and many assumptions about what could or could not be gotten away with were thrown out.

The client, Navistar, went ballistic.

Navistar, however, was illegally overdependent on Deloitte to hold their hand in all accounting matters, even after the Sarbanes-Oxley Act prohibited that reliance.

According to Navistar’s complaint:

“Deloitte provided Navistar with much more than audit services. Deloitte also acted as Navistar’s business consultant and accountant. For example, Navistar retained Deloitte to advise it on how to structure its business transactions to obtain specific accounting treatment under Generally Accepted Accounting Principles (GAAP)…Deloitte advised and directed Navistar in the accounting treatments Navistar employed for numerous complex accounting issues apart from its audits of Navistar’s financial statements, functioning as a de facto adjunct to Navistar’s accounting department….Deloitte even had a role in selecting Navistar’s most senior accounting personnel by directly interviewing applicants.”

It sounds like Nortel had a problem cutting the umbilical cord with Deloitte, too, according to The Globe And Mail:

Former Nortel Networks Corp. chief executive Frank Dunn “did not understand” the role of the external auditors from Deloitte & Touche as they probed issues related to the company’s accounting in 2003, a senior Deloitte partner testified Wednesday.

Donald Hathway, who was the lead audit partner assigned to the Nortel file in 2003, told the Toronto fraud trial of Mr. Dunn and two other former Nortel executives that after almost a year of working daily with Nortel staff at the company’s head office, he concluded that neither management nor the board’s audit committee understood his role.

Mr. Hathway was assigned to head the Nortel audit team in January, 2003, and said he and Deloitte audit partner John Cawthorne quickly found themselves being pressured by Mr. Dunn to help Nortel find strategies to deal with its accounting issues.

“He had lectured John Cawthorne and I on more than one occasion about the need to be creative and come up with solutions … It indicated to me that he did not understand our role as independent auditors.”

By the end of 2003, Hathaway had been replaced as the lead partner, after less than a year, because of raising red flags about excess reserves and Nortel’s schedule for releasing them to boost profitability after many years of losses. Deloitte leadership acquiesced to Nortel’s request to find a partner who could be more “solution” oriented. Audit Committee Chairman Gollogly had complained, according to The Globe and Mail, that Deloitte’s two new lead audit partners – Mr. Hathway and Mr. Cawthorne – were “night and day” compared with Deloitte partners previously assigned to Nortel, and were “turning the audit on its head.”

“Gollogly described Don and John as ‘inflexible,’ ” the interview summary said. “Don and John are not in ‘solution mode.’ ” In a separate client-satisfaction interview with Deloitte, CEO Beatty reportedly told the firm that he felt Mr. Hathway didn’t have any “skin in the game,” suggesting that because Mr. Hathway was new to the file, he felt he could reverse decisions previously approved by others at Deloitte.

So what did Deloitte do when Nortel threatened to fire the firm for Hathaway’s seeming diligence?  Did Deloitte have suspicions of significant misstatements or illegal acts? Did Deloitte make a 10A report to the SEC? Did the firm resign? Did the firm qualify the audit because management was potentially limiting the scope?

No, Deloitte approved the journal entries and the financial statements in contention – in one case after the entries had already been made. Former Deloitte deputy chairman and deputy chief executive officer Bruce Richmond was the supervisory partner on the Nortel’s audit prior to his retirement in 2009. He testified that he pushed Nortel to launch a comprehensive review of all its reserves to determine if more were out of date and needed to be removed from the books.

“Mr. Dunn was not inclined to go down that path,” Mr. Richmond said.

He said the Nortel CEO argued that the review would find no further reserve problems and the $142-million was all there was. But he was persuaded to launch the review, which ultimately led to a restatement of almost $1-billion in liabilities, including $733-million of reserves that had been misstated in the first and second quarters of 2003.

Richmond also testified he faced complaints from Nortel about the work of two new lead audit partners he had assigned to the Nortel file the prior year.

Mr. Richmond said former Nortel CEO Frank Dunn and former chief financial officer Douglas Beatty both felt the new Deloitte partners – John Cawthorne and Don Hathway – were far more rigid than their predecessors had been. “That bothered them,” Mr. Richmond said.

“My response at the time, and today, was that the world had changed.”

Next chance for a trial for a Big Four firm in the US is again against Deloitte. Steven Thomas, the only lawyer who consistently tries and wins cases against the biggest auditors, has a trial for the Taylor Bean & Whitaker mortgage originator fraud case starting in June 2013.

Main page photo is Steven Thomas of TAF Law.