528 Major Cases CO 29255 1016M . Major Case 1 Colonial Bank Case Overview On January 2, 2018, U.S. District Court Judge Barbara Rothstein ruled that PricewaterhouseCoopers (PwC) negligently failed to uncover a $2.3 billion fraud scheme between PwC audit client Colonial Bast and Taylor, Bean & Whitaker Colonial Bank is now in receivership under Federal Deposit Insurance Corporation (FDIC) rules. Taylor Bean is a bankrunt mortgage lender. PwC already paid an undisclosed amount in 2016 to settle related claims by Taylor Bean's trustee.' The decision in the case means it now moves into a damages phase, where the FDIC is seeking as much as $2.1 billion. The collapse of Colonial Bank, which had $25 billion in assets and $20 billion in deposits, was the hi gest bank failure of 2009. The FDIC estimates Colonial's failure will ultimately cost its insurance fund $5 billion, making it one of the most expensive bank failures in U.S. history. The lawsuit against PwC was the first of its kind filed against an accounting firm in the aftermath of the financial recession. In August 12, 2012, some former Colonial Bank directors and officers agreed to settle the securities class action lawsuit against them for the bank's collapse. The settlement did not include WC, While Judge Rothstein held PwC liable for negligence, it rejected similar claims by the bankruptcy trustee for Colonial BancGroup because the bank itself was responsible for the fraud. That professional negligence claim was barred by the in pari delicto doctrine and the audit interference rule. Latin for "in equal fault." In pari delicto means, if the fault of the fraud is more or less equal between two or more parties (ie., Colonial Bank and PwC), neither party can claim breach of the contract by the other. The audit interference rule holds that an auditor may assert a comparative fault defense where it can establish that the client's negligence "interfered with the auditor's performance of its duties, as in the Colonial Bank case. In her opinion, Judge Rothstein emphasized that PwC had relied on the chief architect of the fraud. Taylor Bean chair Lee Farkas, to verify key information about the collateral underlying a Colonial credit facility for Taylor Bean. PwC signed off on Colonial's audit without ever understanding the underlying account ing event, which was based on phantom mortgage securitizations. PwC allowed Colonial to account for certain types of mortgages from Taylor Bean as sales rather than as loans from Colonial to Taylor Bean that were secured by mortgages. Ludge Rothstein ruled PwC was guilty of professional negligence. It rapped the firm for failing to follow "illogical dates and to check whether an entire class of loans-nearly 20% of its mortgage lending ware house_existed. She also cited testimony from a PwC partner in an earlier, related case that that "our audit procedures were not designed to detect fraud." Puceave the bank's parent, Colonial BancGroup, a clean audit opinion for vears before it was disclosca that substantial portions of Colonial's loans to Taylor Bean were secured against assets that did not est In the malpractice case. Judge Rothstein agreed with the FDIC that PwC failed to meet professional accounting standards in its audits of Colonial. PwC did not design its audits to detect fraud and PwC failure to do so constitutes a violation of the auditing standards," Rothstein ruled.? e s com article La Frankel Atheart of FDIC's winy. PwC. an unsettled theory. Reuters, January 2 2018 het stofdic/atheartoffdics win-wpwanunsettled theory-idUSKBNIERIUL Matthew Heller. Pac Found Liable for $2B Colonial Bank Fraud, clo.com, January 2 2018 h pwofound-able-2b-colonial-bank-fraud/- r ad 2015/00 PwC Defense of Audit Major Cases $29 PC in its de private jet, vintage suditors, circun in its defense, said it was duped by Farkas, who skimmed millions of dollars from Colonial to buy et vintage cars, and a vacation home. Rothstein had ruled that Colonial executives lied to circumvented internal controls by recycling mortgage data and even created wire transicts to into believing Taylor Bean's collateral mortgages had been paid off. trick PwC in PwC put its own Colonial Bank emplow actively and substantially in request to inspec had attempted to i tits own spin on the verdict by stating that the court's ruline regnized that in addition to those al Bank employees who perpetrated the fraud. numerous other emploses at Colonial BancGroup and substantially interfered with their audit. But Rothstein faulted PwC for Gilling to inspect or even to inspect the underlying documents for some Taylor Bean mortgages "PwC argues