PwC Faces A Trial For SemGroup Audit And Its Defense Is Predictably Slick

By Francine • Feb 18th, 2014 • Category: Latest, Pure Content, The Case Against The Auditors

PwC, the former auditor of SemGroup, a Tulsa, Oklahoma oil-and-gas service company, is scheduled to go to trial in August, almost six years after SemGroup’s bankruptcy, for malpractice. SemGroup was the second-biggest bankruptcy of a non-financial company in 2008. The SemGroup Litigation Trust, pursuing claims on behalf of the company and its creditors, alleges PwC did a terrible audit.

From the pre-trial conference order document filed February 14, 2014 in Tulsa, Oklahoma.

The Trust contends PwC failed to exercise due professional care in performing its role as an auditor for its client, SemGroup. PwC knew or should have known that certain transactions were improperly reported in SemGroup’s financial statements.

PwC knew, for example, that SemGroup’s CEO was using company money to fund over $300 million of his own personal financial losses and that this was not reported properly and completely in the financial statements. By March 2008, when PwC issued its audit report, PwC also knew or should have known about SemGroup’s precarious financial condition. But rather than conduct any extended “going concern” procedures or issue any “going concern” warnings in its audit report, PwC gave SemGroup a clean bill of health, and SemGroup collapsed just four months later.

When a company goes bankrupt, management’s excuse —and often the auditors’ defense for not warning anyone— is that unprecedented, cataclysmic, rapidly deteriorating economic events caused harm to the company and came out of nowhere, with no warning. Sometimes it’s a sudden liquidity crisis that chokes the company. Sometimes competitors’ moves leave a company vulnerable to an unexpected, life threatening attack.

You’ll have a tough time winning a suit against management and any directors for a bad business strategy implemented in good faith. It’s still true that you can sue auditors but you can rarely bring them to justice, even if they do come in days late, a dollar’s worth of knowledge short, and with the disadvantage of often being on the wrong side of closed doors.

We’ve heard the excuses from executives quite often with regard to the financial crisis. Now we know there was fraud. We hear the “duped” excuse all the time from the auditors. When fraud occurs, the auditors defend themselves by claiming criminal executives lied to them. If that doesn’t work, they are also willing to claim ignorance to mitigate legal liability. Judges often go along with it.

Judge Richard Posner, for example, has an opinion of who an auditor is and what an auditor does. It’s found in his opinion in 2007 that dismissed Ernst & Young from liability regarding a firm that went bankrupt with no auditor’s “going concern” warning.

Judge Richard Posner during oral arguments in Fehribach v. Ernst & Young LLP, 2007 WL 2033734 (7th Cir. 7/17/07) (pdf),

Posner: The auditor’s responsibility … so far as the company is concerned … is to make sure the [numbers] are accurate…. You don’t need an auditor to tell you your market is collapsing….  The auditors are not supposed to have business insight.  They’re counters.  They’re not supposed to make predictions about how your markets are doing.  They’re supposed to reconcile your books and indicate you’re not a going concern because your debt is too high and so on….

Do you think the auditor is supposed to know about market power?…  An auditor is not an economic consultant who goes out and figures out what the market trends in an industry are!…Your trends? That’s what the company knows. [Plantiff’s Attorney: You’re right. Here’s what the auditor’s responsibility under SAS 59...]

Posner: That is too vague for me…”

Beating in pari delicto

The lawyers for PwC tried the in pari delicto tact with the Oklahoma judge and failed. Alison Frankel explains in a column for Thomson Reuters On The Case how the plaintiffs quashed the in pari delicto defense.

PwC lawyer Gabor Balassa of Kirkland & Ellis had argued at a Jan. 17 hearing before Judge Kuehn that SemGroup management put Kivisto in charge of a program of derivative trading to hedge the company against oil price fluctuations. The company knew full well what Kivisto was doing, he argued, and can’t now blame its auditor for a failed business strategy. “Your Honor, the imputation of Kivisto’s trading conduct and his knowledge about trading to SemGroup defeats the elements that plaintiff must establish here, reliance and causation,” Balassa said. “SemGroup could not have relied on some allegedly incomplete disclosure about its trading activity in its audited financial statements because SemGroup knew through imputation about the trading activity.”

