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In the mid-1990s, KPMG Peat Marwick served as an auditor for The Common Fund for Non-Profit Organizations, which manages some $30 billion in endowment funds for colleges and universities. During this time, one of the portfolio managers at a Common Fund subcontractor, First Capital Strategies, began making unauthorized trades in securities and lost $137 million of The Common Fund’s money. In the fallout from these losses, First Capital went out of business, the trader went to jail and The Common Fund sued Peat Marwick for breach of contract and professional malpractice, charging that the accounting firm’s failure to detect and report trading irregularities at First Capital led to the massive losses. When the charges against Peat Marwick were launched, “everybody thought we were dead,” says defense counsel Michael P. Carroll of New York’s Davis Polk & Wardwell. “This was a very appealing plaintiff,” almost the equivalent of the proverbial widows and orphans. “This was a real loss,” he adds, and the defendant was a deep-pockets accounting firm that had not prevented its client from incurring the loss. “The perception was that this is what auditors are supposed to do.” Beyond this, a report by the New York law firm Cravath, Swaine & Moore, which had been retained to investigate, had been scathing in its criticism of Peat Marwick. Cravath wrote, “It is very difficult for us to understand how Peat Marwick, if it was carrying out its responsibilities faithfully and competently, could have remained unaware of the fundamentally defective and inadequate accounting, control and reporting environment.” But by going on the offensive and borrowing a ploy commonly used by criminal defense attorneys — resting without putting on any witnesses — KPMG Peat Marwick was able to convince a New York jury that there was no breach of contract and no professional negligence, and it vanquished The Common Fund’s demand for $137 million in damages. SHORTING A BULL MARKET The trader for First Capital, Kent Ahrens, managed a stock index arbitrage portfolio that was not supposed to lose any money, says Carroll. Ahrens would simply buy futures at the difference between the index rate and the individual option prices. In 1992, Ahrens started going beyond his authorization, and losses began piling up, Carroll adds. “Ahrens was shorting the market while the market was going through a record bull phase.” By 1995, those losses had reached $137 million. Immediately after Cravath released its report on the First Capital losses in January 1996, The Common Fund sued Peat Marwick. The plaintiff charged that “KPMG breached their contracts with The Common Fund to do a proper audit and to look particularly at First Capital,” says plaintiff’s attorney Stephen Black of Washington, D.C.’s Wilmer, Cutler & Pickering. The Common Fund contended that Peat Marwick should have found the trading losses and irregularities by Ahrens during the audits and, by failing to do so, Black says, “violated their professional responsibilities under generally accepted auditing standards.” The Common Fund for Non-Profit Organizations v. KPMG Peat Marwick, No. 96 CIV 255 (6130) (S.D.N.Y.). The Peat Marwick defense team determined that it could not win by spending the trial counter-punching. As a result, the accounting firm set an aggressive affirmative defense, focusing not on its own supposed failures, but on those of The Common Fund. The theme, Carroll says, was “that we are the auditors. We did not hire First Capital. The Common Fund should have known what was going on.” Carroll tried the case with Patrick Bradford of his office, with the assistance of attorneys from Chicago’s Sidley & Austin, Alan Geolot and Michael Warden. The defense explained what auditors are supposed to do and how Peat Marwick did what it was contracted to do. Peat Marwick had been hired not to do a full audit, but a review. A review has different requirements and standards, and Peat Marwick met them, he says. The defense also sought to put the dispute in personal terms. The individual auditors had not been named as defendants, but the defense brought the KPMG partners in charge of audits into the courtroom and introduced them to the jury. TOOK THE OFFENSIVE Through its cross-examinations, the Peat Marwick team went on the offensive in its treatment of the plaintiff’s witnesses. The most critical of these crosses came in the questioning of the final Common Fund witness, Ernest Ten Eyck, the plaintiff’s auditing expert. “It was important to completely neutralize him and take him out,” says Carroll. The plaintiff contended that Peat Marwick was hired to audit and look closely at First Capital. The defense countered that it was hired only to review, which required a different professional standard. “Mr. Ten Eyck testified that the accounting firm had violated professional standards in numerous ways and described these numerous ways, [illustrating] with fancy charts and graphs,” Carroll says. In his cross of Ten Eyck, Carroll says, “I was trying to seriously damage him within the first 10 minutes.” This is important, he believes, because “the jury forms an opinion quickly.” He soon began attacking Ten Eyck on more substantive issues, he says. Ten Eyck testified that the auditors had violated basic audit standards and pointed to language in the volume on auditing standards. Carroll got him to admit that there were different standards for reviews and full audits. Then he charged that Ten Eyck had applied the wrong standards to the Peat Marwick workers. “The standards you used to criticize my auditors on those charts were the audit standards,” he told the witness, then confronted him with a different, slimmer, book covering review standards. “He wasn’t even using the right book,” Carroll says. After Ten Eyck testified, the plaintiff rested; so did the defense. This carried a substantial risk, Carroll says. It’s not uncommon in criminal cases, in which a defendant can win by raising a reasonable doubt, but, “in a civil case, the standard is preponderance of the evidence. You lose if the evidence tips just a little bit.” In addition, he says, “We’ve got $200 million staring at our client. We’ve collected all this evidence and we’re telling the client that we don’t think we should show any of it.” But there were reasons to take the risk, he adds. “We were never going to be in a stronger position.” By continuing the trial, “we would call more attention to our own audit. By putting on our case in the plaintiff’s case, we were able to focus on their actions.” The jury returned a defense verdict. The plaintiff’s motion for a new trial is pending.

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