that even if it attempted to inspect the underlying loan documents, it would not have uncovered the fraud because the ters would simply have created fake documents. This, of course is something that we will never know ther unusual aspect to the claim that PwC did not follow appropriate professional standards is the allegation PC did not understand the nature and scope of the transactions. After a PwC auditor who was supposed to ke sense of the transactions gave up, saying they were above his may ende PaCassigned a college graduate em to evaluate the nearly $600 million asset. Rothstein was distinctly harsh about PwC's failings. Basing Colonial's certification on Farkas' account of Taylor Bean's collateral was "quintessentially the same as asking The fox to report on the condition of the hen house." She added that expecting an intern to decipher a loan facility beyond the expertise of a senior auditor was a truly astonishing departure from PwC's mandate. Internal Audit and ICFR Colonial Bank had outsourced internal audit to another accounting firm, Crowe Horwath. PwC was required to review Crowe's work product, and it did so. Crowe, however, never identified or performed any evaluation of internal controls specifically relating to the credit facility, and there was no documentation suggesting otherwise. Nonetheless, PwC concluded that internal controls for Colonial's Treasury opera- tion (including the credit facility) were effective and could be relied upon by PwC to reduce its substantive audit procedures. PwC reached this conclusion in the absence of any evidence that Crowe (or anyone else) had tested any internal controls for the credit facility. Digging deeper PwC knew that Colonial's Treasury and Securities Purchased Under Agreements to Resell (which included $51.5 billion in credit facility financing for Taylor Bean at December 31, 2007) was "Significant Process for which it would test controls. During the actual audit however, PwC excluded e credit facility entirely from the key controls that it tested despite the credit facility significant account balance and distinct class of transactions that called for transaction-specific controls WC did not perform any walkthrough, skipping this crucial step because key controls were not identified Crowe, and/or PwC did not properly assess the inherent risks regarding the existence and validity of facility assets. PwC instead decided that it would rely on Crowe to perform all walkthroughs FDIC's claims against Crowe Horwath, who acted under a consulting contract as Colonial's internal department were unusual. PwC's workpapers gave FDIC a glimpse into PwC's opinion of the quality 1. PwC i cht. the controls audit department, were u Crowe's work. Regar for any failings * Work. Regardless of what PwC thought, the FDIC believed that PwC did not do enough to con Tallings or verify the assertions about internal controls Crowe made on behalf of Colonial mar Matthew hew Heller. November 10, 2012, https:// "Alison Frankel. pricewaterhousecoopers and colonial bank/#4JSa. Francine Mcken www.forbes.com/sit Francine McKenna. Mckenna A Tale o u au suits PricewaterhouseCoopers and Colonial Bank, forbes.com, November in com/sites/francinemckenna/2012/11/10/sale of two pracewaterhouseCooperando d collusion to per sserted gross negligence by Crowe. Allegedly, there was concealment and collusion was held to the AICPA's standards petrate a fraud within the bank and from outside sources. Crowe was consulting work which, while stringent as the AICPA Code of Professional Conduct standards, do carry the force of law that the Sarbanes-Oxley Act and the PCAOB auditing standards do. The FDICAL maintained that Crowe should have followed the professional standards promulgated by the Institute Internal Auditors. Would an internal audit function staffed by Colonial employees instead of an outsid consultant have been sued under the same circumstances The Colonial ruling marks the first time an auditor has been held liable for fraud in many years. Lawyers who defended auditors were outraged by the ruling, calling it "an aggressive interpretation," "extremely disturbing." and a "one-off decision that will be reversed upon appeal." They are particularly upset that the case ever went to trial. In most auditing failure cases, companies are barred from suing their auditor for failing to detect fraud if-as happened at Colonial-their employees actively participated in the mal Teasance. But in this case, the bank went bankrupt, and the FDIC sued to recover money for taxpavere Courts around the country are split on whether the government can do that, and Judge Rothstein opted to let the FDIC sue. Attorney Michael Dell argued that the Colonial decision would fundamentally change the nature of auditing: "Audit firms would effectively be insurers for the wrongdoing of their clients. If the ruling stands, some lawyers believe investors will find it easier to hold auditors accountable in future corporate fraud cases. Questions 1. Update the facts of this case for any relevant events that have taken place since the January 2018 ruling. 