United States: SEC Initiates Enforcement Actions Against Auditors And Executives Of Failed Banks

Last month, the Securities and Exchange Commission's ("SEC") Enforcement Division filed two unrelated civil complaints – one against two KPMG accountants and the other against bank executives – relating to misconduct that arose from the financial crisis. The KPMG auditors were charged for their roles in a failed audit of a bank that hid millions of dollars in loan losses from investors during the financial crisis and eventually was forced to file for bankruptcy. The former bank executives were charged with understating millions of dollars in losses and masking the true health of the bank's loan portfolio at the height of the financial crisis.

Two KPMG auditors charged with failing to appropriately scrutinize management's estimates of ALLL.

The SEC has charged two auditors at KPMG for their roles in a failed audit of TierOne Bank, a Nebraska-based bank that allegedly hid millions of dollars in loan losses from investors during the financial crisis. The complaint alleges that the two auditors failed to subject the bank's estimates of allowance for loan and lease losses ("ALLL") to appropriate scrutiny. More specifically, the SEC alleged that the auditors relied principally on stale appraisals and bank management's uncorroborated representations of current value, despite evidence that bank management's estimates were biased and inconsistent with independent market data. The auditors were charged with violating numerous PCAOB audit standards in both their audit of internal control over financial reporting and their audit of TierOne's financial statements.

Although the auditors identified TierOne's Asset Classification Committee as a key control for prevention of a material misstatement of the ALLL, the Committee was not an effective control over valuation of the collateral underlying the bank's FAS 114 loans because it did not generate or review written documentation of the rationale and basis for management's assumptions regarding valuation of collateral. Moreover, the auditors failed to identify any control to ensure compliance with TierOne's lending policy, which required all loans to be supported by current appraisals or evaluations. In fact, TierOne frequently ignored or violated its lending policy, continuing to rely on stale appraisals in significantly deteriorated markets. TierOne also failed to obtain new appraisal on loans that had been modified.

According to the SEC, the auditors relied on an unsupported and unsupportable assumption that appraisals less than a year old were "current," without regard to the property's location or state of development, and that market conditions had not materially deteriorated throughout the year. The auditors failed to recognize inconsistencies between the bank's stated policies and actual practices. Finally, the auditors relied on management's uncorroborated representations even though independent evidence indicated that management's estimating and discounting decisions were biased.

Compounding the identified risks were numerous red flags and other irregularities that should have triggered the auditor's professional skepticism to lead them to investigate further. For example, banking regulators identified a deficiency in TierOne's ALLL of between $17 million and $22 million, representing an approximate 25% increase over the previously reported ALLL. As another red flag, TierOne's valuation adjustments on the collateral underlying the bank's FAS 114 loans were inconsistent with independent data. Also, despite market declines, TierOne management often did not get updated appraisals on the collateral underlying the bank's FAS 114 loans, despite the banking regulators and members of the audit engagement team having noted stale appraisals and making recommendations to update them.

According to the SEC, the auditors failed to subject management's estimates to appropriate scrutiny and failed to apply professional skepticism in obtaining sufficient competent evidential matter to support their opinions.

Three former bank executives charged with understating ALLL during financial crisis.

The SEC has charged three former executives of Norfolk, Va.-based Bank of Commonwealth with engaging in conduct that significantly misrepresented the health of the construction and development loan portfolio of the bank and its parent company, Commonwealth Bancshares. According to the SEC, Commonwealth materially understated its ALLL, materially underreported the bank's non-performing loans, and materially understated and underreported its other real estate owned ("OREO") in its filings with the SEC. All the while, the consistent message in Commonwealth's filings and public statements was that Commonwealth's portfolio of loans was conservatively managed according to strict underwriting standards aimed at keeping loan losses low during a time of unprecedented economic turmoil. Many of the documentation and problematic practices were communicated to the former executives by internal and external auditors, bank regulators and third party consultants. Nevertheless, the former bank executives and Commonwealth continued to misrepresent the condition of Commonwealth.

