PwC faces 3 significant trials that threaten its business

The Big Four global audit firms go to court all the time but are hardly put on trial.

PricewaterhouseCoopers LLP, the U.S. member of the global professional-services giant, is currently facing not one, not two, but three significant trials for allegedly negligent audits. An unfavorable verdict in the trial currently playing out in a Florida state court could inflict a significant monetary wound. That, combined with a possible unfavorable judgment in another trial scheduled for federal court in Alabama in February of 2017, and a third in a Manhattan federal court within the next year, may be fatal.

The case against PwC brought by the Taylor Bean and Whitaker bankruptcy trustee is quite unusual, said Tom Rohback, an attorney with Axinn Veltrop & Harkrider. That’s because it is one of the few cases from the credit crisis seeking to hold auditors responsible for crisis-era losses to actually go to trial.

“Beyond the $5.5 billion sought, the case is unusual because the plaintiff is the trustee of the entity that committed the fraud and is suing not its own audit firm but the audit firm of the institution it defrauded,” he said. “The trial has the potential to influence public perception of auditors, as well as strategies used by the plaintiff lawyers that try cases against them, regardless of the eventual verdict.”

Settlements preferred

In the U.S. the Big Four audit firms have, in recent history, almost always settled because of the fear that one catastrophic jury verdict could shut them down for good. In addition, trials show the public just how often auditors fail to detect fraud. Settlements prevent the public from hearing that in open court and typically put partners’ pretrial testimony under confidential court seal forever.

The bankruptcy trustee for Taylor Bean & Whitaker Mortgage Corp., once the 12th-largest U.S. mortgage lender, sued PwC for $5.5 billion in damages in 2012 after the bank went bankrupt in August 2009. Federal regulators, not the bank’s auditor, Deloitte, uncovered a $3 billion fraud involving fake mortgage assets. The bankruptcy trustee for Taylor, however, alleges that PwC was negligent in not spotting the fraud from its perch as auditor of Colonial Bank, which bought the allegedly fake mortgages that Taylor Bean had originated and that made Taylor Bean’s losses worse.

Beth Tanis, the lead attorney for PwC from the firm King & Spalding, issued a statement at the beginning of the trial: “PricewaterhouseCoopers did not audit or perform any other services for Taylor Bean. With regard to the services performed for Colonial Bancgroup, one of the targets of Taylor Bean’s fraud, PricewaterhouseCoopers did its job,” said Tanis. “As the professional audit standards make clear, even a properly designed and executed audit may not detect fraud, especially in instances when there is collusion, fabrication of documents, and the override of controls, as there was at Colonial Bank. We are confident that a jury will understand the applicable rules and standards in this case and decide accordingly.”

A spokeswoman for PwC declined to provide further comment.

Six Taylor Bean executives went to jail for their roles in the fraud. The bank’s former chairman, Lee Farkas, was sentenced to 30 years in prison. Taylor Bean auditor Deloitte settled with the trustee for an undisclosed amount in 2013.

The bankruptcy route

Colonial Bank, a Montgomery, Ala., institution with $25 billion in assets, also filed for bankruptcy in 2009. The Colonial Bank bankruptcy trustee and the Federal Deposit Insurance Corp. brought a lawsuit in 2012 against PwC for negligence as the auditor of Colonial Bank, claiming $1 billion in damages. That case is scheduled to go to trial in February.

The FDIC’s suit was its first against an auditor for a financial-crisis-era bank fraud or failure. Crowe Horwath LLP, Colonial’s outsourced internal audit firm, is also named in the Colonial suit.

Tanis, in her opening statement at the trial on Aug. 9, said that no one at Taylor Bean relied on PwC’s audit of Colonial Bank, even though Colonial was Taylor Bean’s biggest mortgage buyer.

“There will be no document showing you that these directors or anybody else at Taylor Bean ever received these Pricewaterhouse audit reports, actually read these Pricewaterhouse audit reports and relied on them,” she said.

Taylor Bean’s employees, customers and creditors, who all lost something when the firm went bankrupt, were relying on Colonial Bank to operate as an honest business partner that was accurately reflecting its financial obligations to Taylor Bean, a point emphasized by Steve Thomas, the attorney for the Taylor Bean trustee, in his opening statement on Tuesday.

Thomas told the jury that PricewaterhouseCooper’s failure mattered, because many people were counting on it to do its job. “PwC was lending credibility to Colonial’s financial statements. PwC’s failure mattered because Taylor Bean and Whitaker, and others, relied on PwC to do its job,” he said.

PwC and the other Big Four accounting firms all had major clients that failed, were bailed out or were effectively nationalized during the crisis. None of those cases went to trial. Ernst & Young LLP paid $99 million to investors and $10 million to the New York attorney general’s office for its role as auditor of Lehman Brothers Holdings Inc. KPMG settled its exposures early, and within a week of each other in 2010 settled for an undisclosed amount for its audit of New Century, another big mortgage originator, and paid $24 million for its audits of Countrywide Bank, which was distressed when it was sold to Bank of America BAC, +0.20% .

