External accountant, specially the Big 4s, and their performance and liability around the long list of financial scandals and corporate fraud the last decade.
MAHA Global and IPR: Do Actions Speak Louder Than Words?
Accountant Liability. The D & O diary
1. Accountant Liability : The D & O Diary
Kevin M. LaCroix is an attorney
and Executive Vice President,
OakBridge Insurance Services,
Beachwood,Ohio, a division of R-
Home > Accountant Liability > T Specialty, LLC. OakBridge is an
insurance intermediary focused
exclusively on management
Audit Firms' Litigation Woes Mount, Report Shows liability issues. MORE...
Posted on July 23, 2009 by Kevin LaCroix About
As reflected in a recently released and detailed analysis of audit firms’ current litigation Services
and prior lawsuit settlements, the audit firs’ litigation challenges are a serious and
Contact
growing problem. The July 2009 presentation by Mark Cheffers, the CEO of Audit
Analytics, is entitled "Accounting Professional Liability: Scorecards and Commentary" Archives
and can be found here. According to a July 22, 2009 Compliance Week article (here),
Cheffers presented the slides at a recent litigation conference cosponsored by the
American Bar Association and the American Law Institute.
The presentation materials reflect very detailed information about the major accounting firms’ litigation. Among
other things, the presentation aggregates the top 50 accounting malpractice settlements since 1999. The data
show that Ernst & Young has paid the largest amount in malpractice settlements during that period, totaling
$1.92 billion. KPMG follows with settlements totaling $1.42 billion, followed by PricewaterhouseCoopers at
$1.27 billion and Delotte & Touche at $1.25 billion.
As detailed in the presentation, the audit firms now face huge potential exposure from the growing numbers of
lawsuits that have been filed against them in connection with the credit crisis and the Madoff scandal. Cheffers’
presentation lists the current litigation scorecard of cases that have been filed against the audit firms. According
to the Compliance Week article, Cheffers said at the conference that these lawsuits filed so far are "likely just the
beginning."
The presentation also shows the prevalence of going concern audit opinions, both in terms of percentage of all
audit opinions and in absolute numerical terms. The presentation shows that in 2008 going concern opinions,
both in percentage terms and in absolute numbers were at their highest level in the past decade
There may well be other places where this kind of information about audit firm liability exposure has previously
been compiled, but this is the first time I have seen the information presented this comprehensively. The
information presented in the slides is fascinating and one can only hope that Cheffers will continue to update
the information and continue to make it publicly available.
TAGS: Accountant Liability
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KPMG Settles Options Backdating Gatekeeper Claim for $22.5
Million
Posted on June 16, 2009 by Kevin LaCroix
Enter keywords:
In the latest twist in the long-running options backdating saga, and in what appears
to be a significant milestone in the options backdating-related gatekeeper claims, on
June 15, 2009, Vitesse Semiconductor announced (here) that it had reached a
http://www.dandodiary.com/articles/accountant-liability/[17-06-2011 22:03:15]
2. Accountant Liability : The D & O Diary
settlement with its former auditor, KPMG LLP, in connection with the option
backdating related allegations. In the settlement KPMG agreed to pay $22.5 million
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As discussed at greater length here, in June 2007,Vitesse sued KPMG in Los Angeles County Superior Court
alleging that KPMG had been negligent in auditing the company’s stock option grants and financial statements
during the years 1994 to 2000. Vitesse later amended the complaint to include the years 2001 to 2004.
Vitesse itself had been the subject of an options backdating-related securities class action lawsuit in the Central This multipart series explores the
basics of directors' and officers'
District of California, as described here. Vitesse settled that lawsuit for a payment $10.2 million in cash, $8.75
liability insurance. The index for
million of which came from the company’s D&O insurance carrier, and the balance in payments from individual
this series can be found here.
defendants. The settlement also included the transfer of shares of Vitesse stock from Vitesse and from the
individual defendants.
AIM
The plaintiffs in the options backdating securities lawsuit had also sued KPMG and as reflected here, on June
Accountant Liability
16, 2008, the parties to the securities lawsuit filed a stipulation of settlement in which KPMG agreed to
contribute $7.750 million toward the class settlement. Blogging
Class Action Settlements
KPMG’s recent $22.5 million settlement of Vitesse’s own lawsuit is in addition to KPMG’s separate $7.750 Corporate Governance
million contribution to the settlement of the securities class action lawsuit. D & O Insurance
ERISA
As I recently noted (here), the options backdating securities class action lawsuits themselves appear to be Earnings Guidance
winding down, but until word circulated of KPMG’s settlement with Vitesse, I had not heard of the resolution of
Enron
any cases that companies themselves had filed against their outside professional advisors.
Environmental Liability
Executive Compensation
Even if there were prior outside gatekeeper settlements that I missed, the KPMG settlement with Vitesse has to
be the most significant settlement between an outside gatekeeper and a company with respect to the options Failed Banks
backdating scandal. It will be interesting to see whether the final stage of the options backdating saga includes Fair Labor Standards Act
further significant gatekeeper claim resolutions. Given the magnitude of the KPMG settlement, it would Foreign Corrupt Practices Act
certainly seem that there could be other significant settlements and perhaps even the assertion of additional
Hedge Funds
claims.
IPO Laddering Cases
IPOs
I would be very interested to know if readers are aware of the resolution of any other cases that companies have
filed against their outside professionals in connection with the options backdating scandal. Insider Trading
International D & O
As noted here, KPMG is also the subject of a trustee’s claim in connection with the New Century Financial Corp. Madoff Litigation
bankruptcy proceeding. KPMG also remains a defendant in the New Century subprime-related securities class McNulty Memo
action lawsuit, after its motion to dismiss in that case was denied, as discussed here.