The financial fraud at Commonwealth arose primarily from the understatement of Commonwealth's ALLL and OREO with regard to two large loan relationships. In 2008, Commonwealth provided full funding of a $16 million loan facility – its largest single loan - which required a re-appraisal of the building that served as the primary collateral. To start, the appraisal overvalued the building based on several incorrect assumptions. In 2009, Commonwealth's internal auditor raised concerns to the CEO and CFO about the loan, and two separate independent credit consultants raised concerns about the credit quality of the entire loan relationship. Then, in late 2009 and early 2010, the internal auditor alerted the CEO multiple times to the fact that demand deposit accounts for the borrowers were overdrawn and that the overdrawn amounts were being used to fund renovations to the building. In the end, as a consequence of Commonwealth's failure to reasonably calculate impairment with respect to the loan, Commonwealth materially understated its ALLL. By April 2011, Commonwealth had written off approximately $13 million of the $16 million loan.

The financial fraud also included understatement of OREO. In March 2010, Commonwealth effectively foreclosed on a separate loan by taking possession of the collateral under a forbearance agreement. Since the forbearance agreement resulted in Commonwealth taking physical possession of portions of the property, GAAP required Commonwealth to classify the property as OREO, which it did not do for over a year, causing Commonwealth to significantly understate its OREO in its financial statements.

Another problem was Commonwealth's removal of loans from past due reports on the basis of loan modification documents that loan officers generated to extend the maturity date of loans or to extend additional credit without having to submit the loan for the same review approval process as newly originated loans. Commonwealth executed a large number of loan modifications near quarter-end to remove loans from the past due report for at least two large loan relationships. This masked the fact that the loans were non-accrual and prevented them from being included as non-performing loans reported on Commonwealth's public filings. Internal and external auditors and others raised concerns about the excessive use of loan modifications and the possibility that they were being improperly used, and banking regulators raised concerns that Commonwealth's liberal use of loan modifications made it difficult to track the true performance of the loans and could be used to mask problem loans. Nevertheless, the process continued.

In addition to the financial fraud, the SEC complaint alleges that Commonwealth made false and misleading disclosures in its Management Discussion and Analysis section and elsewhere regarding asset quality, underwriting practices and overall financial health. Commonwealth's quarterly and annual reports included the following often-seen statements regarding the company's operations:

As a result of the numerous reporting and operational deficiencies noted by the SEC, these normally boiler plate statements materially misrepresented Commonwealth's underwriting practices and financial health.

The SEC complaint also alleges that Commonwealth omitted required disclosure in its public reports in that SEC Guide 3 requires disclosure of loans "where known information about possible credit problems of borrowers....causes management to have serious doubts as to the ability of such borrowers to comply with the present loan repayment terms and which may require disclosure of such loans as [nonaccrual, past due or restructured loans]."

Lessons learned

These two cases provide a review of the all-too-familiar steps taken by management of struggling banks to delay the recognition of problem loans and avoid charge-offs and thereby present the financial condition of the bank in a more favorable - though less accurate - light. Although the actions of the bank executives appear to be intended to buy time so as to forestall the failure of their banks, rather than to defraud investors, their actions resulted in inaccurate financial statements and financial disclosure, which is actionable by the SEC.

While it may be easy to dismiss these cases as isolated occurrences of lax auditors or rogue management, it is nevertheless important to understand what went wrong in the checks and balances of the financial reporting and audit process. In the case against the KPMG auditors, we must consider whether a stronger internal audit function or a more inquisitive audit committee would have prevented the independent auditors from rubber-stamping management's erroneous asset valuations and ignoring the systemic violations of internal policies. In the case of the Bank of Commonwealth executives, the internal audit function appeared to fail its purpose, as the SEC reports several instances of the internal auditor expressing concerns to the CFO, who brushed them aside. Had the internal auditor reported directly to the audit committee, the audit committee may have stepped in and prevented the understatement and misreporting of the ALLL and OREO.

In the case of the bank executives, having signed their company's annual and quarterly reports as well as the certifications that accompany them, the CEO and CFO have assumed liability for the accuracy of their contents. Even the most banal and boilerplate statements – even if couched in the context of cautionary "forward-looking" disclosures such as "believe" or the like – will form the basis for liability should facts and circumstances known at the time the statements are made contradict those statements.

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