Colonial Bank collapsed in 2009 but its legacy is likely to last lot longer
Colonial Bank collapsed in 2009 but its legacy is likely to last lot longer © Bloomberg

PwC and the auditing profession just lost a big one. On New Year’s Eve, a federal judge in Alabama found that the Big Four firm’s failure to catch a years-long fraud involving made-up mortgages at Colonial Bank amounted to professional negligence.

Judge Barbara Rothstein rapped PwC for failing to follow up on “illogical dates” and check whether an entire class of loans — nearly 20 per cent of its mortgage lending warehouse — existed. She also cited testimony from a PwC partner in an earlier, related case that “our audit procedures were not designed to detect fraud”.

She will now hold a second trial to determine how much PwC owes to the Federal Deposit Insurance Corporation, which spent $2.8bn when it stepped in to protect depositors after Colonial’s 2009 collapse.

The case has sent shockwaves through a profession that has long sought to limit its responsibility for detecting malfeasance. Official standards require auditors to provide “reasonable assurance” that financial statements are free of fraud but add that there is an “unavoidable risk” that some will go undetected.

That is small comfort for investors and creditors when issues are uncovered after a string of clean audits, as occurred in the collapses of Enron and WorldCom, and Steinhoff’s much more recent announcement last month. The global home retailer said it was restating its accounts and was unsure about the “validity and recoverability” of €6bn of assets.

But US courts have largely been sceptical of efforts to sue auditors. The Colonial ruling marks the first time an auditor has been found liable over fraud in many years.

Lawyers who defend the industry are outraged by the ruling, calling it an “aggressive interpretation”, “extremely disturbing”, and a “one-off decision that will be reversed on appeal”. They are particularly upset that the case ever went to trial.

In most auditing failure cases, companies are barred from suing their auditors for failing to detect fraud if — as happened at Colonial — their employees actively participated in the malfeasance. But in this case, the bank went bust and the FDIC is now trying to recover money for taxpayers. Courts around the US are split on whether the government can do that, and Judge Rothstein opted to let the FDIC sue.

Attorney Michael Dell argues that the Colonial decision would fundamentally change the nature of auditing: “Audit firms would effectively be insurers for the wrongdoing of their clients.” PwC was paid $1m a year to audit Colonial but is now potentially on the hook for several hundred million dollars. The firm noted that the judge ruled for the firm on several counts and said it plans to appeal.

If the ruling stands, some lawyers believe investors will find it easier to hold auditors accountable in future corporate fraud cases. “It’s pretty awesome,” one said.

Industry defenders warn that expecting auditors to do more fraud checks would change audit dynamics, driving up costs and delaying companies from issuing their results. “Only plaintiffs benefit from theories expanding professional liability; they are harmful to the accountants [and] to the public companies they audit,” says lawyer Jacob Frenkel.

But step back a minute: the plaintiffs in these cases are defrauded investors, depositors and taxpayers. Changing that balance of power does not sound like such a bad thing.

Letter in response to this column:

Auditing’s expectation gap is worse than ever / From Stephen Kingsley, London, UK

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