Absent Immediate Relief, Kiss BDO Goodbye

August 2007

Library Sections:

Until last week, BDO Siedman was the seventh largest accounting firm in the United States. According to the August 2007 edition of Inside Public Accounting, BDO’s 34 U.S. offices reported a total of $589 million revenues during their June 2007 fiscal year. Of course, as with any professional services firm, BDO’s revenues had already been paid out to the partners and employees as compensation. BDO has around 2,800 U.S. employees, and 250 partners.

The opening sentence above uses “was” as a purposeful description of BDO’s predicament. Last week, a Florida jury awarded a plaintiff $170 million of compensatory damages and $352 million of punitive damages (an allowable approximate two-times multiple), for a total award of almost $522 million. Although BDO claims that some of this is covered by insurance, they declined to provide details. Regardless, Florida law generally prohibits insurance coverage for punitive damages.

Even before the punitive award occurred, BDO said in court filings that the compensatory award would cause massive layoffs and would threaten its position as one of the country’s largest accounting firms. BDO said they would appeal the verdict, and they have the $50 million needed for the Florida appeal bond.

However, even with appeals, the overhang may be too much to survive. The Arthur Andersen failure showed us how fragile a professional service firm is. Recently, Jenkens & Gilchrist’s problems with tax shelter opinions destroyed the firm. The problem is not just the absolute amounts of the liability awards. The larger problems are (i) clients are appropriately concerned about their continuity of service, and (ii) the individual employees and partners seek jobs with a more secure employer that is not burdened in this manner. Significant defections of either clients or personnel (or probably both) soon make the firms’ cost structure for rent and other overhead unworkable, which causes the death spiral to accelerate.

About the Florida Case

The facts of this case are not unusual. Every one of the large accounting firms has similar cases in their “portfolio”. Every one of the major audit firms could be in BDO’s predicament, since a single audit failure can be more than a firm can sustain.

The plaintiff is a Portuguese bank (Banco Espirito) that incurred a $170 million loss on its dealings with E.S. Bankest, a Miami-based receivable factoring firm that was half-owned by the plaintiff bank. The jury awarded the full amount of the bank’s loss in their damage award against BDO.

Florida law recognizes comparative fault in assessing damages. It seems unlikely that a 50% sophisticated owner of a business in the same industry would be able to substantiate zero damages reduction from their own actions or inaction. This is likely one of the bases for BDO’s promised appeal.

The bank’s losses occurred because the factoring company executives were involved in a five-year financial fraud that ended in 2003. The plaintiff did not contend that BDO participated in the fraud or knew that it was happening. The bank contentions were instead based on malpractice; Specifically,

1. The bank made its investment in the factoring company in reliance on BDO’s faulty audits, and
2. After the investment, BDO’s audits should have caught the fraud, but did not.

After the fraud was discovered, Bankest went bankrupt. Seven Bankest executives have been criminally convicted or pled guilty because of the fraud. Earlier this month, the former CEO received a 20-year jail sentence.

The winning trial team was led by Steven Thomas, a Los Angeles partner with Sullivan & Cromwell. Mr. Thomas’s resume indicates he “specializes in representing businesses as plaintiffs in substantial litigations involving fraud, professional negligence …” In other works, he is a nemesis for any audit-based accounting firm.

Fulcrum Inquiry is a forensic accounting and valuation firm that provides expert testimony in cases similar to the one described in this article.