The plaintiffs, represented by Quinn Emanuel’s Brian Timmons, plan to stick to the basics, however, and have an excellent expert witness to support that effort. Lynn Turner, former Chief Accountant of the SEC under Arthur Levitt, will help plaintiffs claim PwC did not follow applicable Generally Accepted Auditing Standards (GAAS) and that PwC is, therefore, liable for malpractice. The potential liability exceeds $1.1 billion.

Here’s how:

Timmons of Quinn Emanuel emphasized that the trustee’s case is about PwC’s failure to audit SemGroup properly. “The fundamental disconnect is this is not a case where we are suing PwC as a joint tortfeasor in an intentional tort for fraud,” he told Judge Kuehn. “What we are suing PwC for here is auditing malpractice. The focus of our claim is on the way financial information and financial activity that took place at the company was reported in the financial statements.” Citing a 2001 Oklahoma Supreme Court case, Stroud v. Arthur Anderson, Timmons argued that the issue isn’t what SemGroup knew about Kivisto’s risky trades but how those trades should have been reported in SemGroup’s financial statements. That reporting, he said, is PwC’s responsibility. (Timmons also said there’s no evidence SimGroup actually knew how risky Kivisto’s trades were.)

In the pre-trial conference order document, Timmons explains further why in pari delicto does not apply:

Further, PwC contends that SemGroup’s former management is at least equally responsible for any harm claimed and “so the claim is barred by the doctrine of in pari delicto.” This mischaracterizes the law governing auditor liability in Oklahoma and is fundamentally inconsistent with the Oklahoma Supreme Court’s decision in Stroud v. Arthur Andersen & Co., 2001 OK 76,37 P.3d 783.

The judge agreed earlier this month that there are too many disputed issues of fact and denied PwC’s motion for summary judgment based on the in pari delicto defense. PwC can make the arguments again to a jury in August. PwC’s lawyers from the Chicago K&E office pulled out the “unfortunate business judgment based on catastrophic economic events” defense, too, when promising Alison Frankel to do just that.

The losses at issue in this case resulted from business decisions made by SemGroup management and an unprecedented rise in the price of oil in 2008. PwC looks forward to defending its work at the trial in August.

How, with oil close to $147 a barrel at the time, did a company that serves that industry fail? According to a BusinessWeek story at the time, SemGroup’s trading unit, owned by the CEO but funded by the company via undisclosed loans to the CEO, made an enormous bet that oil prices would fall. “It was the right call—but a few weeks early, ” said BusinessWeek. (That should be called the losing trader’s lament.) SemGroup could not cover billions in trading losses and filed for Chapter 11 protection on July 22, 2008.

This case is a lot like the others

If the SemGroup story sounds a lot like MF Global, you’re not imagining things. MF Global, also a PwC audit client, filed for bankruptcy on October 31, 2010 after its Chairman and CEO Jon Corzine overextended the firm while trading highly risky sovereign debt funded with repo to maturity agreements that left the brokerage firm unable to cover monstrous margin calls from counterparties when the debt of some countries fell in value.

But that wasn’t the first time MF Global’s weak internal controls and poor risk management caused losses. Shortly after MF Global spun out as a public company from PwC audit client Man Financial in 2007, a rogue wheat trader exploited internal control weakness in trading software and caused $141 million in losses at the fledgling public broker-dealer.

PwC is also auditor to Chesapeake Energy, another Oklahoma energy company, where the former CEO set up his own personal internal hedge fund staffed by company employees and used a unique incentive compensation arrangement to engage in undisclosed related party transactions for his own benefit with one of his company’s business partners. He resigned but was never charged with any crimes.

Back in 1999, at Plains All American, another PwC audit client in the energy industry in Oklahoma, a rogue trader made unauthorized crude oil trades that caused $160 million in losses.

There was no “going concern” warning before SemGroup failed, just like there was none at MF Global and none at another PwC audit client, bankrupt, mired in fraud and also headed to trial, Colonial Bank. (PwC is also struggling to effectively use the in pari delicto defense, for now, in the Colonial case, too.)

The SemGroup pre-trial conference order document, dated February 14, says, according to the plaintiffs:

By March 2008, when PwC issued its audit report, PwC also knew or should have known about SemGroup’s precarious financial condition. But rather than conduct any extended “going concern” procedures or issue any “going concern” warnings in its audit report, PwC gave SemGroup a clean bill of health, and SemGroup collapsed just four months later.