2. Which rules of conduct in the AICPA Code of Professional Conduct were violated by PwC? Explain. 3. Which PCAOB auditing standards were violated by PwC? Explain why those violations occurred and whether PwC should be held responsible. 4. Attorney Michael Dell argued that the Colonial Bank ruling would effectively hold audit firms liable for the wrongdoing of their clients. Is that the way you read the facts of the case and Judge Rothstein's ruling? Is there anything wrong with holding auditors responsible for the wrongdoing of their clients when client employees actively participate in the malfeasance? Explain 5. Is it in the public interest to allow auditors to escape legal liability under the in pari delicto doctrine! 6. When should auditors disclose critical audit matters (CAM)? Assume the Colonial Bank case occurred subsequent to the effective dates of the new auditing standard on disclosing CAMs. Which disclosures should PwC have included in the audit report of Colonial Bank? Maior Case 2 Logitech International Laaitech International S.A. (LOGI) is incorporated in Switzerland and has substantial operations the United States. LOGI is primarily involved in manufacturing and selling peripherals for computer and electronic devices. Its shares are listed on both the Nasdaq Global Select Market under the tradits symbol LOGI. and the SIX Swiss Exchange, under the trading symbol LOGN The company maintains an executive office and its Americas region headquarters in Newark, California LOGI's common stock symbol LOGN, The executive office and its Americas region headquarters in a registered with the Securities Exchange Commission (SEC) pursuant to the Exch ne Exchange Act of 1933. Brooke Masters. PwC's Failure to Spot Colonial Fraud Spells Trouble for Auditors, January content/c2ce45d6-f116-11e7-b220-857e26d laca4 2018 hits www.fl. 528 Major Cases CO 29255 1016M . Major Case 1 Colonial Bank Case Overview On January 2, 2018, U.S. District Court Judge Barbara Rothstein ruled that PricewaterhouseCoopers (PwC) negligently failed to uncover a $2.3 billion fraud scheme between PwC audit client Colonial Bast and Taylor, Bean & Whitaker Colonial Bank is now in receivership under Federal Deposit Insurance Corporation (FDIC) rules. Taylor Bean is a bankrunt mortgage lender. PwC already paid an undisclosed amount in 2016 to settle related claims by Taylor Bean's trustee.' The decision in the case means it now moves into a damages phase, where the FDIC is seeking as much as $2.1 billion. The collapse of Colonial Bank, which had $25 billion in assets and $20 billion in deposits, was the hi gest bank failure of 2009. The FDIC estimates Colonial's failure will ultimately cost its insurance fund $5 billion, making it one of the most expensive bank failures in U.S. history. The lawsuit against PwC was the first of its kind filed against an accounting firm in the aftermath of the financial recession. In August 12, 2012, some former Colonial Bank directors and officers agreed to settle the securities class action lawsuit against them for the bank's collapse. The settlement did not include WC, While Judge Rothstein held PwC liable for negligence, it rejected similar claims by the bankruptcy trustee for Colonial BancGroup because the bank itself was responsible for the fraud. That professional negligence claim was barred by the in pari delicto doctrine and the audit interference rule. Latin for "in equal fault." In pari delicto means, if the fault of the fraud is more or less equal between two or more parties (ie., Colonial Bank and PwC), neither party can claim breach of the contract by the other. The audit interference rule holds that an auditor may assert a comparative fault defense where it can establish that the client's negligence "interfered with the auditor's performance of its duties, as in the Colonial Bank case. In her opinion, Judge Rothstein emphasized that PwC had relied on the chief architect of the fraud. Taylor Bean chair Lee Farkas, to verify key information about the collateral underlying a Colonial credit facility for Taylor Bean. PwC signed off on Colonial's audit without ever understanding the underlying account