Pricewaterhouse Cooper Faces a Trial For SemGroup Audit and Its Defense Is Predictably Slick

Pricewaterhouse Cooper Faces a Trial For SemGroup Audit and Its Defense Is Predictably Slick

 Pricewaterhouse Cooper (PwC), the former auditor of SemGroup, a Tulsa, Oklahoma oil-and-gas service company, is scheduled to go to trial in August, almost six years after SemGroup’s bankruptcy, for malpractice. SemGroup was the second-biggest bankruptcy of a non-financial company in 2008. The SemGroup Litigation Trust, pursuing claims on behalf of the company and its creditors, alleges PwC did a terrible audit.

From the pre-trial conference order document filed February 14, 2014 in Tulsa, Oklahoma.

The Trust contends PwC failed to exercise due professional care in performing its role as an auditor for its client, SemGroup. PwC knew or should have known that certain transactions were improperly reported in SemGroup’s financial statements.

PwC knew, for example, that SemGroup’s CEO was using company money to fund over $300 million of his own personal financial losses and that this was not reported properly and completely in the financial statements. By March 2008, when PwC issued its audit report, PwC also knew or should have known about SemGroup’s precarious financial condition. But rather than conduct any extended “going concern” procedures or issue any “going concern” warnings in its audit report, PwC gave SemGroup a clean bill of health, and SemGroup collapsed just four months later.

When a company goes bankrupt, management’s excuse —and often the auditors’ defense for not warning anyone— is that unprecedented, cataclysmic, rapidly deteriorating economic events caused harm to the company and came out of nowhere, with no warning. Sometimes it’s a sudden liquidity crisis that chokes the company. Sometimes competitors’ moves leave a company vulnerable to an unexpected, life threatening attack.

You’ll have a tough time winning a suit against management and any directors for a bad business strategy implemented in good faith. It’s still true that you can sue auditors but you can rarely bring them to justice, even if they do come in days late, a dollar’s worth of knowledge short, and with the disadvantage of often being on the wrong side of closed doors.

We’ve heard those excuses from executives quite often with regard to the financial crisis. Now we know there was fraud. We hear the “duped” excuse all the time from the auditors. When fraud occurs, the auditors defend themselves by claiming criminal executives lied to them. If that doesn’t work, they are also willing to claim ignorance to mitigate legal liability. Judges often go along with it.

Judge Richard Posner, for example, has an opinion of who an auditor is and what an auditor does. It’s found in his opinion in 2007 that dismissed Ernst & Young from liability regarding a firm that went bankrupt with no auditor’s “going concern” warning.

Judge Richard Posner during oral arguments in Fehribach v. Ernst & Young LLP, 2007 U.S. App. LEXIS 16918 (7th Cir. 7/17/07) (pdf) [an enhanced version of this opinion is available to subscribers],

Posner: The auditor’s responsibility … so far as the company is concerned … is to make sure the [numbers] are accurate…. You don’t need an auditor to tell you your market is collapsing….  The auditors are not supposed to have business insight.  They’re counters.  They’re not supposed to make predictions about how your markets are doing.  They’re supposed to reconcile your books and indicate you’re not a going concern because your debt is too high and so on….

Do you think the auditor is supposed to know about market power?…  An auditor is not an economic consultant who goes out and figures out what the market trends in an industry are!…Your trends? That’s what the company knows. [Plantiff’s Attorney: You’re right. Here’s what the auditor’s responsibility under SAS 59...]

Posner: That is too vague for me…”

Beating in pari delicto

The lawyers for PwC tried the in pari delicto tact with the Oklahoma judge and failed. Alison Frankel explains in a column for Thomson Reuters On The Case how the plaintiffs quashed the in pari delicto defense.

PwC lawyer Gabor Balassa of Kirkland & Ellis had argued at a Jan. 17 hearing before Judge Kuehn that SemGroup management put Kivisto in charge of a program of derivative trading to hedge the company against oil price fluctuations. The company knew full well what Kivisto was doing, he argued, and can’t now blame its auditor for a failed business strategy. “Your Honor, the imputation of Kivisto’s trading conduct and his knowledge about trading to SemGroup defeats the elements that plaintiff must establish here, reliance and causation,” Balassa said. “SemGroup could not have relied on some allegedly incomplete disclosure about its trading activity in its audited financial statements because SemGroup knew through imputation about the trading activity.”

The plaintiffs, represented by Quinn Emanuel’s Brian Timmons, plan to stick to the basics, however, and have an excellent expert witness to support that effort. Lynn Turner, former Chief Accountant of the SEC under Arthur Levitt, will help plaintiffs claim PwC did not follow applicable Generally Accepted Auditing Standards (GAAS) and that PwC is, therefore, liable for malpractice. The potential liability exceeds $1.1 billion.

