Incite: Morgan Keegan suits leave auditor speechless

Now that the Securities and Exchange Commission has accused Morgan Keegan & Co. of fraudulently overvaluing subprime-mortgage bonds in several of its mutual funds, there's still one major player in this saga that hasn't uttered a peep. That would be PricewaterhouseCoopers LLP, the Big Four auditor that blessed the funds' year-end financial statements for fiscal 2007. Funny thing is, officially at least, PwC is still clinging to its position that there wasn't anything wrong with the funds' numbers. That's a lot harder to believe now than it might have been before last week. The SEC wasn't the only regulator that filed a complaint accusing Morgan Keegan of deceiving investors. So did the Financial Industry Regulatory Authority, whose allegations focused on the funds' marketing and sales materials. So, too, did state securities regulators in Alabama, Kentucky, Mississippi and South Carolina, which together estimated the total losses to investors at about $2 billion. So far PwC has yet to withdraw any of its 2007 audit reports on the funds' books. A PwC spokesman, Steven Silber, declined to comment. The funds, which no longer are managed by Morgan Keegan, fired PwC as their auditor in 2008. The accusations by the SEC, which also named one former and one current Morgan Keegan employee as defendants, center on five funds that plunged in value after the subprime-mortgage crisis gained steam during 2007. In one instance, the facts described by the SEC suggest PwC may have missed a potential opportunity to catch the alleged fraud during its year-end audit work. Among other things, the SEC's complaint said the funds' portfolio manager manipulated price quotes he obtained from at least one unnamed broker-dealer, when valuing securities the funds held. Sometimes, he persuaded a salesman at the broker- dealer to provide quotes that exceeded the securities' values. Other times, he got the salesman to make sure his firm refrained from providing quotes that would have been lower than the values on the funds' books, the SEC said. One episode where the SEC's complaint mentioned the funds' outside auditor occurred on March 30, 2007, which was the last trading day of the fiscal year for most of the funds. According to the complaint, the auditor requested price quotes from the broker-dealer on a number of the funds' bonds for its year-end audit, including a collateralized debt obligation called Knollwood. The broker-dealer sent back quotes a month later; however, it didn't provide one for the Knollwood bond. “Consequently, the Knollwood bond continued to be maintained at $92, a price higher than fair value, in the NAV of the relevant funds,” the SEC said. NAV stands for net asset value, which is the number that fund investors care most about. The chain of events, as described by the SEC, suggests PwC may not have followed up to ask why the price quote for the Knollwood bond was missing. It's anyone's guess why PwC hasn't withdrawn its audit reports on the funds for fiscal 2007. Auditors are supposed to provide clean opinion letters only if they obtain “a high level of assurance” that a client's financial statements are fairly presented, U.S. auditing standards say. It's hard to imagine how PwC could feel all that assured now, considering the SEC just accused its former client of accounting fraud. Perhaps PwC is awaiting the final outcome of the SEC's case, which might take years to litigate. While the SEC didn't name PwC as a defendant, the firm is being sued in court by fund investors. So PwC has a clear incentive to avoid acknowledging that any of its audit conclusions may have been wrong. Morgan Keegan, the Memphis, Tennessee-based brokerage unit of Regions Financial Corp., has denied the regulators' allegations, as have the individuals named as defendants in the complaints. In an April 12 letter to customers, Morgan Keegan Chief Executive Officer John Carson said the company “will challenge the SEC's position because we believe the funds were managed in accordance with the prospectus and applicable laws.” This isn't the first SEC case of its kind involving a PwC audit client. In 2006, the SEC accused a former PwC partner, Lawrence Stoler, of professional misconduct for his role in approving falsified results at three hedge funds managed by Lipper Holdings LLC that fraudulently overstated their securities' values. Stoler, who neither admitted nor denied the allegations, agreed to be barred from practicing before the commission for one year. Lipper's portfolio manager, Edward Strafaci, was sentenced to six years in prison. Auditors long have tried to sell the idea that they can't be expected to find fraud. That notion has never taken hold with the general public. After all, if auditors can't detect fraud, what good are they? Under U.S. auditing standards, the auditor's job is to obtain assurance that “the financial statements are free of material misstatement, whether caused by error or fraud.” In other words, they at least have to try Or, as the influential British accountant Lawrence Dicksee put it in his 1892 book, “Auditing,” one of the earliest manuals on the subject: “The auditor who is able to detect fraud is -- other things being equal -- a better man than the auditor who cannot.” He would get no disagreement from the investors who lost money on Morgan Keegan's mutual funds. Too bad more of today's auditors haven't read his book. (Jonathan Weil is a Bloomberg News columnist. The opinions expressed are his own.)