A group of large institutional investors who are suing Delphi Corp. have asked the judge presiding over the company’s bankruptcy proceedings to disqualify Deloitte & Touche from continuing to audit the auto-parts maker's financial statements, citing a potential conflict of interest.

“The more Deloitte were to discover about Delphi's past accounting problems, the more it would implicate itself for having failed to detect them at the time,” the funds wrote in their court filing, according to The Wall Street Journal. “In fact, Deloitte has strong incentive to conceal pre-petition accounting and auditing problems, and to minimize its own liability.”

Coffey

“Why retain an auditor that was so incompetent it missed one of the longer accounting frauds?” asks John Coffey, partner with Bernstein Litowitz Berger & Grossmann, and a co-counsel for the plaintiffs. “Part of the responsibility of the auditors is to evaluate what went wrong before. They are auditing themselves.” Plaintiffs include the Teachers’ Retirement System of Oklahoma, the Public Employees' Retirement System of Mississippi, an Austrian mutual fund manager, and a pension fund in the Netherlands.

“In a bankruptcy that in large part is caused by some sort of financial fraud, you have accountants who were asleep at the switch still there trying to get them [Delphi] out of bankruptcy,” says Jay Eisenhofer, partner at Grant & Eisenhofer, the other co-lead counsel for the institutions.

Challenging Retention

Compliance Week could not find any data or studies illustrating how frequently accounting firms signed off on the financials of company, and then remained on the job after the company was embroiled in an accounting scandal and during bankruptcy proceedings. However, a number of lawyers not involved in the Delphi case agree that, at least theoretically, there are potential conflicts when these situations do arise.

That’s largely because firms may not be as eager to second guess their original audits. “Human nature is to validate your own work,” says Joel Greenberg, partner with Kaye Scholer.

He points out, though, that frequently when there are charges of fraud, the Audit Committee brings in different accounting firm to investigate the allegations.

Zink

In addition, it is not unusual for investors, creditors or other non-insiders to seek the ouster of the accounting firm in a bankruptcy, assert lawyers. “It would be one of the first things they do,” asserts Ted Zink, partner at Chadbourne & Parke.

“It’s not uncommon to have the retention of professional firms challenged,” agrees Alan Gover, partner with Dewey Ballantine. In fact, in addition to the accounting firms, the retention of the financial advisors, law firms and other key outside service providers is frequently challenged.

The Modern World

Gover

Even so, lawyers doubt the bankruptcy court will rule in favor of Delphi’s plaintiffs for a number of reasons. For one thing, if the judge rules against Deloitte, it could make it much easier to disqualify accounting firms in subsequent bankruptcies, thus opening a legal Pandora’s box. “It might create a precedent,” says Gover. “Everyone may be vulnerable to disqualification.”

He also argues that the Big 4 accounting firms are generally not deemed to have a conflict given their enormous size. “They can have a relationship they can wall off and not affect in the modern world [their ability] to be a conscientious advisor,” he adds.

The ‘modern world’ he is referring to is the recent amendments to the bankruptcy laws, which went into effect in mid-October. He says the Bankruptcy Code only allows debtors to retain professionals who qualify as disinterested persons. “The general view of conflicts may be more sophisticated post the amendment as it relates to accountants and lawyers.”

In fact, he thinks laws firms are actually more vulnerable to these kinds of challenges because he says they are held to a tougher standard. Accountants, he reasons, are supposed to be independent, but lawyers by definition are supposed to serve as advocates for their clients. “So, if they have a conflict, they can be distracted,” he explains.

Dykhouse

Lawyers say there are other potential conflicts when retaining professional firms, including accounting firms after a bankruptcy filing. David Dykhouse, partner at Patterson Belknap Webb & Tyler, suggests that on a more pedestrian level, accounting firms suddenly become yet one more creditor on a long list of creditors seeking payment, which could make it more difficult for the firms to perform their jobs. “Professional firms are large creditors,” he emphasizes.

Another potential conflict that has arisen specifically in the Delphi case is the fact that Deloitte also designed and implemented Delphi's financial-information systems. In 2000, Delphi paid Deloitte $6.6 million to audit its financials and an additional $50.8 million for non-audit services. This included $41.3 million for information technology services. Delphi shelled out another $12 million for the project the following year. Financial information systems design is one of nine non-audit services now banned under SEC rules that were adopted in January 2003, as promulgated by Section 201 of Sarbanes-Oxley.

Eisenhofer

Eisenhofer concedes that these kinds of transactions were relatively common before Sarbanes-Oxley. Even so, Greenberg says this arrangement now poses a further potential conflict to the relationship between Delphi and Deloitte. “If they sold the software that caused accounting irregularities, they [potentially] won’t want to find that themselves,” he says. “It’s not good to find that your own stuff is defective.”

Deloitte & Touche would not comment on the record; a spokesperson told Compliance Week that the firm "does not believe it would be appropriate to publicly comment on a retention application that is currently pending before the federal bankruptcy court." However, the spokesperson added that, "[A]ny allegations that Deloitte & Touche LLP acted improperly with respect to its prior engagements for Delphi are untrue."

Coffey concedes that it is a long shot that the plaintiffs will prevail and oust Deloitte. “I acknowledge this is aggressive,” he says.

But Eisenhofer stresses that—even if they don’t prevail—the motion sends a loud message that institutional investors are increasingly taking the position they are going to take aggressive action. “They are not necessarily limited by what worked in the past,” he adds. “They have got to explore different kinds of activism. Investors are increasingly aggressive in pushing the envelope. This is part of a broader trend of the past 12 months to two years.”

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