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Home > Blogs > Ian Fraser > Holding the auditors accountable for missing corporate fraud

Holding the auditors accountable for missing corporate fraud

Auditor Liability | Holding the auditors accountable for missing corporate fraud Ian Fraser

Should accountancy firms be able to walk away from corporate train wrecks Scot-free –  leaving everyone else, including shareholders, bondholders, employees, customers, governments to pick up the tab?

In the wake of the banking and financial crisis, which saw several banks collapse within a few of months of having been given a clean bill of health by their ‘big four’ auditors, this is certainly worthy of examination.

Traditionally, the courts have barred shareholders from pursuing malpractice claims against auditors in cases of corporate fraud. The 'big four' audit firms - PricewaterhouseCoopers, Deloitte, KMPG and Ernst & Young - have been able to deftly sidestep the wrath of shareholders and others.

However historic notions of auditor non-liability are now coming under scrutiny. In a landmark case that started on September 14, the New York Court of Appeal is weighing up whether auditors should continue to avoid prosecution.

Two suits are being heard back-to-back. The first is against PwC and is being brought by investors in the bailed-out insurer AIG, which PwC audited. The second case relates to litigation by the bankruptcy trustee of Refco Inc, a failed futures broker in which damages are being sought from a number of Refco’s professional advisers, including its auditors Grant Thornton.

Stuart Grant, a partner in Grant & Eisenhofer, the law firm representing AIG shareholders, believes the case could have widespread ramifications, even if the result will technically only apply in New York. He is quoted on Francine McKenna's Re: The Auditors site saying:

“This case has huge implications for the auditing industry ... What auditors are asking for is a ‘get-out-of-jail-free’ card that they can play every time their corporate client [the shareholder] sues them for failing to detect fraud by a corporate manager. But detecting that kind of fraud is exactly what the client hired them to do.

"This will mark the New York court’s first opportunity to decide whether New York law recognizes [the traditional "in pari delicto"] defense as an outright bar to auditor malpractice liability. PwC knows well how high the stakes are.

“Corporations hire accounting firms and pay them huge fees to look for fraud by company employees. If an auditor can overlook fraud but escape malpractice liability by blaming the company for committing the fraud in the first place, then where is the accountability for the auditor?"

Grant and the investors allege that PwC mishandled the AIG audit in the early 2000s. At that time some of the insurer’s top brass, including CEO Maurice Greenberg, were allegedly making bogus transactions to flatter the bottom line. After being caught by the authorities, the insurer had to restate years of financial statements that "eventually reduced stockholder equity by $3.5bn," the plaintiffs claim. AIG also had to pay out an additional $1.5bn in fines. Given PwC's failure to spot the fraud, the shareholders believe they should be allowed to sue PwC for malpractice.

The legal precedent that has prevented shareholders from suing PwC is "in pari delicto", which can be translated as "of equal fault", said AmLawDaily. The precedent bars one co-conspirator in a fraud from suing another co-conspirator, since they all formed part of the same rotten scheme.

Basically the US courts seem to consider shareholders to be synonymous with the company they own, and therefore incapable of going after a second participant in the same accounting scam. However Grant argues that this is absurd and says the courts have become lazy in lumping auditors together with those who commit fraud at quoted firms. "It's a lack of intellectual discipline," Grant says.

Greenberg didn't let PwC know he was making bogus transactions, Grant says; in fact, Greenberg and his co-defendants seem to have  concealed the questionable deals from PwC. Grant argues, however, that PwC should have unearthed them.

To lump all of those entities together as "AIG" and bar them from suing PwC and other such parties is plain wrong, Grant argues.

Here's what McKenna said about the current case on the Re: The Auditors website:

The in pari delicto doctrine is being used like a pair of needle nosed pliers by audit firm defense lawyers to diffuse a bomb – huge liability for some of the biggest frauds in history.

Hmmm, interesting. I await the outcome with interest. If Grant is successful, there's going to be a massive chink in the armor and shields once enjoyed by the 'big four' audit firms. I for one support this. Fear of extinction if audits are sloppy and frauds missed is only likely to encourage auditors to do their jobs better.

Further reading on auditing the auditors and auditor liability:

Tags: auditing , auditor liability , auditors , litigation , shareholders , US
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  1. Anonymous Comment says:
    Wed Jun 20 14:52:57 BST 2012

    Super excited to see more of this kind of stuff online.
  2. shafted says:
    Sun Aug 28 14:03:54 BST 2011

    I am currently the victim of one of the many Chinese US listed frauds. I, like so many others, fealt a degree of safety investing in China due to the company having been audited by an American auditing firm, albeit a small one, and having recieved a clean bill of health from that auditor. After the allegations came to light, I personally travelled to China to investigate the company. On a budget of $2,000, and limited to a one-day tour of the company's factory/facilities, I was able to determine the company has been grossly overstating their revenues (by a minimum of 3x), grossly overstating their inventory (by a factor of at least 10x), grossly overstating certain core assets (by a minimum of 10x), and flat out misrepresenting the existance/use of a core technology (their ONLY core technology). I am not an auditor by profession, although I do have experience as a financial analyst. If I was able uncover such gross levels of fraud, on such a limited budget and timeframe, how is it remotely plausible the American auditing firm was unable to do the same, on a budget of roughly $500,000, and two month's access to the facilities?
  3. AnthonyHarrington says:
    Mon Sep 27 17:52:32 BST 2010

    While it is impossible to predict in advance what a NY court might decide, the odds against PwC being found liable are astronomical. One of the best known axioms of auditing is that if senior management are in on or perpetrating a fraud, the auditor has next to no chance of uncovering malpractice. It will be a more interesting contest if the action moves to consider whether PwC should have had a view on the huge, uncovered risk being run by AIG's CDS sales. Definitely one to watch

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