O.C. Hits Auditor Peat Marwick With $3-Billion Bankruptcy Suit : Courts: County opens ‘phase two’ of drive to recover losses by claiming debacle could have been avoided had the accountant done its job right. Firm calls it an attempt to shift blame.

Opening a second front in its campaign to recover its disastrous investment losses, Orange County on Wednesday filed a $3-billion damage suit against its former outside auditors, claiming that the accounting firm failed to uncover the problems that led to the largest municipal bankruptcy in U.S. history.

The 78-page lawsuit, filed in U.S. Bankruptcy Court here, alleges that KPMG Peat Marwick either overlooked or ignored what should have been “red flags” to an auditor: then-Treasurer-Tax Collector Robert L. Citron’s risky investment strategy, which “differed wildly from those of virtually every governmental investment officer in the United States.”

The county claimed in the lawsuit that its entire bankruptcy could have been avoided if Peat Marwick, the world’s fourth-largest accounting firm, had sounded the proper warnings. Instead, the firm’s auditors wrongly “assured the county that all legal requirements were being met,” the lawsuit states.

The suit signals a new round in a legal assault on the Wall Street financial houses, accounting firms and lawyers the county blames for the $1.64 billion in losses it sustained when its investment pool crashed last December.

J. Michael Hennigan, the Los Angeles lawyer spearheading the county’s litigation efforts, said the suit against Peat Marwick was “phase two” of the county’s plan to recover its own losses and the $800 million it needs to repay the cities, schools districts and other governmental entities that had entrusted their reserves to the county.

“There will be other phases in the coming weeks,” