19 Dec Will Deloitte weather the aftermath of ABIL’s storm?
by Matodzi Ratshimbilani
As KPMG recycles faces to lead this once reputable audit firm and issues endless apologies for its role in the state capture project, another big five audit firm, Deloitte, has to defend itself as some of its partners appear before its professional watchdog, the Independent Regulatory Board for Auditors (“IRBA”), for professional misconduct and its role in the collapse of African Bank Investments Limited (“ABIL”).
The pro forma prosecutor at IRBA has accused the Deloitte partners for professional negligence in their auditing of ABIL prior to its demise. It is alleged that whereas one of Deloitte’s partners had built a model to test ABIL’s cash flow forecasts, another partner of Deloitte in charge of auditing ABIL neglected to use the model built by his partner, with the result that at the end of the 2013 financial year, ABIL’s cash flows were overestimated by R510 million. The partner in charge of the ABIL audit accepted a model used by the bank’s management as adequate. In hindsight it seems, as the pro forma prosecutor contends, it should have been relatively easy for a trained eye to pick up that the management’s cash flow forecast model was defective. No ill motive has been ascribed to the partner in charge but it seems that at best the partner was negligent, and at worst he was incompetent.
Either way this does not bode well for a strong brand such as Deloitte. Further, the failure to use a sound cash flow forecasting model, led to an over-evaluation of the bank’s loan book by more than R300 million. IRBA also contends that Deloitte should have picked up warning signs regarding the ability of ABIL to continue as a going concern in the face of the precarious financial position of Ellerines, a high risk business which was earlier incorporated into the ABIL business in 2008. IRBA contends that Deloitte did not subject the Ellerines cash flow projections to adequate stress testing and that Ellerines posed a foreseeable credit risk to the ABIL business at large.
Whereas the IRBA process is only focussed on the professional conduct of its members it is inevitable that the same arguments will be ventilated in civil claims for damages that may be visited on Deloitte by those who lost money in the collapse of ABIL. A court case that will prove instructive in this regard will be what is probably one of the longest civil court cases in the history of South Africa. In 1999, the National Potato Co-operative Ltd (“the Co-Operative”) commenced legal action against PricewaterhouseCoopers Incorporated (“PWC”), claiming nearly a billion rand against PWC for alleged professional misconduct and/or negligence. The litigation in this matter span sixteen years with the final judgment being handed down on 4 March 2016 by the Supreme Court of Appeal of South Africa. This followed sixteen years of legal technicalities gymnastics, several appeals and cross appeals.
The Co-Operative was set up to assist potato farmers to obtain seeds, packaging, fertilizers, insecticides and other necessities for cultivation of potatoes. The Co-Operative was funded through loans from the Land Bank. It purchased the necessary items and on-sold them to its members on credit. The debts incurred by the members were known as production credits. As it would be expected, the value of the production credits was heavily dependent on the vagaries of weather including drought. This scheme exposed the Co-Operative, and in turn the Land Bank to serious financial risks. As a result of amongst others, the drought of the early eighties from 1983 to 1992, the Co-Operative suffered significant losses, and huge amounts were impaired. Notwithstanding its precarious financial position the Co-Operative continued to extend production credits to its members.
PWC had been the auditors of the Co-Operative from its inception until the difficult times that endured throughout the eighties. The financial statements prepared by PWC for the 1983 financial year showed a dire financial position for the Co-Operative. From 1983 onwards the financial statements produced by PWC were successive qualified opinions reflecting the tenuous financial position of the Co-Operative. As a matter of course the financial statements were presented to the directors of the Co-Operative and ultimately its members during the annual general meetings.
In 1997, PWC threw in the towel and resigned as statutory auditors of the Co-Operative. In this financial year PWC issued a disclaimer concluding that they could not express an opinion on the financial statements for 1997 and withheld their opinion.
With the backing of international litigation funders the Co-Operative instituted a protracted litigation battle against PWC. The Co-Operative contended amongst others, that PWC should have determined the proper levels for provision of bad debts and write-offs, that the Co-Operative officials ran it recklessly and dishonestly, deliberately breaching the Co-Operative’s credit policy and that this was known or should have been known by PWC thorough their audit. The Co-Operative further argued that the reckless mismanagement was concealed from the directors and members, and that PWC’s audited financial reports facilitated this concealment.
The court found in favour of PWC maintaining that through its various financial reports over the years, the directors and members of the Co-Operative had enough information to act on the alleged conduct of the officials of the Co-Operative. The court took the view that PWC’s reports until its resignation were adequate and should not result in an award for damages.
On the basis of evidence presented so far against the partners of Deloitte by IRBA, it seems that their conduct and failure to insist on the use of a more robust cash flow forecasting model which they themselves had developed, leaves them exposed to a claim for damages.