The pre-trial conference order document also hints at another cause of action, liability for the “deepening insolvency”.

SemGroup lost over $280 million over time as its funds were used to pay for the personal financial losses of its former CEO. SemGroup’s losses could have been avoided if PwC had done the job it was paid to do. Further, if not for PwC’s audit failures, SemGroup’s Management Committee and its lenders would have been made aware of SemGroup’s precarious financial condition in March 2008, and would have taken steps to prevent SemGroup from suffering over $800 million in additional losses that occurred between March 31, 2008 (the date the 2007 audit report issued) and July 22,2008 (the date SemGroup filed for bankruptcy).

Therefore, had PwC done its job as SemGroup’s outside auditor, SemGroup would have avoided some $1.1 billion in losses.

What should PwC have done?

Judge Posner was dead wrong. The auditor’s role and its responsibility to know its audit client and the risks a client is taking, to understand its business strategy and the impact of changes in the business and economic environment that may affect its success or even its viability, and to adjust the audit scope and the fees it charges for that audit are spelled out clearly in Auditing Standard 9:

Planning Activities

7.     The nature and extent of planning activities that are necessary depend on the size and complexity of the company, the auditor’s previous experience with the company, and changes in circumstances that occur during the audit. When developing the audit strategy and audit plan, as discussed in paragraphs 8-10, the auditor should evaluate whether the following matters are important to the company’s financial statements and internal control over financial reporting and, if so, how they will affect the auditor’s procedures:

  • Knowledge of the company’s internal control over financial reporting obtained during other engagements performed by the auditor;
  • Matters affecting the industry in which the company operates, such as financial reporting practices, economic conditions, laws and regulations, and technological changes;
  • Matters relating to the company’s business, including its organization, operating characteristics, and capital structure;
  • The extent of recent changes, if any, in the company, its operations, or its internal control over financial reporting;
  • The auditor’s preliminary judgments about materiality,5/ risk, and, in integrated audits, other factors relating to the determination of material weaknesses;
  • Control deficiencies previously communicated to the audit committee6/ or management;
  • Legal or regulatory matters of which the company is aware;
  • The type and extent of available evidence related to the effectiveness of the company’s internal control over financial reporting;
  • Preliminary judgments about the effectiveness of internal control over financial reporting;
  • Public information about the company relevant to the evaluation of the likelihood of material financial statement misstatements and the effectiveness of the company’s internal control over financial reporting;

Auditing Standard 12 discusses the auditor’s responsibilities for performing risk assessment procedures.

This standard discusses the following risk assessment procedures:

  • Obtaining an understanding of the company and its environment (paragraphs 7-17);
  • Obtaining an understanding of internal control over financial reporting (paragraphs 18-40);
  • Considering information from the client acceptance and retention evaluation, audit planning activities, past audits, and other engagements performed for the company (paragraphs 41-45);
  • Performing analytical procedures (paragraphs 46-48);
  • Conducting a discussion among engagement team members regarding the risks of material misstatement (paragraphs 49-53); and

AU332 explains to auditors how to audit derivative instruments, hedging activities, and investments in securities.

The auditor may need special skill or knowledge to plan and perform auditing procedures for certain assertions about derivatives and securities.

Talk about an understatement…

If the auditors in Tulsa, Oklahoma lacked those special skills or knowledge, they were supposed to call on experts, whether in or out of the firm, including the PwC National Office and other specialized consulting resources that a humongous global firm like PwC has in spades, available 24/7 from all over the world.

And from AU336:

The auditor’s education and experience enable him or her to be knowledgeable about business matters in general, but the auditor is not expected to have the expertise of a person trained for or qualified to engage in the practice of another profession or occupation. During the audit, however, an auditor may encounter complex or subjective matters potentially material to the financial statements. Such matters may require special skill or knowledge and in the auditor’s judgment require using the work of a specialist to obtain appropriate evidential matter.