ing event, which was based on phantom mortgage securitizations. PwC allowed Colonial to account for certain types of mortgages from Taylor Bean as sales rather than as loans from Colonial to Taylor Bean that were secured by mortgages. Ludge Rothstein ruled PwC was guilty of professional negligence. It rapped the firm for failing to follow "illogical dates and to check whether an entire class of loans-nearly 20% of its mortgage lending ware house_existed. She also cited testimony from a PwC partner in an earlier, related case that that "our audit procedures were not designed to detect fraud." Puceave the bank's parent, Colonial BancGroup, a clean audit opinion for vears before it was disclosca that substantial portions of Colonial's loans to Taylor Bean were secured against assets that did not est In the malpractice case. Judge Rothstein agreed with the FDIC that PwC failed to meet professional accounting standards in its audits of Colonial. PwC did not design its audits to detect fraud and PwC failure to do so constitutes a violation of the auditing standards," Rothstein ruled.? e s com article La Frankel Atheart of FDIC's winy. PwC. an unsettled theory. Reuters, January 2 2018 het stofdic/atheartoffdics win-wpwanunsettled theory-idUSKBNIERIUL Matthew Heller. Pac Found Liable for $2B Colonial Bank Fraud, clo.com, January 2 2018 h pwofound-able-2b-colonial-bank-fraud/- r ad 2015/00 PwC Defense of Audit Major Cases $29 PC in its de private jet, vintage suditors, circun in its defense, said it was duped by Farkas, who skimmed millions of dollars from Colonial to buy et vintage cars, and a vacation home. Rothstein had ruled that Colonial executives lied to circumvented internal controls by recycling mortgage data and even created wire transicts to into believing Taylor Bean's collateral mortgages had been paid off. trick PwC in PwC put its own Colonial Bank emplow actively and substantially in request to inspec had attempted to i tits own spin on the verdict by stating that the court's ruline regnized that in addition to those al Bank employees who perpetrated the fraud. numerous other emploses at Colonial BancGroup and substantially interfered with their audit. But Rothstein faulted PwC for Gilling to inspect or even to inspect the underlying documents for some Taylor Bean mortgages "PwC argues that even if it attempted to inspect the underlying loan documents, it would not have uncovered the fraud because the ters would simply have created fake documents. This, of course is something that we will never know ther unusual aspect to the claim that PwC did not follow appropriate professional standards is the allegation PC did not understand the nature and scope of the transactions. After a PwC auditor who was supposed to ke sense of the transactions gave up, saying they were above his may ende PaCassigned a college graduate em to evaluate the nearly $600 million asset. Rothstein was distinctly harsh about PwC's failings. Basing Colonial's certification on Farkas' account of Taylor Bean's collateral was "quintessentially the same as asking The fox to report on the condition of the hen house." She added that expecting an intern to decipher a loan facility beyond the expertise of a senior auditor was a truly astonishing departure from PwC's mandate. Internal Audit and ICFR Colonial Bank had outsourced internal audit to another accounting firm, Crowe Horwath. PwC was required to review Crowe's work product, and it did so. Crowe, however, never identified or performed any evaluation of internal controls specifically relating to the credit facility, and there was no documentation suggesting otherwise. Nonetheless, PwC concluded that internal controls for Colonial's Treasury opera- tion (including the credit facility) were effective and could be relied upon by PwC to reduce its substantive audit procedures. PwC reached this conclusion in the absence of any evidence that Crowe (or anyone else) had tested any internal controls for the credit facility. Digging deeper PwC knew that Colonial's Treasury and Securities Purchased Under Agreements to Resell (which included $51.5 billion in credit facility financing for Taylor Bean at December 31, 2007) was "Significant Process for which it would test controls. During the actual audit however, PwC excluded e credit facility entirely from the key controls that it tested despite the credit facility significant account balance and distinct class of transactions that called for transaction-specific controls WC did not perform any walkthrough, skipping this crucial step because key controls were not identified Crowe, and/or PwC did not properly assess