Inside Fraud, Outside Negligence & Professional Liability

August 26th, 2008

What follows is the introduction from my law review comment written in the aftermath of the Savings and Loan crisis. The title is: “Inside Fraud, Outside Negligence and the Savings & Loan Crisis: When Does Management Wrongdoing Excuse Professional Malpractice?” (26 Loy. L.A. L.Rev. 1165 [June 1993].) With a steady stream of corporate scandal, from Enron to the mortgage meltdown, the subject remains timely. Regulators and class action lawyers still go after the lawyers and accountants. But can they be held to account to investors and creditors for concealed management fraud? Read on.

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The Federal Deposit Insurance Corporation (FDIC), seeking to make attorneys and accountants liable for losses at corrupt savings and loan associations (S & Ls or thrifts), has filed an unprecedented number of malpractice suits against these professionals. Many of these suits resemble the following hypothetical case of Charley K., a successful real-estate-developer-turned-savings-and-loan-kingpin.

In the early 1980s, Charley bought Jefferson Savings & Loan, a small thrift that until then had only made single-family home loans. Charley believed he could make more money by directly investing depositors’ funds in riskier ventures. Under Charley’s management, Jefferson S & L bought 100 acres of undeveloped land on the outskirts of a large city for $50 million. Unfortunately for Charley, the real estate market crashed, and the land value declined to $40 million. Because Jefferson S & L’s capital was only $10 million to start with, the $10 million loss wiped out all of Jefferson’s capital. The institution was–on paper, at least–worth nothing.

Charley should have reported Jefferson’s insolvency to the Federal Savings and Loan Insurance Corporation (FSLIC), which would have closed the thrift. Instead, Charley made a secret deal with speculator X, who owned land near Jefferson’s holdings. Charley, as an individual, would buy Ms. X’s land for $50 million (which was $10 million more than market value) if Ms. X would buy Jefferson’s land for $60 million (which was $20 million more than market value). Charley agreed that his S & L would make a $10 million nonrecourse loan to Ms. X to buy the land without putting any cash into the deal. Besides being an unsound business deal, the transaction violated federal law, and Charley knew it. First, Ms. X could not legally borrow $10 million from Jefferson S & L because that exceeded the maximum amount the thrift was allowed to lend to one person. Second, Charley intended to borrow money from Jefferson to buy Ms. X’s land. This not only exceeded the maximum that the S & L could lend to one borrower, but also would raise regulatory concerns about preferential insider lending. Charley covered up these problems by making the loans to Ms. X and himself through a handful of “dummy” corporations controlled by “straw” parties. The loan applications named neither Charley nor Ms. X.

Charley hired two prestigious law firms to handle the loan documentation. He paid more in fees to split the work, when one firm could have done the job more efficiently, so that neither firm would suspect the true nature of the overall transaction. If lawyers at either firm had scratched below the surface, they would have discovered the connections between the dummy corporations, Charley and Ms. X, but neither firm did. The land deals closed, resulting in a $10 million “profit” to Jefferson. Because the sale on paper appeared to be an arms-length transaction, Jefferson’s Big Six accounting firm approved the entire $10 million as profit–an overnight doubling of the thrift’s capital.

Charley’s scheme, however, could not last indefinitely. The slump in the real estate market worsened, forcing Charley and Ms. X to default on $60 million in loans from Jefferson S & L. By then, the two tracts of land were worth only $40 million together. The two bad loans wiped out Jefferson’s capital and left a $10 million negative net worth. The FSLIC paid off depositors and covered the deficit out of the S & L insurance fund.

Shortly after closing Jefferson S & L, FSLIC lawyers sued the two law firms and the accounting firm to recover $20 million in losses allegedly caused by the firms’ negligence. According to the FSLIC, the land deals were so obviously fraudulent that the professionals must have “looked the other way” to protect a client and their large fees. Because Charley was bankrupt, the well-insured professionals were the “deep pockets” to which the FSLIC looked for recovery. The accounting and law firms were shocked to discover their unwitting role in Charley’s and Ms. X’s fraud and embarrassed that they had not uncovered it. The firms, however, adamantly denied liability, even if they were negligent. The firms moved for summary judgment on the grounds that Charley’s insider fraud and concealment cut off any liability for mere negligence.

The alleged negligent omission of Jefferson’s attorneys and accountants was the failure to uncover the fraud and concealment by their client’s top management. Professionals in this situation have raised what this Comment refers to as the “insider fraud defense.” Part II of this Comment examines the role of attorneys and accountants in the S & L crisis and defines the “insider fraud defense.” Part III compares the facts, procedural background and reasoning of the two leading cases on the insider fraud defense: FDIC v. O’Melveny & Meyers [sic], which rejected the defense, and FDIC v. Ernst & Young, which allowed it. Part IV explores the bases in case law for the defense and applies the precedents to S & L fraud and professional malpractice. Finally, this Comment concludes that courts should allow the insider fraud defense when top management dominated the thrift and successfully concealed its wrongdoing from outside professionals.

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