Opt-Outs
Options Backdating
How Will GM Sell Cars Now?: General Motors certainly faces a daunting challenge trying to sell cars as a
Outside Director Liability
bankrupt company. I have posted a video link below of an irreverent but particularly funny take on what a
bankrupt GM’s ads might look like. The spoof ad does a great job ripping conventional car ad clichés, which PCAOB
clearly won’t work now (if they ever did). PIPEs Financing
Hat tip to the Planet Money blog for the link to the video. Warning, the ad contains language some might Patriot Act
consider offensive. Paulson Committee
Plaintiffs' Bar
Private Equity
Proxy Statements
Regulatory Reform
SOX (Generally)
SOX Whistleblower
Securities Litigation
Share Buybacks
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3. Accountant Liability : The D & O Diary
Shareholders Derivative Litigation
Subprime Litigation
Thompson Memo
Videos
Warren Buffett
TAGS: Accountant Liability, Options Backdating, accountants liability, gatekeeper liability Archives
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All China, All the Time
New Century Trustee Sues KPMG; Will Other Gatekeeper Eleventh Circuit Affirms
HomeBanc Subprime Securities
Claims Follow? Suit Dismissal
Supreme Court Holds Fund
Posted on April 2, 2009 by Kevin LaCroix
Management Company Cannot
In a development that may foreshadow further "gatekeeper" claims as part of the Be Held Liable for Funds'
Statements
current credit crisis litigation wave, on April 1, 2009, the trustee for the New
Century Financial Corp. liquidation initiated lawsuits in California and New York Should Directors Be Held Liable
More Often?
against KPMG and its international parent, seeking to recover $1 billion in damages
for negligence and for aiding and abetting breaches of fiduciary duty. Predicting the Supreme Court's
Decision in Janus
Securities Litigation: Variations on
The California complaint, filed in the Los Angeles County Superior Court (copy here) against KPMG LLP, alleges a Chinese Theme
that the firm "did not act like a watchdog" but rather "acted like a cheerleader for management."
Confidential Witness Statements
Lead to Dismissal Motion Denial
in Regions Financial Subprime
The complaint alleges that KPMG "performed grossly negligent audits and reviews" and "failed to detect
Securities Lawsuit
material errors" with respect to New Century’s residual interest on loans it securitized and on its loan
repurchase liability. The complaint also faulted KPMG for its approval of faulty loan loss reserves, alleging that Supreme Court Reverses Fifth
Circuit in Halliburton Case; Proof
an audit partner silenced the concerns of a more junior audit team member who questioned the reserve of Loss Causation Not Required
calculation. At Class Certification Stage
D&O Insurance: Does
"Fraudulent" Mean "Fraudulent"?
The complaint also alleges that KPMG "aided and abetted New Century’s directors’ and officers’ breaches of
their fiduciary duties." The complaint alleges that KPMG knew that management was improperly reserving for In a Must-Read Opinion,
risks the company faced and that management had failed to implement an effective system of internal controls. Delaware Court Rejects Bid to
Block Massey Merger
Yet Another Lawsuit Following
The aiding and abetting allegations includes the charge that KPMG aided and abetted company officials "in "No" Vote on "Say on Pay"
maintaining material weaknesses and significant deficiencies in New Century’s system of internal controls over
White Collar Crime-Fighting and
financial reporting." The complaint alleges that KPMG is "jointly responsible with the directors and officers for Other Web Notes
damages resulting from these breaches."
The complaint seeks compensatory damages of $1 billion, as well as punitive damages. Madoff Investor and Feeder Fund
Litigation: The List
Subprime Lawsuits DIsmissal
The complaint filed in the Southern District of New York (copy here) substantially repeats many of the same Motion Grants and Denials
allegations as the California complaint, but addresses the alleged liability of KPMG’s international parent. The
Counting the Subprime-Related
complaint alleges that the parent represented that it would "ensure that member firms’ work would meet
Derivative Lawsuits
professional standards and regulatory requirements."
Counting the Subprime Securities
Class Action Lawsuits
The complaint alleges that KPMG International did not fulfill these responsibilities, and as a result New Century Options Backdating Settlements,
was harmed. The complaint seeks unspecified compensatory as well as punitive damages from KPMG Dismissals and Denials
International.
Counting the Options Backdating
Lawsuits
The trustee’s filings in these complaints certainly suggest the possibility that auditors and other "gatekeepers"
could be targeted in the wake of the subprime meltdown. Leading accounting indusrty commentator Francine
McKenna (also the author of the indispensible "re:The Auditors" blog) is quoted in the April 1, 2009 Wall Street Cyber Inquirer
Journal as saying that the case "may embolden others to look more closely at the possibiltiy of bringing Delaware Corporate and
[accounting] firms to some level of culpability for the things that happened" that led to the credit crisis. Commercial Litigation Blog
Drug and Device Law
But in assessing that possibility it may be important to note the particular key circumstances that preceded the III Insurance Industry Blog
trustee’s claims against KPMG.Specifically, the new lawsuits follow more than a year after the February 29,
PLI Securities Law Practice
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4. Accountant Liability : The D & O Diary
2008 581-page report of Michael Missal, the KPMG bankruptcy examiner, in which the examiner concluded that Center
KPMG had "contributed" to certain of New Century’s "accounting and reporting deficiencies by enabling them to
PLUS Blog
persist in, and in some instances, precipitating the Company’s departure from, applicable accounting
standards." A detailed review of the examiner’s report, including a link to the report itself, can be found here. Pension Risk Matters
SOX First
The examiner’s exhaustive review, which among other things specifically suggested the possibility of negligence Securities Docket
claims against KPMG, was effectively a road map for the April 1 lawsuits. While the lawsuits might well have Securities Litigation Watch
been filed even without the examiner’s report, few other prospective claimants considering "gatekeeper"
The 10b-5 Daily
litigation will have such a detailed script from which to compose their complaint.
The AAO Weblog
On the other hand, many of the complaints already filed in numerous lawsuits as part of the current subprime The CorporateCounsel.net
and credit crisis-related litigation wave have already targeted a variety of gatekeepers, including offering The D&O E&O Monitor
underwriters, credit rating agencies, and, in some cases, even the outside auditors.
The FCPA Blog
The Harvard Law School
Indeed, the securities lawsuit filed against New Century’s former directors and officers also specifically named Corporate Governance Blog
KPMG as a defendant. In his December 3, 2008 order denying the defendants’ motion to dismiss the securities The Race to the Bottom
lawsuit, Central District of California Judge Dean Pregerson specifically denied KPMG’s separate motion to
WSJ Law Blog
dismiss, finding that the complaint in that case adequately alleged that KPMG was aware of accounting and
internal control deficiencies but nevertheless issued its audit opinion in connection with the company’s 2005 White Collar Crime Prof Blog
financial statements. A detailed discussion of Judge Pregerson’s decision, including a link to the opinion, can be With Vigour and Zeal
found here.
re:The Auditors
The outcome of KPMG’s dismissal motion in the New Century securities lawsuit, as well as the trustee’s filing of
the April 1 lawsuit, among other things suggests that the U.S. Supreme Court’s decision in the Stoneridge case
may not deter prospective litigants from pursuing claims against auditors and other gatekeepers.
One of the more interesting aspects of the trustee’s complaint against KPMG is his claim seeking to hold the
accounting firm "jointly responsible" with New Century’s former directors and officers for the officials’ breaches
of their fiduciary duties. While the trustee’s claims at this point represent nothing more than allegations and it
remains to be seen whether his claims on this theory will result in any recovery, the possibility that auditors may
be alleged to be "jointly liable" for directors’ and officers’ fiduciary breaches raises a host of concerns and
questions, not the least of which relate to co-defendant (or third-party defendant) proceedings, such as cross-
claims for contribution.
All of which leads to a point I have been asserting for some time, which is that we are still only in the earliest
stages of the credit crisis related litigation wave. Not only are the cases against the defendant companies
continuing to pour in, but the likelihood of further gatekeeper litigation like that filed against KPMG suggests
that the litigation will continue for many, many years to come.
The "re: The Auditors" blog has an interesting and detailed analysis of the KPMG complaints, here.
Hat tip to the Wall Street Journal (here) for copies of the KPMG complaints.
Honoring Those Who Serve: A recent MSNBC segment reported on what my good friends, David Bell of
AWAC and John McCarrick of the Edwards and Angell law firm, have been doing to honor those who have made
the ultimate sacrifice in service to our country. As reflected in the video below, a group they helped to organize,
Grateful Nation Montana, is taking steps to ensure that the children of U.S. soldiers killed in the battle will be
able to pursue a college education.
Please watch this video. It is guaranteed to bring tears to your eyes, but it will also make you appreciate the
efforts of a couple of industry leaders, who have done something substantial and worthy to help make a
difference.
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5. Accountant Liability : The D & O Diary
TAGS: Accountant Liability, New Century Financial Corp., Subprime Litigation
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So What About Auditor Liability Caps?
Posted on April 24, 2008 by Kevin LaCroix
One of the recurring suggestions in would-be reformers' standard litany of proposed changes
for litigation relief is the introduction of auditor liability caps. For example, the Committee
on Capital Markets Regulation interim report (about which refer here) proposed the
“elimination or reduction of gatekeeper litigation, either through a cap on auditor liability or
creation of a safe harbor for certain auditor practices.” Similarly, in early 2007, the European Commission
launched a study (about which refer here) on “whether there is a need to reform the rules on auditor liability in
the EU.”
But while these initiatives are only at the proposal or study phase, the U.K. has moved forward to permit
“auditor liability limitation agreements,” under legal provisions that recently went into effect. The newly
effective provisions are part of the Companies Act of 2006 (refer here for the Act’s text). The auditor liability
limitation provisions are contained in Sections 532 to 538 of the Act, which took effect on April 6, 2008,
according to the Act’s implementation timetable (here). For background regarding the Act, refer here.
The Act allows auditors to limit their liability by contract, provided that their client’s shareholders approve.
Section 534(1) of the Act allows auditors to limit their liability “in respect of any negligence, default, breach of
duty or breach of trust, occurring in the course of an audit of accounts.” The limitation cannot cover more than
one financial year and it must be approved by a resolution of shareholders. Under Section 537, the liability
limitations are not effective except to the extent they are “fair and reasonable” in the particular circumstances.
The Act itself does not specify the particular kinds of limitations that are allowable nor does it prescribe the
form the limitation is to take. However, a working group of the Financial Reporting Council, the supervisory
body for U.K. auditors, has proposed “draft guidance” (here) suggesting ways that the limitation agreement
might be framed. The FRC guidance document even includes specimen language to be used as a reference in
preparing limitation agreements.
The FRC guidance suggests three alternative ways the auditor’s liability might be limited: (a) proportionality,
“where the auditor’s liability is limited to his share of the company’s loss, taking into account the liability of
others”; (b) fair and reasonable, “where the auditor’s liability is limited to such amount as is fair and
reasonable in accordance with Section 537 of the Act”; or (c) monetary cap, “where the auditor’s liability is
limited to a particular amount, which is either stated or calculated in some way, e.g.. as a multiple of audit fees.”
The Act’s auditor liability limitation provisions represent an interesting experiment, but it will be even more
interesting to see how widespread the acceptance of auditor liability limitations agreements becomes. The Act’s
requirements themselves may deter widespread adoption, particularly the one-year time limitation and the
requirement for shareholder approval. One might also conjecture that there might be some stigma associated
with a company’s agreement to limit its auditor’s liability, to the extent the existence of an agreement is
interpreted to suggest that the only way the company could procure an auditor’s services was by granting the
auditor a liability limitation. There is also legal uncertainty surrounding such issues as the extraterritorial effect
of any limitations, which may be of particular concern for auditors of companies that have shareholders,
creditors or other business partners outside the U.K.
It is probably also relevant that the auditor liability provisions were adopted as part of the Companies Act,
which also contains provisions defining directors’ duties and incorporating new statutory procedures for
bringing claims against directors. One wonders whether a company’s directors, newly sensitized to their duties
and potential litigation risks, will be comfortable relieving their auditors of liability to the company for
negligence or other misconduct. Even though the liability limitation has to be approved by shareholders, you can
imagine the second-guessing and accusations that might surface if problems do arise later.
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6. Accountant Liability : The D & O Diary
Within its draft guidance document, the FRC anticipates that companies may well wrestle with the question
whether (or even why) they should agree to limit their auditor’s liability, and expressly observes that directors
“will wish to establish that it is in the company’s interest to enter into a liability limitation agreement.” The
guidance document does not attempt to suggest what interest a company would have in limiting its auditor’s
liability.
