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Jan 1990

The liability ramifications of the S&L crisis. (savings and loan)

by Goldwasser, Dan L.

    Abstract- The civil liability of the accounting firms of failed savings and loan institutions (S&Ls) has been brought into question by legal actions being initiated against certain firms by the Federal Savings and Loan Insurance Corporation (FSLIC) and a report of the General Accounting Office citing significant audit and reporting problems. The recovery of damages from the audit firms of failed S&Ls will be a fraction of total losses. The liability exposure for losses will be limited by the detailed litigation involved and formidable legal defenses brought by large firms. There are substantial legal obstacles to the FSLIC bringing claims against the firms because questionable bank practices by S&L management were known to exist by bank regulators prior to the industry's economic distress.

The author carefully places this factual situation in perspective, pointing out the bank de-regulation activity of the early 1980s, the precipitous changes in interest rates, and gyrations in oil prices, as well as massive changes in the ownership, management and activities of many S&Ls. He carefully outlines the position of auditors in this scenario and gives his view as to the likelihood of financial recovery from S&L auditors.

There has been much publicity about the S&L crisis and the legal actions which the Federal Savings & Loan Insurance Corporation ("FSLIC") has been bringing against a group of accounting firms based upon their audits of defunct savings & loan institutions ("S&Ls") insured by FSLIC. Now that the S & L bailout legislation has become law, we are led to expect that there will be new suits against accounting firms.

The public debate over the failure of the accounting profession to uncover the cancer destroying the S&L system was fueled earlier this year by the publication of a report of the U.S. General Accounting Office ("GAO") to the House Committee on Banking, Finance and Urban Affairs in which the GAO cited several "significant audit and reporting problems" it had uncovered in its review of the audits of certain failed S&Ls in the Dallas Federal Home Loan Bank District. Indeed, the GAO's report cited material inadequacies in six out of the eleven audits which it had reviewed, concluding that the accounting profession failed to fulfill its oversight role which is "an integral part of the system of control designed to identify and report problems in S&Ls. . . ."

Although the GAO report did not address the exposure to civil liability of accounting firms arising out of the failures it identified, numerous articles in the financial press clearly implied the liability exposure of the accounting profession for failing to uncover problems in the nation's S&Ls will be nothing short of catastrophic.

Contrary to the GAO's report, the accounting profession, unlike Congress and the bank regulators, has been in a state of continuous reaction to the changing environment within the S&L industry resulting from deregulation and changes in the financial markets. This was amply demonstrated by the AICPA testimony before the House Committee citing the scores of pronouncements on auditing and accounting standards affecting the S&L industry that have been promulgated over the past 10 years. In fact, there is no evidence indicating that the accounting profession's record in carrying out its responsibility is anywhere near as tarnished as that of the S&L industry itself and its regulators. Notwithstanding the recent disclosure relating to the auditor of Lincoln Savings Bank, the accounting profession's liability exposure for the losses in the S&L industry has been greatly exaggerated.

Background to the Crisis

The S&L industry was created to further the American dream of every citizen owning his or her own home. S&Ls were established in the 1930s and were originally authorized only to offer interest bearing savings accounts and to invest the deposited funds in residential mortgages. Like other regulated industries, S&Ls are governed by a myriad of rules and regulations (including interest rate ceilings) and are subject to periodic audits by federal and state regulators.

In the late 1970s, a public reaction arose with respect to the high degree of regulation of American industry. At that time, the securities industry was beginning to offer a wide variety of investments, including many fixed-income securities bearing high interest rates, frequently secured by tangible assets. Moreover, the issuers of these securities were not limited in the ways in which they could invest the proceeds from sale of their securities. To place all financial institutions on a more equal footing, Congress embarked upon a program of deregulation which, with respect to the S&L industry, raised interest rate ceilings, relaxed standards regarding the persons who could own S&Ls and expanded the types of investments S&Ls could make with their deposited funds. Congress also raised from $40,000 to $100,000 the amount of federal deposit insurance on S&L accounts.