Also QC Section 20.19:

Policies and procedures should also be established to provide reasonable assurance that personnel refer to authoritative literature or other sources and consult, on a timely basis, with individuals within or outside the firm, when appropriate (for example, when dealing with complex, unusual, or unfamiliar issues). Individuals consulted should have appropriate levels of knowledge, competence, judgment, and authority. The nature of the arrangements for consultation depends on a number of factors, including the size of the firm and the levels of knowledge, competence, and judgment possessed by the persons performing the work.

The PCAOB Auditing Standards also give significant guidance about auditing related-party transactions, which seem to abound at  PwC’s clients. In particular, it’s not enough to take management’s word for the ones they do tell you about. There’s an art to becoming aware of all of the related party transactions and making sure they are adequately disclosed. AU334 explains and a separate section provides an FAQ on the issue.

Finally, financial statements prepared under Generally Accepted Accounting Principles are usually presented on a “going concern” basis. Therefore, “the auditor has a responsibility to evaluate whether there is substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time, not to exceed one year beyond the date of the financial statements being audited (hereinafter referred to as a reasonable period of time). The auditor’s evaluation is based on his or her knowledge of relevant conditions and events that exist at or have occurred prior to the date of the auditor’s report.”

This evaluation should not be a perfunctory “check-the-box” exercise. Auditors are not soothsayers, but I think we have established that they are supposed to know the company quite well and to know the way its assets, liabilities, revenues and expenses should be accounted for and disclosed even better than executives. That’s why auditors get paid to create an opinion and investors don’t just take management’s word for it. The auditors are not supposed to forget to be professionally skeptical, independent and objective when evaluating if there is a “substantial doubt” that the company will not exist a year from now.

The standards for evaluating a company’s “going concern” status, including an FAQ, are here under AU341.

Under seal

Almost all the records associated with this case, except the initial complaint, the most recent pre-trial conference order, a transcript of the hearing regarding the motions for summary judgment and the original bankruptcy examiner’s report, are under confidential seal.  Attorney for the plaintiffs Brian Timmons told me, “If a motion were made to unseal the record, I suspect PwC would be the only party who would object.”

It’s pretty typical of audit firms to request the judge to seal from public scrutiny the transcripts of oral arguments and, especially, depositions. That’s because if the case settles, all the stupid things the audit firms’ lawyers and partners say to defend the firm will be a secret forever.

I’ve written about what happens when a firm goes to trial. Stupid things, for example, were said by PwC and its partner in a case in Australia, Centro, before the firm realized it was getting killed and settled in the middle of the trial. It was the largest class action settlement ever against an audit firm in Australia.

Every once and a while you run across a case against the auditors where the records aren’t sealed and idiotic, unbelievable, amazing things are in the transcripts, pending trial. I’ve got a few of those on my desk. I also have a few where a motion to unseal filed by a journalist could convince a judge to unseal. Judges typically side with the public interest when anyone from the public like a journalist shows a bit of interest in letting the public in on the proceedings.

There’s enough that’s available in the public records of the SemGroup case, though, to tempt an unseal order request. For example, just look at whom PwC has asked to testify on its behalf.

PwC’s Partners and staff

The names of the PwC partners responsible for the audit during the period in question are available in the pre-trial conference order document.

David Colwell was the concurring partner on the SemGroup audits from 2000-2004, and the lead engagement partner on the SemGroup audits from 2005-2007. The pre-trial conference order says “his expected testimony will concern the engagement letters and applicable audit standards that governed the relationship between PwC and SemGroup, and PwC’s understanding of SemGroup’s business, growth, and management structure. Colwell will also address the significance of the audit report under the audit standards, and the withdrawal of the 2007 audit report. Colwell may also address the overall audit process, including PwC’s audit of related parties and derivatives, including the auditors’ consideration of monitoring by SemGroup’s lenders, and PwC’s going concern consideration.”

Colwell retired from PwC in 2012 after 34 years. A biography for a company he joined in January of this year as a Director says he was Managing Partner of the PwC Oklahoma practice for over ten years until his retirement. Colwell serves as Chairman of that company’s audit committee.

Colwell has a brief LinkedIn profile that says he was the Managing Partner of the Oklahoma practice for PwC. PwC has one office in Oklahoma, in Tulsa, and it is coincidentally in the same building as SemGroup. That implies Colwell was also ultimately responsible for PwC’s audit of Chesapeake Energy, based in Oklahoma City, if not also the lead engagement partner or concurring partner at one time.

