FDIC files first lawsuit against auditor of failed bank, targets PwC

November 2, 2012

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.

That’s no longer true. On Wednesday the FDIC, as receiver for the Colonial Bank of Montgomery, Alabama,sued PricewaterhouseCoopers and Crowe Horwath in federal court in Montgomery, claiming that they committed professional malpractice and breach of contract by failing to detect that two Colonial employees helped the notorious (and defunct) mortgage lender Taylor Bean poke hundred-million-dollar holes in Colonial’s balance sheet. (PwC was the external auditor and Crowe Horwath performed internal audits.)

“All the time that (Taylor Bean) was carrying out an increasingly brazen and costly fraud against Colonial, PwC and Crowe never realized that many hundreds of millions of dollars of bank assets did not exist, had been sold to others, or were worthless,” wrote the FDIC’s counsel at Bailey & Glasser and Mullin, Hoard & Brown. “Missing huge holes in Colonial’s balance sheet and serious gaps in internal control, PwC and Crowe continued to perform auditing services for Colonial without ever detecting the (Taylor Bean) fraud. Had they performed their auditing work in accordance with applicable professional standards, they would have learned of the TBW fraud in time to prevent additional losses suffered by Colonial.”

Specifically, the complaint asserted that two Colonial mortgage lending employees permitted since-convicted Taylor Bean officials to divert money from Colonial without the bank receiving collateral in return. Taylor Bean allegedly stole almost $1 billion from Colonial in 2008 and 2009 by promising to supply it with mortgages that it actually sold to other banks. Colonial, according to the FDIC complaint, was seized by Alabama banking regulators in 2009.

You probably recall that auditing firms are frequently the beneficiaries of an old common-law doctrine called in pari delicto, which holds that one wrongdoer can’t sue another for the proceeds of their joint misconduct. Depending on how broadly state courts have interpreted the doctrine (New York offers a particularly broad reading), in pari delicto generally blocks companies that engaged in fraud from suing their auditors for failing to uncover or expose it.

The FDIC seems clearly to be anticipating an in pari delicto defense. The complaint acknowledges that the two Colonial mortgage lending employees, Catherine Kissick and Teresa Kelly, were not only aware of the Taylor Bean scheme but actually facilitated the illegal diversion of cash. They knew full well that Taylor Bean’s chairman was a “pathological liar and fraud” who stole from his own company — yet were so enmeshed in his scheme that they subsequently pled guilty to aiding the fraud. Typically, since the actions of employees are imputed to the corporation, that would make Colonial a wrongdoer right alongside Taylor Bean — exactly the scenario in which in pari delicto would protect its auditors.

But the complaint paints the Colonial lending officials as rogue employees who acted in their own interest but against the interest of the bank. “At no time did this fraud benefit Colonial,” the complaint said. “Rather, the fraud perpetrated was against Colonial, harmed Colonial, was to the detriment of Colonial and resulted in Colonial lending (Taylor Bean) many hundreds of millions of dollars that were secured by worthless or non-existent loans.” If the FDIC can show that Kissick and Kelly were explicitly acting for themselves and against the interests of the bank, in pari delicto may not shield the auditors.

PwC is represented by Elizabeth Tanis of King & Spalding, who took issue in a statement with the FDIC’s assertions. “The Colonial Bank executive who spearheaded the fraud on the Colonial Bank side has testified that her actions were motivated by a desire to prevent loss to the bank and to save an important client relationship. She further testified that (Taylor Bean) was paying Colonial Bank $20 million to $30 million per month in interest,” Tanis said. Moreover, Tanis said, auditors can’t be expected to have uncovered a fraud that was “so well-concealed that neither the FDIC nor the OCC discovered it, even when they performed targeted exams of the mortgage warehouse lending division, where the fraud occurred.”

A Crowe Horwath representative sent an email statement: “The FDIC’s claims are without merit, and Crowe stands behind our work and the people who performed it.”

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