To a significant degree, these actions were taken in order to save the S&L industry from the slow death it was then experiencing. Even as early as 1980, numerous S&Ls were already insolvent, a fact that was obscured by regulatory accounting principles.

Aside from the political pressures to ignore the problem, legislators assumed that the public would continue to be protected because, faced with increased competition, S&Ls would be more responsive to their customers' needs and demands. Moreover, there was a general perception that periodic examinations by regulators would be adequate to identify those S&L owners who operated their institution in an unsafe and unsound manner, particularly when aided by audit reports of independent CPAs on each S&L's annual financial statements. Unfortunately, this was a policy born more out of idealism than realism.

To be sure, Congress was focusing only on the constructive aspects of competition. It completely ignored the fact that competitive pressures frequently prompt free enterprise to accept greater financial risks. Competition generally works well if the persons running unregulated enterprises are operating with their own money. The principle, however, is not easily adapted to a financial institution, organized for the purpose of investing "other people's money." In adopting a policy of deregulation, the legislators also did not fully comprehend the highly volatile economic conditions that would beset the U.S. during the early 1980s. In addition, they did not fully appreciate that auditing procedures for banks and S&Ls were not nearly as pervasive as they had imagined or that CPAs are not mandated by their professional standards to uncover the types of frauds that were to take place.

Even if the policy of deregulation had been basically sound, the S&L system was simply not designed for the economic chaos that prevailed in the U. S. during the early 1980s. Beginning in the mid- 1970s with the Arab oil embargo, the price of crude oil began a steady rise from approximately $2 per barrel to $40 per barrel. This dramatic increase in energy costs set off a wave of inflation which ran at double digit levels until it was finally placed under control after the country had experienced interest rates as high as 22%, which, in turn, sent the nation's economy into a recession in the later part of 1981 and 1982. The wild fluctuations in interest rates which characterized this period also wreaked havoc with many financial institutions which found themselves having to pay high short-term interest rates to maintain sufficient deposits to support long-term mortgage loans made in earlier years.

This phenomenon was recognized by Chief Judge Weinstein of the U.S. District Court for the Eastern District of New York in a case arising out of the collapse of the Flushing National Bank. In dismissing the government's case against the bank's officers, Judge Weinstein observed (at a hearing on February 23, 1989):

"It is clear from the testimony in this case that what happened in this situation was that the huge interest rates that the bank had to pay in the early 1980s led to enormous pressure on this bank and smaller banks all over the country. They had to buy money at a high rate and they were under agreement to sell it at a low rate because of their long-term mortgages."

When interest rates and inflation did subside beginning in 1982, a building boom was unleashed in which many S&Ls rushed to finance high interest (and high risk) land acquisition, development and construction loans. This was particularly true in oil and gas producing states where record high prices for energy had sent local economies soaring. Unfortunately, most S&Ls were ill-prepared to undertake this type of activity. Residential loans require little real estate expertise, since many such loans are secured by FHA and VA guarantees. Moreover, the dwellings securing such loans are already built and appraised on the basis of sales of comparable dwellings. The more risky acquisition, development and construction loans, on the other hand, require an understanding of the construction process (and the inherent possibilities of delays and cost overruns) as well as an understanding of the real estate market. This later requirement is important because if the developer's building is not being rented or homes are not being bought, there is no way a developer will be able to repay its loan.

Unfortunately, the building boom of the early 1980s was short-lived. By 1984 the OPEC cartel was beginning to unravel, causing crude oil prices to fall from $40 a barrel down to $15 a barrel. This collapse in energy prices brought with it an end in the real estate boom in the "oil patch" which eventually led to the failure of approximately 200 S&Ls in Texas, Louisiana, and Oklahoma.