George Schulz was the engagement partner on PwC’s audits of SemGroup’s 2000 through 2004 financial statements. According to the pre-trial conference order “Schulz is expected to testify concerning the genesis of the SemGroup engagement and PwC’s relationship with SemGroup.” A source knowledgeable about the litigation tells me that Schulz has also recently retired.

I often speak to accounting students at universities about the high risk of being on the wrong audit under the wrong partner and getting your name in the paper for the wrong reasons. This is one of those situations where names of potentially gullible, submissive, “pleaser” staff people, with too much responsibility per GAAS for adequate planning, review and supervision by partners, are now going to be “Googleable”, publishable by journalists like me and permanently in the legal record because of a dud client.

John Norton was an associate, senior associate, and then manager on PwC’s SemGroup audit engagements from 2002 through 2008. “Norton is expected to testify concerning the work he performed to plan and execute the audits in compliance with GAAS, including work concerning SemGroup’s related party transactions and derivatives trading activity, and PwC’s assessment of SemGroup’s ability to continue as a going concem. Norton is also expected to testify regarding his supervision of more junior auditors on the audit team.”

Akin Adekunle was a senior associate on PwC’s audits of SemGroup’s 2006 and 2007 financial statements. He came over to Tulsa on secondment from PwC Nigeria because of his oil and gas audit expertise. Adekunle must now testify regarding the work he performed to plan and execute the SemGroup audits in accordance with GAAS, including work concerning SemGroup’s derivatives trading activity. Adekunle is also expected to testify regarding his supervision of more junior auditors on the audit team.

Jennifer Lark was an auditor on the 2005 though 2007 audits of SemGroup’s annual financial statements. “Lark is expected to testify concerning PwC’s audit testing on SemGroup’s accounts receivables and financial ratio debt covenants.”

Jonathan Bound was an auditor at PricewaterhouseCoopers UK “who conducted a statutory (UK law) audit of certain of SemGroup’s UK subsidiaries for the year ended 2007. Bound is expected to testify that the work he did on derivatives was limited to the statutory audit, and was not part of the US firm’s audit of SemGroup.”

A special consulting engagement

Keith Considine and Mark Allan Smith are partners in PwC’s energy consulting practice. According to the pre-trial conference document, they are expected to testify about a special consulting engagement related to SemGroup’s derivatives trading that SemGroup’s management retained PwC’s energy consultants to perform in July 2008.

This is odd for two reasons. First, an auditor risks an independence violation when it takes on a “special consulting engagement” for its audit client.  That’s especially true when the engagement’s subject is an area of the business PwC says itself it was not hired to audit. From the pre-trial conference order document:

SemGroup did not hire the PwC financial-statement auditors to assess the risks the derivatives trading presented or to provide advice as to how to manage that risk as oil prices reached unprecedented highs fi-om late 2007 through mid-2008. SemGroup management, not its financial statement auditors, was responsible for monitoring and evaluating those trading risks.

The engagement is also weird because it was performed in July 2008 a week before SemGroup filed for bankruptcy and two months before PwC resigned as auditor. The bankruptcy examiner’s report, prepared by Louis Freeh who as Trustee also ran cover for creditors with claims agaisnt MF Global Holdings, the other PwC trading failure client, explains the purpose of this engagement:

July 15, 2008. Ward stated that PwC representatives arrived in Tulsa and were instructed to review SemGroup’s trading book. PwC’s review was limited to SemGroup’s OTC positions because it was the only ongoing trading liability remaining on SemGroup’s books. PwC reported early in its review that SemGroup was using “strangles” as a trading strategy.

It looks like PwC finally called in the cavalry but it was much too little and way too late.

At around the same time this was going on, Goldman Sachs was also at SemGroup rooting around the trading book. Investor and board member Thane Ritchie made the introductions between Goldman Sachs investment bankers and SemGroup. From the bankruptcy examiner report:

Ritchie stated that in December 2007, when SemGroup was considering an IPO, he introduced CEO Kivisto to representatives of Goldman. In early January 2008, Ritchie traveled to SemGroup’s Tulsa office, where SemGroup did a presentation on the company’s value for Goldman representatives, in order to secure its backing for the IPO.

