The recent ruling (28th December) by US District Court Judge Barbara Rothstein, granting the FDIC’s professional negligence claim against PwC, and ruling that PwC breached the professional duties it owed CBG as CBG’s independent, external auditor, has potentially far-reaching consequences.
The case now proceeds to the damages phase, where it is unknown how much Rothstein will award the FDIC for PwC’s professional negligence. However, by holding the FDIC eligible to collect on claims the bank is prevented from pressing (because Rothstein ruled that the Alabama bank and its holding company were barred from recovering money over the fraud because their employees perpetrated the crime or knew about it), the judge has entered new territory. The FDIC is only able to claim damages as this is based on an earlier novel ruling by the court that immunised the FDIC from imputation-based defences.
PwC argues it cannot be ordered to serve as insurer for a fraud neither it nor State and Federal banking regulators uncovered. If the judge’s ruling stands, PwC may be held to that role and liable to pay very substantial damages. This could mean higher costs for future clients of auditing firms, as they are forced to add the cost of a huge potential liability into every assignment.
What Happened ?
On August 3rd 2009, the FBI and the Treasury Department simultaneously raided the offices of Colonial and Colonial’s largest customer, TBW. As a result, the US financial sector, which was already reeling from the subprime mortgage crisis, the collapse of Lehman Brothers, and a drop in the Dow Jones Industrial Average of more than 20%, was rocked by yet another financial crisis: Colonial, one of the 25 largest banks in the United States at the time of the FBI raid, had been the victim of a multi-year (commencing in 2002), multi-faceted, multi-billion dollar fraud.
Ten days after the raid, the State of Alabama Banking Authorities closed Colonial and appointed the FDIC its Receiver. CBG, Colonial’s parent company, filed for Chapter 11 bankruptcy protection eleven days later. CBG’s bankruptcy filing was followed by that of TBW, the largest privately held mortgage company in the United States at the time.
If the judge’s ruling stands, external audit costs for companies could rise substantially, as external audit firms build in the added costs of huge potential liabilities into every engagement. Investor returns could fall significantly, and post-tax profits available for distribution via dividends to shareholders would be reduced. Bad news all round.
Perhaps more significantly, the nature of the relationship between external auditors and their corporate clients, and of the dynamic of the external audit itself, would fundamentally change. There would be greater emphasis on companies to implement the most rigorous fraud prevention controls and allocate increased resources to fraud prevention and detection. We believe that Institutional investors will increasingly demand this, and that in years to come, they may not consider investing in companies that have not been independently assessed from a fraud risk perspective, both from internal and external threats.