Judge Weinstein, in Flushing National Bank, noted in this regard:

"The Federal Home Loan Bank Board and the federal government, instead of coming to grips with the problem, placed pressure on this bank and its board of directors and its officials, who were incompetent to handle this kind of pressure, to go out and make these risky loans to improve their income. The Board of Directors was explicitly told by the Home Loan Bank Board that it was too conservative."

The removal of restrictions on the types of loans that S&Ls could make also gave rise to another development. Real estate promoters and other entrepreneurs viewed S&Ls as new sources of capital with which to finance their own ventures. Although the S&Ls after deregulation still had strict rules limiting the amount of funds that could be loaned to any single borrower (or, in any geographic area) and outright prohibitions against loans to their owners, they were soon being bought up in droves by entrepreneurs who simply ignored (or otherwise circumvented) these restrictions and used the funds of the acquired S&Ls to finance their own ventures.

The results of deregulation and the dramatic moves in the U.S. economy during the early 1980s are well documented. There have been literally hundreds of bank failures, more than at any other time since the Great Depression, with many more likely to come as federal bank regulators currently have in excess of 500 banks on their list of closely watched institutions. Although the Bush Administration currently estimates that the S&L bailout will cost approximately $166 billion, many experts now predict that the ultimate price tag will be significantly higher.

The Regulators Strike Back

For the most part, bank regulators have sought to restore the financial health of their insured institutions through careful oversight of those S&Ls deemed to be near the brink of insolvency and by taking control of, refinancing and installing new managements in those which had passed beyond the brink of solvency. Once it was clear that it is no longer possible to reverse the fortunes of an ailing S&L under its receivership, regulators generally sought to arrange a merger with a financially strong S&L so as to eliminate further depositor losses. For those S&Ls for which there was no salvation, bank authorities simply liquidated the S&L and paid the S&L's depositors with insurance.

The drain on the insurance fund assets as a result of such efforts was substantial. This prompted the FSLIC to petition the federal government to obtain additional financing for its insurance pool. Unfortunately, the Reagan administration, with its "no new taxes" pledge, was unwilling (or politically unable) to address the issue. Only with the election of President Bush was FSLIC's plight even discussed publicly. Unfortunately, the ensuing delays took their toll. The S&L debacle was finally addressed in the FSLIC bailout legislation enacted in the summer of 1989. The price tag for that bailout had become so large that Congress demanded that the parties responsible for the debacle be identified and made to pay for their sins. Indeed, a whole title of this legislation is devoted to enforcement.

To be sure, FSLIC and its successor under the bailout legislation have embarked on a program pursuing those persons who used S&L assets irresponsibly or for their own benefit. Unfortunately, vengeance, though sweet, is not particularly cost effective as many of the former S&L owners sought the protection of the bankruptcy courts. Accordingly, like other plaintiffs, bank regulators are learning that litigation only pays if it is directed toward a "deep pocket." It is in this connection that they have embarked upon the well-publicized campaign to seek recoveries from those accounting firms who failed to uncover financial irregularities at defunct or distressed S&Ls.

The GAO Report

In February 1989, the GAO, at the request of the Committee on Banking, Finance and Urban Affairs of the U.S. House of Representatives, presented a report Failure of CPA Audits to Identify and Report Significant Savings & Loan Problems." It is not clear whether this report was prompted by a desire to determine whether significant recoveries could or should be sought from the accounting profession, or whether it was simply motivated as a means of transferring the focus of the debate from Congress' own blunder in deregulating the banking industry without adequately considering the potential ramifications or the administration's failure to properly oversee the S&L industry. Although the GAO's report is specifically aimed at the accounting profession, it acknowledges that the losses in the S&L industry largely resulted from "extremely risky lending practices, fraud, insider abuse and poor economic conditions." The report also acknowledges that an independent audit is only one of a handful of tools for regulating the S&L industry and that the problems which now exist are partly attributable to "inexperienced and insufficient numbers of federal examiners, FSLIC's poor financial condition, and conflicting responsibilities on the part of the Federal Home Loan Bank Board, promoters of the S&L industry and regulators of S&L activities."

