Questions about Arthur Andersen LLP being sued

SUMMARY: Arthur Andersen LLP has been sued by various Arizona state government agencies for allegedly turning a blind eye to warning signs of fraud at one of its clients, the Baptist Foundation of Arizona (BFA). QUESTIONS: 1) Which Arizona agencies are suing Arthur Andersen? What is the principal allegation in the lawsuit against Arthur Andersen? What is the firm's response? What other actions are state agencies taking against Arthur Andersen? 2) What was the nature of the alleged fraud at the Baptist Foundation of Arizona? What is a Ponzi scheme? How does a Ponzi scheme operate? What is the typical result of such schemes? How did BF A market itself to investors? 3) How did BFA fare in its investments? How did it cover up its real estate losses during the 1980s? How did it convince Arthur Andersen that it was making gains on these investments? Why should auditors be especially careful in reviewing related party transactions? 4) According to the lawsuit, what warning signs did Arthur Andersen ignore? What evidence is cited in support of the allegation? Did Arthur Andersen do anything to suggest that they did heed the warning signs? 5) According to the article, "The suit says the auditor routinely gave BFA unlimited copies of audited financials, which were subsequently distributed to investors." Should this behavior be grounds for a lawsuit? Should investors be denied access to audited financial statements of companies that solicit investments? Would BFA have been unable to photocopy and distribute its audited financial statements to investors if it wanted to do so?Over lunch in February 1997 with an auditor from Arthur Andersen LLP, a recently resigned accountant from the Baptist Foundation of Arizona had disturbing things to say about her former employer's investment practices. She claims she warned the Arthur Andersen accountant, who was handling the foundation's audit, that the religious group had inflated the value of assets and was covering up losses. Just weeks after the lunch, Andersen issued a clean audit, which the foundation subsequently used in its marketing material to attract new investors. While Arthur Andersen maintains that the former accountant only vaguely complained of possible problems at the lunch and didn't spell out details, this much now seems certain: It wasn't the first hint of troubles that the firm received that would later engulf the foundation. How Arthur Andersen reacted to these warning signs is now the subject of litigation brought in state court jointly by Arizona's Corporation Commission's securities division and the state's attorney general, and it also is the subject of disciplinary action brought by Arizona's board of accountancy, a government-operated board. Allegation and Response "While Arthur Andersen's audits were seriously flawed in 1991 through 1994, beginning in 1995 the facts lead to the conclusion that Arthur Andersen not only aided and abetted the securities fraud being perpetrated on investors but in fact may have directly or indirectly participated in that fraud." -- from a lawsuit filed by Arizona's Corporation Commission and attorney general 'Arthur Andersen did everything it was supposed to do ... BFA was involved in a very complicated conspiracy to defraud investors and Arthur Andersen." -- Ed Novak, an outside attorney for Arthur Andersen, who adamantly denies the firm was involved in fraud or a cover up The litigation and complaint are among the latest developments in an alleged fraud that began to surface in mid-1998. In August 1999, state officials ordered BFA to stop marketing investment products, and BFA filed in bankruptcy court several months later, listing debts of $640 million and assets of $220 million. While accounting firms routinely get sued by plaintiffs lawyers seeking to tap deep pockets, in this instance some of the harshest allegations are coming from the state officials. Their lawsuit contends that Arthur Andersen's failure to heed red flags made the auditors a willing participant in the alleged fraud, with anadditional $200 million invested in the foundation before the state shut it down. The behind-the-scenes details surfacing in this case provide a rare look into an accounting tirm's interaction with a client that allegedly was seeking to deceive the public. According to the state's litigation, which seeks investor restitution of as much as $600 million, the ignored warning signs also include an anonymous phone call in mid-1997 to the film's legal group warning that the foundation's investment operation amounted to a Ponzi scheme. In such a scheme, money paid in by later investors is used to pay inated rettuns to the original investors. Also allegedly ignored: a spate of financial transactions with a related company. Andersen maintains that it acted appropriately. "Any time senior management conspires to defraud investors, this kind of complicated fraud will be very difficult to detect, " says Ed Novak, an outside attorney for Arthur Andersen. l-Ie denies the firm was involved in a fraud or a cover-up, and predicts the state will have a difficult time proving its case. He says the accounting firm's only potential liability is for the $175,000 average annual fees it received since 1984, not for investor losses. He adds that Arthur Andersen has cooperated fully with a criminal investigation in the matter. A Bl-'A attorney couldn't be reached for comment