This Major Gap in Regulation Is Protecting Fraudsters from Justice

Something unexpected just happened... A tiny piece of earth was lobbed into a very deep regulatory black hole.

The Senior Judge of the U.S. District Court for the Western District of Washington, Judge Barbara Jacobs Rothstein, ruled last week that the accounting giant PricewaterhouseCoopers was liable for failing to uncover a multibillion-dollar fraud that sank Alabama-based Colonial Bank in 2009.

Allowing the FDIC to try and collect the $2.5 billion Colonial's demise cost the FDIC's insurance fund puts the accounting industry on notice - especially Deloitte, Ernst & Young, KPMG, and PwC, who collectively audit companies that account for 98% of the value of U.S. stock markets. Auditors may be liable for inadequate or fraudulent audit reports they typically rubber stamp with gold stars.

Unfortunately, it's only a shovelful of earth that probably won't hit the bottom of the deep regulatory hole accounting giants swim freely in. Still, there's a potential here for a ripple effect that could end up changing the broken system that allows this level of fraud to happen under auditors' noses.

Here's how deep the regulatory gap is and the odds on PwC being held accountable or settling...

First, Just the Facts

Catherine Kissick, the head of Colonial Bank's mortgage lending department, aided and abetted an insane fraud perpetrated by Colonial's biggest mortgage banking customer, Lee Farkas, the former chairman of bankrupt mortgage lender Taylor, Bean & Whitaker.

Kissick "bought" hundreds of millions of dollars in mortgages from TBW that they didn't own or had previously pledged to other lenders. She also allowed the failing business to freely "sweep" money from Colonial accounts into a TBW overdraft account to keep insolvent TBW afloat in the financial crisis.

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Taylor, Bean & Whitaker collapsed. Farkas was sentenced to 30 years in prison. Six other TBW executives went to jail for their roles in the scheme, and Catherine Kissick was sentenced to eight years for fraud.

Deloitte, TBW's external auditor, settled with TBW's bankruptcy trustee for an undisclosed sum in 2013.

Colonial Bank collapsed in 2009 when it was discovered there wasn't any collateral behind the loans it made to TBW.

That's the straight and narrow view of what happened, and it's incriminating enough. But now it gets even more complicated.

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Loopholes Standing in the Way of Justice

The FDIC, which "stands in the shoes of Colonial Bank as receiver for the failed institution," is suing PwC (Colonial's outside auditor) for not uncovering the TBW scheme in its regular audits of the bank. By law, the bank itself is barred from suing or recovering any money because the bank's own employees either perpetrated the fraud or knew about the crime.

PwC, in its defense, claimed the FDIC, acting on behalf of Colonial, couldn't sue because it was the same as the bank suing it. But Judge Rothstein ruled that while Colonial Bank and its Alabama holding company were barred from recovering anything, the FDIC's case had enough merit to go forward.

According to Michael J. Dell, a law partner with Kramer Levin who isn't representing any party in the case, Judge Rothstein departed from precedent by "raising the FDIC to a higher status as plaintiff than the bank." Dell said, "I would think PwC will win on this issue on appeal."

Specifically, Dell acknowledged, while court-appointed trustees have the right to sue on behalf of the estate of a failed business, they also inherit that institution's legal status.

Even before PwC faces trial in the case, it's claiming "the FDIC was only able to prevail on the claim that it did based on an earlier novel ruling by the Court that immunized the FDIC from imputation-based defenses."

In a prepared statement, PwC said it "intends to appeal that novel ruling at the earliest possible opportunity."

So the little piece of hope thrown into the regulatory black hole that might hold accounting firms responsible for evergreen audits, the same way rating agencies rubber-stamp credit ratings of companies that pay them to tell investors they are safe and sound, might never see the light of day.

History Repeats Itself

That's not because the case is not going to trial - it is. It's just that PwC will settle long before any judge or jury hears all the facts and must render a verdict.

PwC and the other "Big Four" accounting firms all had clients that failed, were bailed out, or were effectively nationalized during the crisis.

All of them were sued. Not a single one of those cases went to trial but were settled instead.

Ernst & Young LLP paid $99 million to investors and $10 million to the New York attorney general's office for its role as auditor of Lehman Brothers Holdings Inc.

KPMG settled for an undisclosed amount for its audit of the mortgage originator and fraudster New Century, and paid $24 million for its audits of insolvent Countrywide Bank, which was sold to Bank of America.

Deloitte settled its exposure as auditor of Bear Stearns for $19.9 million, and as auditor of failed Washington Mutual contributed $18.5 million to a settlement with investors for its negligent audits.

The chance of PwC being held accountable now is exactly between slim and none. Why? Because accounting firms, like rating agencies, are "protected" businesses.

Soon I'll tell you exactly who protects them and what will happen next in this shady saga.

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About the Author

Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.

The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.

Shah founded a second hedge fund in 1999, which he ran until 2003.

Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.

Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.

Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.

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