In December 2007 SemGroup began negotiations with Goldman Sachs for a non-public 144A equity offering, in an initial effort to raise $700 million. According the the bankruptcy examiner’s report:

Although this was to be a private equity offering, Goldman’s due diligence requirements were the same as if it was an initial public offering (“IPO”). In approximately June 2008, Goldman’s review of Sem Group’s financial data revealed that SemGroup’s trading losses were approaching $2 billion, and that its margin calls were devouring its capital. Goldman began to wonder exactly what SemGroup was doing with respect to its commodities trading and whether it was reall y operating a matched book, as it claimed. In response to Goldman’s inquiries, SemGroup explained that, since hedge accounting constricted it, SemGroup engaged in options trading which required daily financial MtM accounting, resulting in huge unrealized losses.
In late June 2008, Goldman requested that CEO Kivisto turn over the company’s trading book to it for analysis. Goldman advised that two events, which occurred within 48 hours or each other, convinced it not to do any more business with SemGroup. First, Kivisto called Goldman and advised it that the company’s credit line was low and that he had decided to sell one third to one half of SemGroup’s trading book. Kivisto did not reveal a possible buyer.
Next, Goldman completed its analysis of SemGroup’s trading book, which revealed that SemGroup was short 18 million barrels of crude assets. This convinced Goldman that SemGroup was not hedging based upon physical inventory.
In early July 2008, Goldman advised SemGroup that it was discontinuing their business relationship

According to the bankruptcy examiner report, Goldman then made a move experts have told me is rather unusual. Goldman, as part of its due diligence, had a meeting with PwC, SemGroup’s auditors. However, SemGroup executives were not invited.

During this meeting, Goldman learned about Westback. PwC explained that Westback was a legacy company owned by Kivisto, which conducted its commodities trading through SemGroup, and that it currently owed SemGroup approximately $260 million. This revelation was a major concern to Goldman, and Goldman subsequently advised SemGroup that it could not market the equity offering with Westback on its balance sheet.

PwC is also Goldman Sachs’ auditor. Goldman Sachs’ J. Aron commodity trading division became a major counterparty to SemGroup’s derivative trades. If this scenario sounds familiar you may be thinking about a similar one that played out between Goldman Sachs and AIG, with mutual auditor PwC in the middle, during the same period.

I wrote:

Maybe PwC didn’t stand a snowball’s chance in hell to be a truly independent, objective advocate for shareholders by forcing a true and fair presentation, in all material respects, of the financial position of either one of these companies and the results of their operations and their cash flows in conformity with accounting principles generally accepted in the United States of America. But is there a truly good excuse for PwC to not have been a preemptive strike force, a beacon, an early warning system for shareholders of the financial Armageddon we faced? They had longstanding, thorough, perfect knowledge of both sets of financial statements.

Add to this perfect knowledge the additional capital markets insight PwC has given its audit relationship with other large global financial institutions such as JP Morgan, Bank of America, Freddie Mac, Fortis, Barclays, Northern Rock…

Well, you get the idea.

On July 22, 2008, SemGroup, LP filed for Chapter 11 bankruptcy protection. The company listed both debts and assets of more than $1 billion.

On September 29, 2008, PricewaterhouseCoopers LLP  resigned as the independent registered public accounting firm for SemGroup Corporation, formerly known as SemGroup, L.P.

(BDO is now the auditor for the successor firm but PwC Tulsa still audits a subsidiary that did not file Chapter 11, the former SemGroup Energy Partners LP now called Blueknight Energy Partners LP. Blueknight is separate in ownership and assets although sharing a pipeline system with SemGroup.)

In July 22, 2009 PwC informed SemGroup that PwC’s audit report dated March 28, 2008 should no longer be associated with the Company’s consolidated financial statements as of and for the years ended December 31, 2006 and 2007 as a result of matters raised in the bankruptcy examiner’s investigation report dated April 15, 2009. See the October 2010 10K.

More special witnesses

SemGroup significant investors and board members Thane Ritchie and John Kermath have also been deposed, according to the pre-trial conference order document, on behalf of PwC. Ritchie served as a member of SemGroup’s Management Committee from 2006 until after SemGroup’s bankruptcy. He is the founder and former Chief Executive of Richie Capital, headquartered in a western suburb of Chicago. Ritchie is expected to testify about SemGroup’s Management Committee, its monitoring of SemGroup’s derivatives trading activity, the Westback relationship (the CEO’s trading firm within the company) and his understanding of those issues.