Wednesday; in the past, BFA executives have either denied allegations of fraud or declined to comment. In the separate criminal probe, the state attomcy general's office is expected to announce within a few weeks whether it will seek to indict foundation executives and accounting-firm principals, according to people with knowledge of the investigation. The state prosecutor's office declines to comment. The Phoenix foundation's vvoes date to the 1980s, when it grew rapidly by offering Baptist church members high rates of interest and promising that some of the funds would go toward helping local ministries. The foundation put its money into a variety ofdifferent real-estate projects and other investments. When many of the real-estate properties lost value by the late 1980s during the savings-and-loan debacle, 131% executives chose not to write down the assets, according to state officials. Instead, faced with the need to show a balanced budget every year, foundation executives hid the losses in affiliates and independent shell companies -- most with ties to current and former BFA directors and officials - so the parent company still could show a profit, the suit alleges. Between 1991 and 1994, the accounting firm should have known that the fund had become a Pouzi scheme in which new money was needed to pay interest payments to earlier investors, the state alleges. One such key entity used in the alleged fraud was A.L.O. Inc, owned by a former 1317A director, the suit maintains. The entity bought BFA's depressed real-estate assets at inated prices, in transactions usually done in December for BFA to create income or to avoid a loss, the state alleges. During the early 19905, Arthur Andersen knew that Phoenix real-estate values had plummeted -- and that specific properties on BFA's books were sold to affiliated entities for more than they were worth, the suit says. " Without these fabricated transactions BFA would have lost money each year," the suit alleges. Furthermore, because A.L.O. had few liquid assets, it borrowed money from BFA to pay for the real estate. A.L.O. had to borrow more and more to pay the debt service and for new transactions. By 1994, Arthur Andersen, which had reviewed the notes due to EPA and knew that A.L.O. was the largest single creditor, never requested A.L.O.'s balance sheets, available from the state corporation commission, which showed a $14 million loss for 1994, the suit says. Other warning signs also include the departure from BFA in 1996 of five midlevel professionals, who had expressed to EPA senior management concerns about the transactions and relation ships between RFA and related entities, according to the suit. One of these was Karen Paetz, the certified public accountant who met with the Andersen auditor in February 199?. According to the laWsuit, she detailed at the lunch meeting how bad assets with inated values were being shuttled between affiliates to cover up losses, and warned that A.l..0. had a $100 million deficit and was posting losses of $2.5 million a month, the state alleges. Mr. Novak, the attorney for Andersen, denies that Ms. Paetz offered the auditor substantive information about the alleged fraud. The lawsuit maintains that the accounting firm did try to change its audit approach in early 1997 to examine the allegations, but BFA management refused to turn over annual financials for A.l..0. and other purportedly independent entities that the suit maintains were related. Arthur Andersen didn't pursue the matter, relied on senior management's opinions to support the value of the real estate and issued a clean opinion for BF A's 1996 financial report, the suit says. Making matters worse, the state argues, Arthur Andersen knew that its work as the auditor was used as a marketing tool. The suit says the auditor routinely gave BFA unlimited copies of audited financials, which were subsequently distributed to investors. The accounting firm denies it had any involvement in marketing BFA securities. Later in 1997, came the anonymous phone call. The caller telephoned the Chicago headquarters of the firm, and the information made its way to the lead auditing partner on the job, who wrote an internal memo alluding to the allegation, according to the lawsuit. But the allegation didn't earn a mention in Arthur Andersen's audit work papers -- an absence that the state cites as evidence that the accounting firm "purposely modified its audit work papers," that is, intentionally omitted any reference that would show knowledge of the fraud. The lawsuit also cites a worksheet with some erasures. As originally filled out, according to the lawsttit, someone at Arthur Andersen had marked various different fraud risk factors. But some of those markings were subsequently erased, the suit says. Potential fraud issues " were adequately covered in the work papers," Mr. Novak, the attorney for Andersen, say s. "The plaintiffs wouldn't know about them if they weren't." Mark Sendrow, director of the state's securities division, say s: "When there were red flags and information that Arthur Andersen should have acted on and didn't, it reached the point where the auditors were complicit in what happened." Arthur Andersen left the account in mid-1999 and was replaced by Ernst & Young LLP, which concluded after an investigation that BFA had negative cash flow for nine of l 1 years between 1988 and 1998. Write to Michael Schroeder at mikeschroedertlwsjcom