BDO Seidman were the outside accountants for ABFS, which raised its capital by packaging and selling collateralized mortgage obligations.  Service fees based on interest only strips accounted for slightly over 50% of ABFS' revenues in the years audited by BDO.  ABFS allegedly altered its loan delinquency rate by improperly and artificially lengthening its delinquency period and using creative loan reaging techniques.  When ABFS was unable to sell securitized pools of mortgages to Wall Street, it marketed these notes itself and financed its operations by selling high-interest promissory notes without involving underwriters or brokers.  The notes were non-transferable except with ABFS' permission.  BDO also provided other services to ABFS which generated substantial fees.

The complaint alleged that BDO was liable for certifying misleading financial statements.  Specifically, BDO certified financial statements despite knowing that (i) the company's internal accounting controls were materially deficient and inadequate and could not be relied upon and (ii) the company violated GAAP and fraudulently manipulated its earnings and assets by making unsupportable assumptions in connection with evaluation of the interest only strips and servicing rights.  BDO allegedly violated GAAS by failing to exercise due professional care in the performance of its audits, failing to maintain its independence, failing to consider properly the fraud risk, failing to obtain sufficient competent evidential matter concerning the assertions in ABFS' financial statements, failing to use the work of valuation specialists, and over-relying on management representations. 

BDO sought to dismiss the complaint, among other reasons, on the basis that the alleged violation of GAAS standards was not pled with facts specifically explaining how BDO knowingly or recklessly violated those standards.  Clearly this complaint was much too general.  But the court held that there were significant red flags suggesting that BDO either knowingly or recklessly disregarded GAAS standards in producing its two unqualified audited opinions.  The subsequent failure of BDO to take further steps to investigate, when coupled with its substantial financial incentives for handling this client, were held by the court to constitute strong circumstantial evidence of conscious misbehavior or recklessness, which the court deemed sufficient to survive a motion to dismiss. 

The first red flag was the resignation of the prior auditor.  The resignation letter of the prior auditor identified four potentially large unresolved audit issues:

1. The discount rate;
2. An anomaly in the amortization of deferred selling costs;
3. A key assumption in calculating the servicing asset - the projected future service fees; and
4. Ability to collect fees receivable.

Plaintiffs contended that if BDO had made an appropriate inquiry underlying the reasons for the mid-audit resignation, that investigation would have raised questions regarding the company's management, integrity, financial condition, controls or reporting. 

The court also cited other red flags:

(a) Strong comment letters from the SEC;
(b) Outstanding matters with the state-level securities commission;
(c) A subpoena of the company's records by the US Attorney with respect to published interest rates;
(d) Recurring negative cash flows from operations for seven years in a row;
(e) The company's poor liquidity and dependence on debt financing;
(f) 80% of securitization gains being based on estimates of the fair value of retained interests;
(g) Management's insistence on a material decrease in the discount rate applicable to interest only strips, which was a rate much lower than used by the company's peer group;
(h) Domination of management by a small number of individuals;
(i) The company's consistent reporting of delinquency rates far lower than rates generally prevailing in the industry;
(j) The misallocation of approximately $5,000,000 from an escrow account to its operating account;
(k) Material unreconciled differences in the company's main cash clearing account;
(l) The company's projection of future servicing fees exceeded the present rate, thus materially inflating the servicing assets; and
(m) The company's miscalculation with respect to a particular securitization, which led to a material over-evaluation of interest only strips.

Of course, each case is different.  But the red flag allegations in the American Business Financial Services, Inc.  Noteholders Litigation illustrate the sort of conduct, which perhaps while individually not a basis of liability, can in the aggregate constitute actionable conduct.  As a financial professional, it is all the more important to be alert for these warning signs, and properly document your investigation of these red flags. A clever attorney can use them to create a complaint against you, which will survive a motion to dismiss.  Please contact us at checht@hechtlegal.com, if you would like a copy of the opinion.

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CHARLES HECHT has been a principal of his own law firm specializing in securities law since 1971. He was previously on the staff of the Division of Corporate Finance of the Securities and Exchange Commission at its headquarters in Washington, DC. Contact him at 212.490.3232 or visit www.securitiescounselors.com