Kermath served as Ritchie Capital’s President from 2007 until after SemGroup’s bankruptcy. He served as Ritchie Capital’s corporate representative at his deposition.

In a “stranger than fiction” strategy by PwC, Richie will also testify, according to the pre-trial conference document, that he never read or relied on SemGroup’s financial statements. Kermath is also expected to testify about Ritchie Capital’s understanding of SemGroup’s trading operations, Ritchie Capital’s non-reliance on PwC or the audited financial statements for information about SemGroup’s trading activity, and SemGroup’s bankruptcy.

The idea, I guess, is to counteract the plaintiffs’ claim that PwC’s audit opinion and the accuracy of the financial statements are important to investors and have some value. I guess if you’re going to be accused of doing a lousy job your only defense may be to say no one of any importance really pays attention to the opinion anyway.

PwC’s lawyers said the same thing directly in the pre-trial conference order document:

Indeed, when third parties were interested in SemGroup’s trading, they did not look to the Company’s financial statements, but to independent experts and SemGroup’s management for information.

Ritchie Capital is also being sued by the Litigation Trust.

The creditors of SemGroup LP are suing Carlyle/Riverstone and Ritchie Capital Management LLC, which backed the company before it filed for bankruptcy. They are seeking to recoup $56 million of dividends that the two firms collected in February 2008, only a few months before SemGroup filed for bankruptcy.

Their justification: the company was insolvent at the time the dividends were issued, so the money rightfully belongs to SemGroup’s creditors. As Brickley writes, “The lawsuit is based on a technical provision of the bankruptcy code, not allegations Ritchie or Carlyle/Riverstone had a hand in alleged illicit trading” at the company.

However, in this case the prosecutors believe SemGroup may have left a “t” or two uncrossed. According to the lawsuit, “On information and belief, SemGroup did not request or receive an opinion indicating that SemGroup was solvent immediately prior to the Partnership Distribution.” That, together with the short period of time that passed between the payout and the bankruptcy, is unusual.

“The vast majority of PE-sponsored companies doing dividend recaps will as a matter of course get a solvency opinion because it’s cheap insurance against suits like this,” the lawyer said.

And from an earlier SEC enforcement order:

…from at least January 2001 through September 2003, Ritchie Capital engaged in an illegal late trading scheme. Specifically, Ritchie Capital placed thousands of late trades in mutual fund shares and used post- 4:00 p.m (ET) news and market information to make its mutual fund trading decisions while receiving the same day’s net asset value (“NAV”) for the mutual funds traded. Thane Ritchie approved the use of late trading by Ritchie Capital’s mutual fund group, reviewed the performance of the group, and occasionally suggested mutual fund late trades. DeMaio supervised mutual fund trading at Ritchie Capital and was involved in the development of various mutual fund trading strategies, including late trading.

Ritchie Capital and RMS Fund paid to the Securities and Exchange Commission (the “Commission”) disgorgement, jointly and severally, in the amount of $30 million and prejudgment interest, jointly and severally, of $7,441,966.82. As also required by the Order, Ritchie Capital and Thane Ritchie paid a civil money penalty, jointly and severally, of $2,500,000, DeMaio paid a civil money penalty of $250,000, and both Thane Ritchie and DeMaio each paid disgorgement in the amount of $1.00, for a total payment of $40,191,968.82 (“Settlement Amount”).

PwC’s motto, I guess, is winning by any means necessary.

The case is BETTINA M. WHYTE, Plaintiff, v. PRICEWATERHOUSECOOPERS LLP, Defendant. United States District Court, N.D. Oklahoma.

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2 Responses »

  1. Judge Posner’s remarks in the 2007 EY case surprise me (well, I wish they did). Especially for reasons you noted. Most people have an understanding or belief that auditor’s should have broad business knowledge anyway, and it sure sounds like he’s discounting that. Those remarks would be insulting if they weren’t such a protective umbrella for auditors.

    Defenses in audit failure cases are great. I mean, Richie testifying that he did not rely on the audit report? That’s great.

    Thanks for this piece.

  2. Good report! Kept my interest because it’s like a Sherlock Holmes story. Thanks

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