Along with the question of what the take-up of the limitation agreement will be for U.K. companies is the
question whether other jurisdictions will adopt the U.K. approach or similar auditor liability limitation
provisions. A March 2006 report by Michael Gass and Ashwani Kochlar of Edwards Angell Palmer & Dodge
entitled “U.K. Gives Auditor Liability Agreements a Greenlight, But U.S. is Unlikely to Do the Same” (same)
takes a look at the new U.K. provisions and considers the possibilities for reform efforts in the U.S. The report
concludes that current U.S. reform efforts are “ill-timed” and that given the turmoil in the financial markets,
“garnering attention and support to adopt proposals … will be challenging” – unless one of the Big Four
accounting firms implodes, in which case “all bets are off.”
The CorporateCounsel.net Blog also has an interesting post here discussing the newly effective U.K. provisions
and expressing skepticism for the likelihood of auditor liability reform in the U.S. anytime soon.
Readers interested in the topic of auditor liability caps may want to refer back to my earlier post, here, in which
I discuss the very interesting alternative proposal of George Washington University law professor Lawrence
Cunningham. Professor Cunningham suggests having the audit firms issue bonds to the capital markets as a way
to provide financial protection for their liability risks.
U.K. Government to Appeal BAE Systems Ruling: In a recent post (here), I reviewed the April 10, 2008
decision by the U.K.’s High Court of Justice against the British government’s decision to terminate the
investigation of alleged bribery involving BAE Systems in connection with a Saudi arms deal.
On April 22, 2008, Transparency International, on its own behalf as well as on behalf of several other
organizations, wrote (here) to the U.K. Attorney General “urging the government not to appeal the
judgment.” The letter stated that “halting the investigation has caused untold damage, both to the reputation of
the U.K. and to global efforts to improve governance and combat corruption.” The letter also urged that the
action to drop the investigation has “reduced [the U.K.’s] standing among its peers” in the OECD, and any move
by the government to appeal “would compound the reputational damage to the U.K.” and would undermine the
implementation of the United Nations Convention Against Corruption.
Nevertheless, on April 22, 2008, the Serious Fraud Office announced (here) that it will “seek permission to
appeal to the House of Lords” against the lower court’s April 10 judgment. The SFO’s announcement quoted the
current SFO director as saying that the April 10 judgment “raises principles of general public importance
affecting, among other things, the independence of prosecutors and the role of the court in reviewing a
prosecutor’s evaluation of the public interest in a case like this.”
It is very hard to argue that the U.K.’s efforts to suppress the BAE Systems investigation will not undermine its
efforts elsewhere to fight corrupt practices. The unmistakable message is that the U.K. only cares about small
scale corruption involving the less powerful, those whom the U.K. feels it can safely push around; but that these
impediments can be overcome if the bribe is large enough and the corrupt official powerful enough. Nothing
could do more to breed cynicism over anticorruption efforts that for the U.K. government to successfully
suppress this investigation.
Hat tip to the Sox First blog (here) for the links to the Transparency International and Serious Fraud Office
announcements.
Time Out for an Idol Thought: I was delighted to learn that my former partner from the Ross, Dixon & Bell
law firm, Bill Hopkins, now apparently known by his nom de plume Will Hopkins, is a finalist in the American
Idol songwriting competition. The WSJ.com Law Blog has an excellent interview of Bill, er, Will, here.
Hopkins, we shall call him, left active law practice to try to write music about the same time I left the law firm to
become involved on the business side of insurance. Everyone must follow their own muse, I suppose.
Speakers' Corner: On Monday April 28, 2008, I will be speaking as a panelist at the C5 Conference on
Securities Litigation in London, on a panel entitled "Liability Never Goes Away:Managing Risk and Tackling
D&O Liability" The conference features a number of very distinguished speakers. A copy of the seminar
materials, including conference agenda, can be found here. If you are attending the conference, I hope you will
make it a point to greet me.
TAGS: Accountant Liability, Auditor Liability Caps, Companies Act 2006, Limited Liabiltiy Agreements,
Litigation Reform
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New Century Examiner's Report Faults KPMG, Company
Officials
http://www.dandodiary.com/articles/accountant-liability/[17-06-2011 22:03:15]
7. Accountant Liability : The D & O Diary
Posted on March 27, 2008 by Kevin LaCroix
In a sweeping 581-page report (here), the examiner appointed in connection with the New
Century Financial Corporation bankruptcy found that New Century “engaged in a number
of significant improper and imprudent practices related to its loan originations” that
“created a ticking time bomb that detonated in 2007.”
Bankruptcy examiner Michael J. Missal issued his report as part of the investigation he undertook at the request
of New Century’s bankruptcy trustee to examine “any and all accounting and financial statement irregularities,
errors and misstatements.” The report is dated February 29, 2008, but it was unsealed on March 26, 2008 at
the request of former New Century Employees.
The examiner’s report concludes that New Century “had a brazen obsession with increasing loan originations,
without due regard to the risks associate with that business strategy.” The report also concludes that New
Century “engaged in at least seven wide-ranging accounting practices in 2005 and 2006” that “resulted in
material misstatements of the Company’s financial statements.” The examiner did not find sufficient evidence to
conclude that New Century engaged in earnings management or manipulation “although its accounting
irregularities almost always resulted in increased earnings.”
The report also states that New Century’s outside accounting firm, KPMG, “contributed to certain of these
accounting and financial reporting deficiencies by enabling them to persist and, in some instances, precipitating
the Company’s departure from applicable accounting standards.”
The report states that as a result of New Century’s accounting failures New Century understated its repurchase
reserve in the third quarter of 2006 by 100%, and reported a quarterly profit of $63.5 million when it should
have reported a loss.” In addition, the accounting errors resulted in the payment of performance bonuses to key
executives in 2005 “that were at least 300% more than they should have been.” New Century also made “a
number of false and misleading statements in its public filings, press releases and other communications.”
Based on his investigation, the examiner believes that “several causes of action may be available to the estate.”
