Litigation cases that could possibly take down a Big 4 firm

If a judgment at trial were big enough, it could mean the end of a large firm. Writing on August 13th at Market Watch, Francine McKenna explains PwC faces 3 major trials that threaten its business.

That threaten its business phrase in the headline actually means could take down the entire firm.

There are three major cases, each with a serious enough impact, that an adverse ruling in any one could take out the firm. One is in court now, another expected next February, with the final one in court within a year.

Work with me as I try to process through the cases. Here is the thumbnail version.

Two lawsuits over one client

Taylor Bean & Whitaker Mortgage Corp allegedly generated massive amounts of fraudulent loans, a large portion of which were sold to Colonial Bancgroup.  Both companies failed during the financial crisis.

PwC audited Colonial Bank and allegedly did not discover the bad loans that their client, Colonial Bank, bought from PwC’s non-client Taylor Bean.

PwC is being sued by the FDIC and Colonial Bank trustee, claiming $1B in damages related to PwC’s audit of Colonial Bank.

Deloitte, auditors of Taylor Bean, settled with the Taylor Bean bankruptcy trustee for an undisclosed amount.

Now, the Taylor Bean trustee is suing PwC over PwC’s audit of Colonial Bank. The amazingly creative idea is that if PwC had discovered the Taylor Bean fraud while auditing Colonial Bank, that would have revealed the Taylor Bean fraud, thus forcing Taylor Bean to stop the fraud, thus reducing the amount of the loss incurred by Taylor Bean. That line of reasoning asserts that PwC is liable for fraud committed by a non-client.

Got that?

Massive expansion in auditor liability

Let me try again – The Taylor Bean trustee is seeking $5.5 billion from PwC for not discovering the alleged fraud in a company that PwC did not audit.

The trustee wants to hold the auditor of the victim firm responsible for the fraud committed by the alleged fraudster, whom the CPA firm did not audit.

That would represent a massive expansion in auditor’s liability. Seems to me that would make every auditor responsible for the fraud committed by just about any counterparty to the client.

If that makes sense to anyone, please explain it to me.

Impact of total exposure

The third case facing PwC is a claim for $1B over the failure of MF Global.

That brings the exposure on the three current cases to $7.5 billion.

The article brings in Jim Peterson’s analysis of the tipping point at which a Big 4 firm might fail.

The traditional analysis suggests it would take a loss of around $7B to bring down a world-wide Big 4 firm.

Mr. Peterson points out that is the tipping point at which financially a loss might not be survivable. He drops the number down to the estimated point at which lots of partners in a firm would lose confidence in the firm, withdraw their capital, leave the firm, and take their clients with them, thus triggering a death spiral in the firm. He estimates that tipping point would be about $3B for a world-wide settlement.

Since the Big 4 firms are actually a consortium of all the legally independent national firms, surviving a $3B settlement would require that lots of other national firms would chip in their capital to help one national firm.

Based on history of Uncle Arthur’s collapse (and I’m guessing a dose of understanding human psychology), Mr. Peterson thinks a settlement for an individual national firm of a smaller amount would be sufficient to take out one of the firms. He estimates a $900M settlement could push a national entity into that death spiral.

Article points out Mr. Peterson points out that the loss of one firm could create a contagion because there are not enough huge firms to shuffle around the work if one firm were to “exit the market” (as the euphemism goes). Independence rules typically mean there might not be another firm to take over the work for a large portion of clients. Concentration of industry expertise means there might not be another firm with enough experienced staff to take on the work even if the firm were independent.

So, those three cases are each a rather big deal. If you’ve read to the end of this post, you will really want to read Ms. McKenna’s full article.

Other articles

Here are a few more articles to stretch your brain:

3/21/13 – Reuters – Analysis: Knives out for auditors as class actions go global – Three year old article provides more context for legal environment of Big 4 firms.

About 20 years ago, there were only three countries that allowed class action law firms. Without class action, it is difficult (I’ll guess actually impossible) to sue a large accounting firm. Three years ago there were 20 countries allowing class actoin suits.

Three years ago all the Big 4 self-insured for litigation through a captive formed at the international level. No commercial insurance is available for the risks faced by the Big 4.

Article makes the point that with many more countries allowing class action, the risks of a firm-ending judgment are spreading to more countries and the risks in those countries is increasing.

Keep in mind the international firms are an affiliation of firms in each country. Thus the firm-ending risk ought to be assessed at the country level. One analysis estimated that in England the largest settlement which could be survived was in the range of $324M to $685M, depending on which firm is considered.

To remind us of the industry concentration, the article points out that only two of the companies included in the S&P 500 index are audited by firms other than the Big 4 and less than 10% of the companies in the FTSE 350 index have an auditor other than those four.

Ms. McKenna’s article is getting lots of attention. Here is one followup discussion:

8/14 – Jerri-Lynn Scofield at Naked Capitalism – And Then There Were 3? Three Trials Over Financial Firm Audits Loom for Big Four Firm PwC – Most of the article is pursing the ideas and data points outlined in Market Watch column. Added in is the reduced enforcement under the current administration.

Entertainingly, this article, using the phrase “unintended consequence”,  describes the unintended consequences of the heavy regulatory burden of the Dodd-Frank legislation: TBTF banks are bigger, medium-sized banks are merging in order to grow in size, concentration continues in the federally required ratings industry, and there have been minimal criminal prosecutions. Unexplained in the article is the idea that in order to cope with the massive volume of new rules, larger size is needed for all players in the financial markets.

Reminds me that in general regulatory over-reaction to a crisis continues some of the previous problems and creates new ones. Article almost gets to making the point that the reaction to the financial crisis is the cause of new problems.