Investor Lawsuits Against Auditors Prove Difficult to Win

Investors looking to pin blame on auditors for failing to flag risks ahead of the credit crisis are having a hard time getting their cases to stick.

All of the “Big Four” auditors have been sued by investors who collectively seek to recoup billions of dollars lost in the financial meltdown. But while some key cases are yet to be resolved — and a recent civil fraud lawsuit against Ernst & Young by New York prosecutors potentially opens a new front — auditors so far have scored some significant court victories.

Lawsuits have been dismissed against Deloitte & Touche over its audits of mortgage financier Fannie Mae, as well as a case against PricewaterhouseCoopers accusing it of helping hide risks at insurer American International Group.

KPMG settled a lawsuit stemming from its audits of mortgage lender Countrywide Financial Corp, now part of Bank of America , for a relatively modest amount.

“Every time somebody comes up with a new fraudulent scheme, auditors miss it,” said Andrea Kim, a partner at law firm Diamond McCarthy LLP in Houston who represents plaintiffs in auditor lawsuits. “The historical pattern is that they find a way to manage the litigation to limit their liability.”

The credit crisis, which pushed the U.S. financial system to the brink of collapse, led to a wave of investor litigation against banks, lenders and others. Auditors are prime targets because investors try to rope in as many defendants as possible to increase recoveries. Auditors also may have the deepest pockets if the company they audited files for bankruptcy.

Plaintiffs in recent auditor litigation include activist investor Bruce Sherman, the Teachers’ Retirement System of Louisiana and big New York City and New York State pension funds.

Government actions also can open the door to private lawsuits. That may happen in the wake of the New York Attorney General’s civil fraud lawsuit against Ernst & Young over its audits of Lehman Brothers, whose 2008 bankruptcy was the largest in U.S. history, legal experts said.

“To the extent that any regulator blazes a path of wrongdoing, the class-action bar often will bring follow-on lawsuits because a lot of the legwork has been done,” said Scott Berman, a partner at Friedman Kaplan Seiler & Adelman LLP who represents investors in securities litigation.

The New York lawsuit accuses Ernst & Young of helping Lehman move tens of billions of dollars off its balance sheet to hide its true leverage. Ernst rejects the allegations and has said it intends to defend itself against the suit.

AIG RULING MAY REVERBERATE

Plaintiffs, however, face many legal hurdles.

The New York Court of Appeals in October upheld the principle of “in pari delicto,” or equal fault. The ruling allowed PricewaterhouseCoopers to win dismissal of a lawsuit over its audits of AIG, which had to be propped up with $182 billion of federal bailouts.

New York state’s highest court denied plaintiffs’ requests to broaden exceptions to the rule, reaffirming an auditor’s defense where the company it audited was equally to blame for wrongdoing.

“This squarely states that at least for purposes of New York law, the ‘in pari delicto’ defense will be available in most cases to accounting firms,” said William McSherry, a partner at law firm Crowell & Moring LLP in New York.

A 2008 Supreme Court decision on secondary parties in securities cases has also made it harder to sue auditors, said Jake Zamansky, founder of law firm Zamansky & Associates who represents investors in securities fraud cases.

“The Supreme Court has basically said that they have to be a primary violator — you can’t sue them for what we call aiding and abetting under the federal securities laws,” he said. But cases may still be brought in state courts, he said.

Accounting experts also say there was less outright accounting fraud during the credit crisis than in earlier corporate scandal waves such as those of the Enron era.

A lawsuit by Fannie Mae investors against Deloitte & Touche has been tossed out for lack of evidence of fraudulent intent. The complaint did not “sufficiently establish that Deloitte knew or should have known that the housing market would collapse and take Fannie with it,” U.S. District Judge Paul Crotty wrote in his opinion in September.

LEHMAN, OTHERS STILL LOOM

When auditors cannot win dismissals, they typically settle to avoid the risk of a big damage claim. Legal experts say it is impossible to predict the size of settlements that could be reached, but so far amounts have not been crippling.

KPMG in May agreed to pay $24 million to resolve litigation brought by several pension funds over its audits of Countrywide. By comparison, KPMG paid $456 million in 2005 to settle a federal investigation into tax shelters.

Auditors are not out of the woods. Potentially massive claims are still pending over audits of Washington Mutual , Bear Stearns and Lehman Brothers.

In the Washington Mutual case, Deloitte is being sued for alleged improper accounting that plaintiffs say hid problems in the bank’s mortgage lending business. The case is proceeding to mediation by a former federal judge.

Deloitte is also accused of signing off on financial statements for Bear Stearns that overstated the value of mortgage securities. That lawsuit was brought by Bruce Sherman, co-founder of Private Capital Management and Bear Stearns’ largest investor before its 2008 collapse.

Legal experts do not expect any of the lawsuits to put an auditor out of business the way the Enron scandal caused the collapse of Arthur Andersen.

“A lot of it comes down to massive, massive insurance coverage,” said Anthony Sabino, a professor of law and business at St. John’s University in New York. “Five years from now people will say, ‘a sad chapter, but one that we’ve learned from and more importantly moved on from.”‘

(Reporting by Dena Aubin, editing by Matthew Lewis)