First, the report concludes that the estate may be able to assert causes of action against KPMG for “professional
negligence and negligent misrepresentations.” Second, the estate may be able to assert causes of action against
former officers “to recover certain of the bonuses… that were tied, directly or indirectly, to the incorrect
financial statements.” These causes of action, the report states, “could seek million of dollars of recoveries.”
The examiner also considered whether the company’s former officials breached their fiduciary duties, and
whether the estate has possible claims against the officials. The report notes that any assertion of these claims
would have “strong defenses to overcome, particularly the business judgment rule and statutory and other
limitations.”
While the examiner’s conclusions may (and undoubtedly will) be the subject of substantial debate, the report’s
analysis of the company’s loan origination practices and accounting shortcomings is remarkably detailed. The
sheer sweep and magnitude of the report and the depth of its detail could make New Century the poster child
for the excesses of the subprime lending boom, evoking inevitable comparisons with Enron as the byword for an
entire era. Indeed, the report suggests a number of echoes from that earlier period, including in particular the
accounting firm’s supposed complicity in the company’s alleged excesses.
The fallout from the subprime meltdown will continue to accumulate in the months and years to come, but the
New Century bankruptcy examiner’s report may represent the first installment on the history of the era.
A March 26, 2008 Bloomberg.com article discussing the examiner’s report can be found here. A March 27,
2008 Wall Street Journal article discussing the report can be found here.
TAGS: Accountant Liability, New Century Financial Corp., Subprime Lawsuits, Subprime Litigation,
suprime-related litigation
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Fraud Detection and the "Expectations Gap"
Posted on November 19, 2007 by Kevin LaCroix
As a result of the Sarbanes-Oxley Act and other reforms, a variety of structures and
procedures were put into place to try to prevent or detect fraud. A number of these
reforms involve auditors and the audit profession, in the implicit assumption that auditors
have an important role to play in preventing and detecting corporate fraud. But a recent
Grant Thornton survey (here) shows that many CFOs still do not feel constrained by their
auditors' oversight, notwithstanding the reform measures.
According to the survey, 62% of the 221 CFOs surveyed believe it would be possible to intentionally misstate
their financial statements to their auditors. As one commentator in the November 15, 2007 CFO.com article
(here) commenting on the survey put it, these numbers are "alarming," given that "CFOs - if they've a mind to -
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8. Accountant Liability : The D & O Diary
are in a unique position, having the necessary information, intelligence and access to trick auditors in ways that
are hard to decipher."
Indeed, it is disconcerting that nearly two-thirds of CFOs feel they could fool their auditors on intentionally
falsified financial statements. Clearly, if such a large percentage of CFOs feel they could, some of them might,
and a few of them will. This intimation of the possibility of undetected fraud should be disconcerting to
investors, analysts, and others (including D & O underwriters) who rely on auditors' assurance that the financial
statements are free from "material misstatement."
The disappointment and even anger that investors and others feel when they find they have been misled by
falsified financial statements often encompasses a sense of frustration that the auditors failed to detect the
fraud. Accordingly, auditors are often named as co-defendants in securities fraud lawsuits, based on a failure to
detect the fraud and the auditors' statements that there are no material misstatements in the financial
statements.
But a further Grant Thornton survey finding underscores the theoretical limitations of audit fraud detection. 83
percent of the surveyed CFOs said they did not feel that it was even possible for auditors to detect corporate
fraud in all cases. This survey finding embodies the same sentiment expressed in the November 2006 statement
of the heads of the six leading accounting firms entitled "Global Capital Markets and the Global Economy: A
Vision From the CEOs of the International Audit Networks" (here). The accounting industry leaders noted that
"there are limits to what auditors can reasonably uncover, given the limits inherent in today's audits." They go
on to note that while there are audit techniques whose principal goals are to "ascertain whether fraud has
occurred," these techniques are "not foolproof, nor can they be expected to be."
The problem for everyone, both auditors and those who rely in their audits, is that there is, in the words of the
industry leaders' statement, an "expectations gap." According to the accounting leaders, the gap arises because
"many investors, policy makers, and the media believe that the auditor's main function is to detect all fraud, and
thus, where it materializes and auditors have failed to find it, the auditors are presumed to be at fault." The
accounting leaders go on to assert that:
Given the inherent limitations of any outside party to discover the presence of fraud, the
restrictions governing the methods auditors are allowed to use, and the cost constraints of the
audit itself, this presumption is not aligned with the current auditing standards.
The accounting leaders' frustration is palpable; they apparently recognize, as do the CFOs that responded to the
Grant Thornton survey, that management bent on misrepresenting their company's financial condition can
conceal the misrepresentations from the auditors. But the reason there is nonetheless an expectations gap is
that investors and others do rely, as they must, on company's audited financial statements. Merely naming the
problem as an expectations gap, or citing the limitations of current auditing standards, does not address the
problem, which is that investors and others rely on the audited financial statements in ways the auditors
apparently wish they wouldn't or believe they shouldn't. It almost seems as if the auditors' message to those who
would rely on financial statements is - don't (or, at least, not so much).
Given the CFOs' and the accounting leaders' recognition of the limitations of audit fraud detection, it may be
well argued that audited financial statements in fact should not be relied upon. But what alternative do investors
have? The investors necessarily place some value on the fact that professionals independent of management
have examined the financial statements.
It is nevertheless a significant concern that nearly two-thirds of CFOs believe they can fool their auditors. And
apparently the auditors agree with the general proposition as well. This ought to make anyone who needs must
rely on audited financial statements very uneasy.
Special thanks to John Condon at Audit Integrity for the link to the survey results and the CFO.com article.
A Service Error Apology: I am sorry that early in the evening on November 19, 2007, my syndication service
spontaneously generated an erroneous email with the cryptic message "Forbidden 403." (For those, like me,
who have to know, Error 403 messages are explained --sort of -- here.) I do not know why this error message
was sent. I apologize to all of my readers for the unsolicited distribution email. I am attempting to ensure that
this error will not recur.
TAGS: Accountant Liability
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An Alternative to Auditor Liability Caps?