It should be noted that the GAO report makes no effort to deal with the specific problems which have caused the S&L crisis or with how the accounting profession might have prevented the catastrophic losses which have resulted. In fact, the report makes no effort to determine whether a perfect performance by the accounting profession in any way would have diminished the problems which beset FSLIC. In short, the report concentrates on perceived failures by S&L auditors, without any attempt to correlate those deficiencies to the resulting losses.

The study conducted by the GAO was relatively limited with the GAO reviewing only eleven audits of S&L institutions, and finding six to contain material deficiencies. Those statistics, which would seemingly imply that more than half of all S&L audits were defective, are entirely misleading. First, it must be appreciated that these audits were selected from the audits of the 29 S&Ls in the Dallas District (which includes the states of Arkansas, Louisiana, Mississippi, New Mexico and Texas) that failed between 1985 and 1987. No effort was made to review the audits of any S&Ls which had remained relatively healthy. In addition, nine out of the eleven audits were selected using the following three criteria:

1. There was high growth in the S&Ls' assets in the three to four year period before failing;

2. The S&Ls' financial statements did not reflect relatively large loan losses; and

3. The audit reports for the S&Ls' did not question the extent of loan losses. Thus, the GAO's very selection process used criteria designed to reveal likely audit oversights. It is a credit to the accounting profession that selection with this type of hindsight only yielded audit deficencies in 55% of the cases. Indeed, in fairness to the accounting profession, it should be pointed out that all but three of the 29 failed banks and five out of the six whose audit reports were criticized, received either adverse or qualified audit opinions.

The GAO's report goes on to list a number of perceived auditing and accounting deficiencies. For the most part, the accounting deficiencies cited include failures to report regulatory violations, such as excessive loans to a single borrower and/or to related parties; failures to note formal regulatory actions, such as "cease and desist" orders; failures to note concentrations of high risk loans within a limited geographic area; and failures to report internal control weaknesses. The auditing failures noted by the GAO report are generally in the form of failures on the part of an auditor to evidence in his working papers the procedures taken: 1) to identify classes of problem loans; and 2) to review appraisal values for collateral underlying problem loans.

It should be noted that the GAO report briefly refers to the regulatory scheme, pointing out that it is the regulators' function to determine whether S&Ls were complying with rules relating to loans to affiliates, and excessive concentrations of loans within geographic limits or to single borrowers. Yet, much of the criticism relating to reporting deficiencies contained in the GAO's report centers on the accounting profession's failure to "report" such violations.

In addition, the GAO report also notes that the auditing literature published by the AICPA at the time did not require the audit procedures which it found lacking. Thus, the report encourages the AICPA to reexamine its current standards with respect to the audits of S&Ls. This very finding seemingly implies that the auditing deficiencies noted by the GAO were not even prescribed by generally accepted auditing standards.2

Finally, the GAO report also pointed to the failure of the auditors to report material weaknesses in internal controls. This charge is somewhat ambiguous as it seems to assume a duty on the part of auditors to report to regulatory authorities their findings with respect to internal control deficiencies. Under the general auditing literature in effect through March 1988, accountants were only required to examine an audit client's internal controls to the extent necessary to plan and conduct their audit.

Any internal control weaknesses uncovered by an auditor during the course of what was frequently only a cursory review were required to be reported to the client's management. The FHLBB had a corresponding requirement that any letter or report to an S&L concerning recommendations for strengthening its internal controls be filed by the S&L with the FHLBB's district office. Some states had similar requirements. Although the GAO report seems to imply that any failure to report internal control weaknesses was the fault of the S&L's auditors, it is distinctly possible that the S&Ls may have failed to carry out their duty to forward their auditor's reports. Only in the case of certain regulated industries, such as the securities industry, are auditors specifically required to render a report addressing internal control weaknesses directly to regulatory authorities.