Here’s how:

Timmons of Quinn Emanuel emphasized that the trustee’s case is about PwC’s failure to audit SemGroup properly. “The fundamental disconnect is this is not a case where we are suing PwC as a joint tortfeasor in an intentional tort for fraud,” he told Judge Kuehn. “What we are suing PwC for here is auditing malpractice. The focus of our claim is on the way financial information and financial activity that took place at the company was reported in the financial statements.” Citing a 2001 Oklahoma Supreme Court case, Stroud v. Arthur Anderson [enhanced version], Timmons argued that the issue isn’t what SemGroup knew about Kivisto’s risky trades but how those trades should have been reported in SemGroup’s financial statements. That reporting, he said, is PwC’s responsibility. (Timmons also said there’s no evidence SimGroup actually knew how risky Kivisto’s trades were.)

In the pre-trial conference order document, Timmons explains further why in pari delicto does not apply:

Further, PwC contends that SemGroup’s former management is at least equally responsible for any harm claimed and “so the claim is barred by the doctrine of in pari delicto.” This mischaracterizes the law governing auditor liability in Oklahoma and is fundamentally inconsistent with the Oklahoma Supreme Court’s decision in Stroud v. Arthur Andersen & Co., 2001 OK 76,37 P.3d 783.

The judge agreed earlier this month that there are too many disputed issues of fact and denied PwC’s motion for summary judgment based on the in pari delicto defense. PwC can make the arguments again to a jury in August. PwC’s lawyers from the Chicago K&E office pulled out the “unfortunate business judgment based on catastrophic economic events” defense, too, when promising Alison Frankel to do just that.

The losses at issue in this case resulted from business decisions made by SemGroup management and an unprecedented rise in the price of oil in 2008. PwC looks forward to defending its work at the trial in August.

How, with oil close to $147 a barrel at the time, did a company that serves that industry fail? According tor a BusinessWeek story at the time, SemGroup’s trading unit, owned by the CEO but funded by the company via undisclosed loans to the CEO, made an enormous bet that oil prices would fall. “It was the right call—but a few weeks early, ” said BusinessWeek. (That should be called the losing trader’s lament.) SemGroup could not cover billions in trading losses and filed for Chapter 11 protection on July 22, 2008.

This case is a lot like the others

If the SemGroup story sounds a lot like MF Global, you’re not imagining things. MF Global, also a PwC audit client, filed for bankruptcy on October 31, 2010 after its Chairman and CEO Jon Corzine overextended the firm while trading highly risky sovereign debt funded with repo to maturity agreements that left the brokerage firm unable to cover monstrous margin calls from counterparties when the debt of some countries fell in value.

But that wasn’t the first time MF Global’s weak internal controls and poor risk management caused losses. Shortly after MF Global spun out as a public company from PwC audit client Man Financial in 2007, a rogue wheat trader exploited internal control weakness in trading software and caused $141 million in losses at the fledgling public broker-dealer.

PwC is also auditor to Chesapeake Energy, another Oklahoma energy company, where the former CEO set up his own personal internal hedge fund staffed by company employees and used a unique incentive compensation arrangement to engage in undisclosed related party transactions for his own benefit with one of his company’s business partners. He resigned but was never charged with any crimes.

Back in 1999, at Plains All American, another PwC audit client in the energy industry in Oklahoma, a rogue trader made unauthorized crude oil trades that caused $160 million in losses.

There was no “going concern” warning before SemGroup failed, just like there was none at MF Global and none at another PwC audit client, bankrupt, mired in fraud and also headed to trial, Colonial Bank. (PwC is also struggling to effectively use the in pari delicto defense, for now, in the Colonial case, too.)

The SemGroup pre-trial conference order document, dated February 14, says, according to the plaintiffs:

By March 2008, when PwC issued its audit report, PwC also knew or should have known about SemGroup’s precarious financial condition. But rather than conduct any extended “going concern” procedures or issue any “going concern” warnings in its audit report, PwC gave SemGroup a clean bill of health, and SemGroup collapsed just four months later.

The pre-trial conference order document also hints at another cause of action, liability for the “deepening insolvency”.

SemGroup lost over $280 million over time as its funds were used to pay for the personal financial losses of its former CEO. SemGroup’s losses could have been avoided if PwC had done the job it was paid to do. Further, if not for PwC’s audit failures, SemGroup’s Management Committee and its lenders would have been made aware of SemGroup’s precarious financial condition in March 2008, and would have taken steps to prevent SemGroup from suffering over $800 million in additional losses that occurred between March 31, 2008 (the date the 2007 audit report issued) and July 22,2008 (the date SemGroup filed for bankruptcy).

Therefore, had PwC done its job as SemGroup’s outside auditor, SemGroup would have avoided some $1.1 billion in losses.

What should PwC have done?

Judge Posner was dead wrong. The auditor’s role and its responsibility to know its audit client and the risks a client is taking, to understand its business strategy and the impact of changes in the business and economic environment that may affect its success or even its viability, and to adjust the audit scope and the fees it charges for that audit are spelled out clearly in Auditing Standard 9.

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

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