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9. Accountant Liability : The D & O Diary
Posted on September 11, 2007 by Kevin LaCroix
As the various blue-ribbon panels studying the competitiveness of the U.S. financial markets have proposed
various regulatory reforms, one recurring theme has been the proposal for auditor liability caps (refer here), a
topic that is also under study by the European Commission (refer here). A 2007 paper by Professor Lawrence
Cunningham of the George Washington University Law School entitled "Securitizing Audit Failure Risk: An
Alternative to Caps on Damages" (here) proposes an alternative to auditor liability caps for the risk of
catastrophic audit failure, by having the audit firms issue bonds to the capital markets to provide coverage for
the risks.
Cunningham notes that at the center of the arguments in support of auditor liability caps are concerns about the
limited availability of insurance for auditors; while these arguments are most persuasive during hard insurance
markets when insurance is relatively unavailable, the arguments may be less persuasive during soft insurance
markets when insurance is relatively more available. Cunningham notes that "proposals to cap liability that are
supported by arguments about lack of insurance may be unable to respond to the dynamics of these markets."
The likelihood of a legislative liability cap solution that is appropriately sensitive to these changing insurance
marketplace dynamics is unlikely.
But in any event, the periodic fluctuations of the insurance market clearly present limitations on the value of
insurance-based risk transfer mechanism; Cunningham's article reviews those limitations at length. As an
alternative to the insurance-based model, Cunningham proposes "insurance-based securitization" that would
"distribute risk of audit failure through the capital markets." Cunningham's proposal is modeled in the existing
use of catastrophe bonds (or cat bonds as they are more commonly known) to transfer risk for extreme property
loss or damage events. These bonds pool investor funds, which are invested in low-risk investment vehicles and
pay out interest income, with the principal available to pay loss in the event of the occurrence of certain defined
events. Cunningham proposes that just as these bonds are available to protect against the risk of natural events
such as earthquakes and hurricanes, similar types of bonds could also be used to protect against the risk of
catastrophic audit failure.
Cunningham advances a number of arguments in support of his proposal. Among other things, he argues that
managing these risks through the capital markets "should reduce the volatility that auditors have faced for
decades and that is an important basis for the insurance based arguments in favor of establishing ex ante
damage caps on auditor liability for auditor failures." Cunningham also argues that, through risk-sensitive
interest rate requirements, capital markets will introduce "capital market monitoring of auditing firm
performance." Finally, Cunningham notes that a private bond offering "is relatively simple for auditing firms to
complete compared to the political challenge necessary...to establish caps on damages."
Cunningham's innovative proposal is both novel and interesting. The general success of the existing cat bond
market does suggest the innovative potential of this proposal. I do have several concerns about the proposal
though, which are as follows.
In general, the cat bond market has extended only to first-party property damage risk, not to third-party liability
risk. I am guessing there are several reasons for this. The first is that the triggering event for a property cat bond
is easily identifiable, and the losses are short-tail - that is, the event occurs and the losses are ascertained within
a relatively short time thereafter. In contrast, a third-party liability claim can have a very protracted life with an
uncertain outcome. The extent and duration of this uncertainty may be ill-suited to the requirements of the
capital markets and of investors; the claims uncertainty could undermine reliable bond valuations during the
long duration of the claim.
In addition, the losses that trigger cat bond payments are beyond anyone's control; the mere existence of the
bonds do not and cannot attract claims. By contrast, the actions of third parties can cause events that would
trigger liability bond losses, and indeed the very existence of the bonds arguably could attract claims (consistent
with the old insurance adage that limits attract losses).
Along the same lines, the existing cat bond market is supported by a very sophisticated cat modeling industry
that produces robust, scientific frequency predictions concerning the likelihood of one of the triggering natural
events. As someone who as spent a lifetime pondering liability claim frequency and severity, I know that
projecting either liability frequency or severity are very difficult and uncertain enterprises. It would be a very
difficult task indeed to compose the kind of disclosure that would be required to provide investors with the kind
of projections these bonds would require in order to support a robust marketplace. This difficulty could require
interest rate payments on the bonds that could make the bonds uneconomical for the marketplace. (This same
principle is at work in insurance pricing, where the loss ratio insurers use as a pricing input is usually more
demanding than for property lines, leading to higher pricing requirments to account for the uncertainty.)
In addition, the big four accounting firms operate as private entities. Their history and their clients'
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10. Accountant Liability : The D & O Diary
expectations could both militate against their voluntarily undertaking the kind of disclosure investors would
require. Investors clearly would expect detailed information about the distribution of the firms' clientele, and
logically could expect disclosures about firm representation of certain specific companies. The level of disclosure
the accounting firms would be required to provide investors, even if limited to the context of a private offering
and to select investors, could prove to be a difficult if not insurmountable barrier for the accounting firms
themselves.
Finally, the whole value of a capital market based solution is to avoid the cyclicality and volatility of the
insurance marketplace, but the capital markets for these kinds of bonds could be subject to the own cyclicality.
Indeed, during a time of significant losses, there may be little or no market interest in bonds of this kind, just as
when insurer losses mount insurance can be scarce or unavailable. For that reason, I am uncertain whether the
availability of this type of capital market alternative, even if the other barriers could overcome, would in the end
remedy the concerns for which an alternative to the traditional insurance marketplace was sought.
These concerns notwithstanding, Professor Cunningham's paper is interesting and makes a valuable
contribution to the dialog surrounding proposed auditor liability caps. Special thanks to Professor Cunningham
for providing me with a link to his article.
UPDATE: Professor Cunningham Reponds: Here are Professor's Cunningham's responses to my
comments about his article:
Thanks, Kevin, for your thoughtful comments on my paper exploring adapting cat bonds to auditor liability.
Some more background on my motivations before addressing your concerns:
1. Statistical research (here and here) suggests a non-trivial medium-term risk that large liability cases could
destroy one of the remaining four big auditing firms and thus threaten our system of private auditing of public
enterprises.
2. Reducing this risk by putting legal caps on auditor damages is a hard political sell--Members of Congress
find it difficult explaining to American investors why these firms should enjoy such a privilege and any choice
of cap levels could seem arbitrary.
3. Proponents of caps currently have incentives, when in doubt, to interpret information in ways that
overstate the stakes (as when asserting that the prevalence of self-insurance is due to unavailability of
external insurance, a claim I evaluate in the paper).