the inherent risks regarding the existence and validity of facility assets. PwC instead decided that it would rely on Crowe to perform all walkthroughs FDIC's claims against Crowe Horwath, who acted under a consulting contract as Colonial's internal department were unusual. PwC's workpapers gave FDIC a glimpse into PwC's opinion of the quality 1. PwC i cht. the controls audit department, were u Crowe's work. Regar for any failings * Work. Regardless of what PwC thought, the FDIC believed that PwC did not do enough to con Tallings or verify the assertions about internal controls Crowe made on behalf of Colonial mar Matthew hew Heller. November 10, 2012, https:// "Alison Frankel. pricewaterhousecoopers and colonial bank/#4JSa. Francine Mcken www.forbes.com/sit Francine McKenna. Mckenna A Tale o u au suits PricewaterhouseCoopers and Colonial Bank, forbes.com, November in com/sites/francinemckenna/2012/11/10/sale of two pracewaterhouseCooperando d collusion to per sserted gross negligence by Crowe. Allegedly, there was concealment and collusion was held to the AICPA's standards petrate a fraud within the bank and from outside sources. Crowe was consulting work which, while stringent as the AICPA Code of Professional Conduct standards, do carry the force of law that the Sarbanes-Oxley Act and the PCAOB auditing standards do. The FDICAL maintained that Crowe should have followed the professional standards promulgated by the Institute Internal Auditors. Would an internal audit function staffed by Colonial employees instead of an outsid consultant have been sued under the same circumstances The Colonial ruling marks the first time an auditor has been held liable for fraud in many years. Lawyers who defended auditors were outraged by the ruling, calling it "an aggressive interpretation," "extremely disturbing." and a "one-off decision that will be reversed upon appeal." They are particularly upset that the case ever went to trial. In most auditing failure cases, companies are barred from suing their auditor for failing to detect fraud if-as happened at Colonial-their employees actively participated in the mal Teasance. But in this case, the bank went bankrupt, and the FDIC sued to recover money for taxpavere Courts around the country are split on whether the government can do that, and Judge Rothstein opted to let the FDIC sue. Attorney Michael Dell argued that the Colonial decision would fundamentally change the nature of auditing: "Audit firms would effectively be insurers for the wrongdoing of their clients. If the ruling stands, some lawyers believe investors will find it easier to hold auditors accountable in future corporate fraud cases. Questions 1. Update the facts of this case for any relevant events that have taken place since the January 2018 ruling. 2. Which rules of conduct in the AICPA Code of Professional Conduct were violated by PwC? Explain. 3. Which PCAOB auditing standards were violated by PwC? Explain why those violations occurred and whether PwC should be held responsible. 4. Attorney Michael Dell argued that the Colonial Bank ruling would effectively hold audit firms liable for the wrongdoing of their clients. Is that the way you read the facts of the case and Judge Rothstein's ruling? Is there anything wrong with holding auditors responsible for the wrongdoing of their clients when client employees actively participate in the malfeasance? Explain 5. Is it in the public interest to allow auditors to escape legal liability under the in pari delicto doctrine! 6. When should auditors disclose critical audit matters (CAM)? Assume the Colonial Bank case occurred subsequent to the effective dates of the new auditing standard on disclosing CAMs. Which disclosures should PwC have included in the audit report of Colonial Bank? Maior Case 2 Logitech International Laaitech International S.A. (LOGI) is incorporated in Switzerland and has substantial operations the United States. LOGI is primarily involved in manufacturing and selling peripherals for computer and electronic devices. Its shares are listed on both the Nasdaq Global Select Market under the tradits symbol LOGI. and the SIX Swiss Exchange, under the trading symbol LOGN The company maintains an executive office and its Americas region headquarters in Newark, California LOGI's common stock symbol LOGN, The executive office and its Americas region headquarters in a registered with the Securities Exchange Commission (SEC) pursuant to the Exch ne Exchange Act of 1933. Brooke Masters. PwC's Failure to Spot Colonial Fraud Spells Trouble for Auditors, January content/c2ce45d6-f116-11e7-b220-857e26d laca4 2018 hits www.fl