Deloitte settled its exposure as auditor of Bear Stearns for $19.9 million. Bear Stearns was bought for a relative pittance by J.P. Morgan JPM, -0.21% during the crisis. Deloitte was also the auditor of Washington Mutual and contributed $18.5 million to a settlement with investors for its negligent audits. Deloitte went on to earn hundreds of millions of dollars reviewing J.P. Morgan’s exposure to foreclosure fraud claims for Bear Stearns and Washington Mutual mortgages it inherited as part of those purchases.

The litigation hit

Those settlements pale in comparison to the total of $6.5 billion that Taylor Bean and Colonial Bank trustees are looking for from PwC. On Aug. 5 U.S. District Judge Victor Marrero in Manhattan rejected PwC’s request to dismiss MF Global’s lawsuit alleging professional malpractice that contributed to the October 2011 bankruptcy of the brokerage firm once run by former New Jersey Gov. Jon Corzine. That suit is seeking $1 billion in damages, bringing the total potential claims PwC is facing over a very short period to $7.5 billion.

Jim Peterson, a former in-house attorney for Arthur Andersen and the author of the book “Count Down: The Past, Present and Uncertain Future of the Big Four Accounting Firms,” has periodically asked the question on his blog: “How big is the ‘worst case’ litigation hit that would disintegrate one of the surviving Big Four?”

Back in September 2006, a report by the consulting firm London Economics to the EU markets commissioner modeled the collapse of a Big Four partnership in the U.K. That model quantified the level, according to Peterson, “of personal sacrifice, beyond which the owner-partners would lose confidence, withdraw their loyalty and their capital, and vote with their feet.”

Peterson’s analysis concluded that critical numbers of partners would defect and put a firm into a death spiral, if they faced a partner-income-distribution reduction of 15% to 20% that extended over three or four years. Peterson extended the figures to the global level to calculate breakup figures for the Big Four. That brought the number down from an optimistic maximum of about $7 billion to about $3 billion.

However, global numbers assume that a Big Four network under deadly financial threat could hold it together and count on the support of its member firms and partners around the world. But that’s not what happened to Arthur Andersen after the bankruptcy of client Enron and an indictment for obstruction of justice in 2001. Instead, Andersen’s non-U.S. member firms flew the coop in 2002, and the firm itself was forced to fold.

Based on the experience of Arthur Andersen, it is unlikely, Peterson told MarketWatch, that PwC’s non-U.S. member firms would pitch in to pay a U.S.-based catastrophic court judgment or a series of them. Peterson’s most recent update of his tipping-point calculation, completed in early 2015, assumes the U.S. firm is left to pay its own way out, as was Andersen’s U.S. firm. The worst-case tipping points for the U.S. practices shrinks from the $3 billion global number down to $900 million for the most financially vulnerable of the four firms.

These numbers matter, according to Peterson, because the loss of another Big Four firm would throw the entire system into chaos.“There is no contingency plan or readiness among the three survivors to stay in an even more risky business or take on the failed firm’s risky clients or outstanding litigation claims,” he said.

The Petrobras angle

The three lawsuits against PwC that are on trial or going to trial in the next year all name only the U.S. firm as a defendant. Another large case names PwC’s Brazil member firm for its allegedly negligent audits and failure to detect a multibillion-dollar bribery and corruption fraud at the state-sponsored oil company Petrobras.

Those plaintiffs, which include the Bill Gates Foundation, could decide to name PwC U.S. as a defendant or eventually require the U.S. firm to ante up to pay a verdict that would otherwise knock out the Brazilian firm, a key cog in its service network for multinational clients.

MarketWatch asked Rohback why PwC would choose to go to trial given the stakes. “Oh, they probably didn’t choose to try the case. They just haven’t hit on a settlement number they can stomach yet,” he said.

PwC has few options at this point, Rohback said. “There’s still time to settle, and they could win it. If they lose, they can ask the judge for a stay in enforcing any judgment until an appeal can be heard.”

Florida law prohibits judgments that would bankrupt a defendant. PwC would probably be reluctant to go to court and open its books to prove it was too poor to pay a judgment. However, in a previous case against an audit firm in Florida tried by Taylor Bean trustee attorney Thomas, the court allowed audit-firm partners to be paid “profits” each year before considering claims of any parties damaged by the firm’s frauds or gross negligence.

Audit firms have no duty to reserve for or disclose serious legal contingencies, since they are partnerships. Thomas had to file a motion to force discovery because he suspected that while the case was under appeal “assets have been or are being dissipated or diverted while such a stay is in place.”

Source: MarketWatch