4. Elsewhere, I endorse Josh Ronen's novel idea of financial statement insurance to address some such
problems, but recognize that it is also a hard political sell absent a crisis rationalizing the radical change it
entails.
5. Here, I consider cat bonds because they: (a) could add resources to meet claims that threaten to destroy
audit firms or the industry; (b) avoid political obstacles facing both caps and financial statement insurance;
and (c) highlight informational problems in the policy debate on caps.
On the substance of your excellent points about cat bonds, particularly how they are used in first-party
property damage contexts but not yet for third-party liability contexts:
1. True, property cat bonds address shorter tail losses than third-party claims usually do, raising concerns
addressed by contract and pricing. Cat bonds have a set contractual maturity, such as one year or two, and
state contractual triggering events that determine whether principal is repaid or lost at maturity (such as
judgments or settlements exceeding stated catastrophic amounts during the bond term). So bondholders don't
wait until claims are resolved before the payout determination is made. True, a bond's maturity date
influences strategic decisions in pending litigation (whether to settle or not and for how much). Contract terms
limit this capacity (through tailored rules governing litigation management and general principles like good
faith). These contractual features are priced into the bond.
2. Also true, property cat bonds address risks that are purely fortuitous while auditors have some control over
exposure, creating the serious problem of moral hazard. But moral hazard exists under existing external
insurance and even self-insurance to an extent. Worse, the fact that only four large firms exist can create
moral hazard if partners and employees act as if their firms are too big to fail (about which refer to my prior
paper, here). So reducing moral hazard seems vital. Financial statement insurance may be better than cat
bonds for that purpose but cat bonds contribute bondholders offering market monitoring to diminish the
problem not exacerbate it. Also, cat bonds do not attract suits against auditors because they fund only
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11. Accountant Liability : The D & O Diary
catastrophic loss layers, with negotiated triggers set at upwards of $500 million.
3. True, again, cat bonds for natural disasters are supported by scientific risk modeling tools enabling valid
predictions that may not be adaptable to auditing risks. Lacking requisite information could dissuade
investors from buying bonds, at least at interest rates less than costs of auditor self-insurance or external
insurance. But (a) the statistical research referred to earlier provides a foundation for such exercises and (b)
at least some reasonably reliable facsimile of such models seems necessary to justify political decisions to
establish caps on auditor liability by legal fiat.
4. Your fourth point seems the most compelling explanation for why auditors have not issued cat bonds and
presents the most significant impediment: for understandable reasons, firms don't want to disclose
information that investors would require about their client base, financial resources or claims history. Again,
however, similar data should be required to justify a political decision to cap liability or set optimal cap levels.
On this and the preceding point, it is possible to see informational problems as a sort of market failure
supporting regulatory intervention. Yet the information is within firms' control and they can decide whether to
use it in the political arena, in markets, or not at all. Notably, using this data in the political arena to support
caps creates incentives to overstate risk whereas using it in the marketplace to sell cat bonds creates
incentives to understate risk.
Admittedly, cat bonds may or may not work for auditing. But if they work or might work, this may weaken
arguments for caps (and could add protection against audit industry destruction); if they are shown to be
unworkable, this may strengthen the case for caps. So either way, I appreciate your giving the idea a public
forum for debate (and for your comments that will improve my paper). It would be wonderful if risk modeling
firms and investment banks would consider the idea, perhaps even pitch it to auditing firms, for a non-
academic test.
More About the AIM Challenge: Behind the reform proposals of the blue-ribbon panels mentioned above
are concerns about U.S. financial market's loss of IPO market share to overseas' securities markets, particularly
London's Alternative Investment Market (AIM) (about which I most recently commented here). But changing
marketplace conditions have put the AIM in an altogether different light, as illustrated in the September 10,
2007 Bloomberg.com article entitled "London's AIM Exchange Loses Members on Costs as Nasdaq Prospers"
(here).
According to the article, companies that have listed on AIM are starting to grow disenchanted. 116 companies
exited AIM in the first half of 2007, 35 more than a year earlier, and delisting more than doubled to 40 during
the same period, compared to 15 last year. (Delistings on Nasdaq meanwhile fell from 41 to 30.) Among other
reasons for these departures are high costs and a perceived lack of issuer company benefit - the AIM market is
"showing signs of saturation."
As one commentator cited in the article noted, while "there's a good market for small caps," the supply of
investment has not been able to keep up with the supply of equity. Another commentator cited in the article
notes that the increase in companies leaving AIM "is probably a reflection of the market having attracted too
many poor quality businesses," as there has been a "deluge of companies that should never have been brought to
market."
As I have noted before (refer here), the would-be reformers case for regulatory reform has always seemed to be
"weak," but as the global marketplace evolves there appear to be increasing reasons to question whether the
premise on which the reformers' proposals are based even exist. (For further commentary on this same topic,
refer here)
Subprime Litigation Wave: The D & O Diary has commented frequently (most recently here) on the wave of
litigation growing out of the subprime lending mess. The Washington Post has a September 11, 2007 article
entitled "Mortgage Mess Unleashes Chain of Lawsuits" (here) which sounds many of the same themes.
Among other tidbits in the article is the comment that the SEC has formed a working group to examine
"accounting and disclosure issues, as well as stock sales earlier this year by executives at companies that have
since been ensnared by the subprime mess." An official at the SEC enforcement division is quoted as saying "we
will look at those responsible for any potential fraud, by company management, auditors, lawyers, credit-rating
agencies or others."
You Can't Make This Stuff Up - But Plaintiffs' Lawyers Can!: This article appeared in Crain's Chicago
Business on September 10, 2007 (here) -- please note that in referring to this article I mean no disrespect to
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12. Accountant Liability : The D & O Diary
Mrs. Akkad, and I do not in any way mean to make light of her terrible loss. Mrs. Akkad has our deepest
sympathies. My inclusion of this article relates particularly to her lawyer's comments in the final two paragraphs
about her case:
The widow of a Hollywood producer who died in a Jordan terrorist bombing is suing hotel chain
Global Hyatt Corp.
