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

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.

Read this article in its entirety at the re: The Auditors, a blog by Francine McKenna.

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