Assessing the Threat

The economic and political climate that currently exists will undoubtedly prompt bank regulators to bring more suits against accountants; and, indeed, bank regulators have been quoted in the press to the effect that additional suits are being readied. These suits, however, may be far less productive than one might expect. First, it must be understood that suits against the auditors are not only highly technical in nature, but also generally involve vast amounts of documents and detailed procedures which must be ascertained, reviewed and correlated. Thus, this type of litigation tends to be far more detailed and expensive than others, and its prosecution frequently will cost hundreds of thousands, if not millions, of dollars. This, in itself, makes such suits far less than a bonanza, especially when launched against small accounting firms whose malpractice insurance may only be $2 to $3 million dollars and in most cases will be no more than $1 million. The net recovery against small accounting firms, at best, will only be a small fraction of its losses. Although the larger accounting firms have much greater insurance coverage, they also typically have numerous S&L clients so that the loss of a single lawsuit takes on much greater significance. As a result, the large accounting firms tend to defend these claims vigorously and are not apt to enter into settlements only for the purpose of avoiding legal costs. In fact, most of the larger firms are loathe to enter into any settlement, much less one that is likely to encourage multiple lawsuits in its wake.

Finally, it should be appreciated that bank regulators will face a number of serious substantive legal obstacles when they bring these claims. As noted above, most of the deficiencies cited by the GAO dealt with alleged failures on the part of the audit firm to document its audit procedures. Although the documentation of procedures is frequently a problem associated with smaller accounting firms, it is relatively rare among larger accounting firms whose internal quality control practices dictate a high degree of documentation of audit procedures.

Even if bank regulators are successful in establishing that an accounting firm's audit procedures were below professional standards, they may still have a difficult time establishing a causal link between those failures and the damages actually suffered by its S&L clients. In fact, such suits by regulators seem to assume that the accounting firm, by acting diligently, could have somehow prevented the losses that were incurred. In this connection, it should be appreciated that auditors perform their services after the fact, reporting upon that which has already transpired. Thus, in a very real sense, "the horses would have already left the barn" by the time the accountants came onto the scene. In this same regard, the GAO report faulted auditors in their review of the various classes of "problem loans." The very fact that these types of loans are considered problem loans" raises the implication that by the time the accountant identified them it may have been too late to prevent the S&L from incurring losses as a result of those loans.

Additionally, the GAO attacked the accounting firms for failing to take note of questionable bank practices which had already come to the attention of bank regulators. This seems to undermine regulators' theory of loss causation; namely, that these loan losses would have never occurred had the auditors properly performed their duties. The GAO's findings, however, seem to support the contrary theory that bank regulators would not have acted upon reports of improper practices. Thus, their own theory of damages seems to be highly speculative; and the courts frequently preclude speculative theories of damages from even going to the jury.

Lastly, the GAO report seems to indicate that many of the problems arose as a result of improper actions on the part of management of the troubled S&Ls. Not only is there a serious question as to whether any actions on the part of the auditors could have influenced these managements to change their evil ways, there is also a serious question as to whether those very improper practices on the part of S&L managements may be imputed to the regulators as successors to failed banks, when they seek to recover losses from the auditors. This is because the regulator, as receiver for a defunct S&L, "stands in the shoes" of the S&L; and is, therefore, subject to any defense that could have been asserted against the S&L. In sum, the actions of the S&Ls' managements may be imputed to the plaintiff, unless the plaintiff brings its actions solely in its capacity as guarantor.

To be sure, the damages incurred and to be incurred by the federal insurance fund as a result of the current crisis are extremely large. However, even a small recovery from the accounting profession must be taken seriously by the profession and its insurers. Yet, for the reasons discussed, the actual liability exposure of the accounting profession may not be nearly as great as it has been proclaimed. 12

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