A guest at the Hyatt in Amman, Jordan, Moustapha Akkad was killed Nov. 9, 2005, in an attack by
a suicide bomber, according to a statement from law firms representing his widow, Sooha Akkad.
The complaint alleges that Chicago-based Hyatt was negligent in failing to responsibly protect its
registered guests from foreseeable criminal attacks,
failing to provide metal detectors, and failing to keep unauthorized individuals from accessing the
inside of the hotel, according to the statement.
A spokeswoman for Hyatt declined to comment.
Hyatt should've had heightened security on the date Mr. Akkad was killed in part due to the date
itself, according to the statement. In the Middle East and in many countries, date precedes month
when writing out full dates, according to the statement.
"Thus, November 9 becomes 9/11," said Thomas Demetrio, a lawyer with Chicago-based law firm
Corboy & Demetrio.
Special thanks to a loyal reader for proving a link to this article.
TAGS: Accountant Liability
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The Content and Timing of the PCAOB's Big Four Inspection
Reports
Posted on January 27, 2007 by Kevin LaCroix
The Public Company Accounting Oversight Board (PCAOB) has been the target of extensive
criticism for the timing and content (or lack thereof) of the public reports for its inspections of the Big Four
accounting Firms. (Prior D & O Diary posts on this issue can be found here and here.) This issue is reviewed at
length in a January 26, 2007 CFO.com article entitled "Why The Big Four Are Still a Mystery" (here), and the
article is supplemented by an email interview (here) with PCAOB board member Charles Niemeier.
The article reviews the frequent criticisms that the public inspection reports reflect a "lack of context," because
the PCAOB does not publicly reveal how many inspections it conducts on each firm. Without this kind of
quantitative data, there is no way to assess how widespread the concerns are. The absence of this information
means that the inspection process "is not producing the kind of results that it should for people who are using
the results and trying to understand what this means," according to the former head of Deloitte, who is now the
chair of four public company audit committees, and who is quoted in the article.
The delay in reporting the results is also a concern. For example, the reports for the 2005 inspections of Ernst &
Young (here) and KPMG (here) were not released until January 2007. The audits inspected were obviously
completed substantially before the inspections. The delay gives analysts and others "little leeway in being able to
gauge the current performance of an audit firm."
Niemeier's response to the concern about the lack of disclosure concerning the number of audits inspected is
that it is "not a relevant figure" and "could encourage misleading, superficial comparisons between firms."
Niemeier also is opposed to supplying further details about the audit concerns noted in the inspection reports,
even information designed to convey how serious the problems noted were; Niemeier feels this would be
inconsistent with PCAOB's statutory confidentiality obligations.
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13. Accountant Liability : The D & O Diary
Niemeier is also opposed to any overall qualitative evaluation of the firms audited, on the theory that this would
"divert attention" from the PCAOB's efforts to identify risks in the audit firm's processes. With respect to the
timeliness of the inspection reports, Niemeier says that the "timing of the reports has been due to internal
operational processes" and that "the time between completion of an inspection and issuance of a report should
be shorter in the future."
What to make of all of this depends on the purpose of the PCAOB's public inspection reports. If, as with
Niemeier, you believe the public reports are designed to provide the audit firms with appropriate incentive to
remedy noted concerns, then the current process is adequate. But if that is the sole purpose, why bother with
public reports at all? Why not simply reserve public disclosure for those concerns the audit firms fail to address
during the 12-month cure period? But the reports clearly are made public (at least to the extent they are made
public) for a separate purpose, which is to inform. On that score, as the CFO.com article notes, the inspection
reports "don't paint a clear enough picture about what the auditor overseer was probably trying to say in its
reports."
Niemeier's comments that added information, such as the number of audits inspected, might be misued
amounts to an assertion that investors and others can't be trusted with the information. Clearly, the policy
decision to withhold the information is calculated for the audit firms' protection, to the detriment of the
investing public. These competing interests ought to militate that the PCAOB should go as far as it could to
disclose information consistent with its statutory constraints - and subject only to the statutory constraints. The
numerical and evaluative information critics argue that the inspection reports lack are not barred by the
statutory constraints. The audit firm's best protection against vulnerability to adverse information is in their
power to control, through their own audit execution.
A good summary of the shortcomings of the PCAOB's public inspection reports, with links to other sites, can be
found on the White Collar Fraud blog, here and here.
Audit Liability Caps: In a prior post (here), The D & O Diary took a look at various proposals to cap auditors'
liability. In a January 25, 2007 speech (reported here), Conrad Hewitt, the SEC's Chief Accountant, came out in
favor of protecting the "major accounting firms" from legal liability if their audit clients become embroiled in
accounting-related scandals. Hewitt is concerned about auditor liability because there are only four major
accounting firms left. "It's a concern to us if something should happen to any of the four firms."
So The D & O Diary wonders - is the PCAOB's policy on its public reports of the Big Four firm's audit
inspections the product of a similar concern for the survival of the "remaining four?"
TAGS: Accountant Liability, PCAOB
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Looking at Auditor Liability Caps
Posted on January 20, 2007 by Kevin LaCroix
When the Committee on Capital Markets Regulation (popularly known as the Paulson
Committee) in its Interim Report (here) recommended "setting a cap on auditor liability," the Committee relied
for support on the steps in that direction that have been taken by the European Commission. In its latest effort
along those lines, the European Commission on January 18, 2007 launched a "public consultation on whether
there is a need to reform the rules on auditor liability in the EU." A copy of the Commission's press release can
be found here. A copy of the Staff Working Paper can be found here.
In the Working Paper, the Commission's staff offered four alternative proposals to cap the liability accounting
firms potentially face when auditing public companies. (The Commission is asking for comment on the four
proposals by March 15, 2007.) The four proposals are: a fixed monetary cap on damages that could be sought
from auditors; a cap based on the audited company's market capitalization; a cap based on a multiple of the
audit fees charged; or the introduction of proportionate liability , which would hold the auditor responsible only
for the damages that could be specifically attributed to them.
The initiative to afford accountants some form of liability protection is being led by Charlie McCreevy, the
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15. Accountant Liability : The D & O Diary
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Kevin M. LaCroix
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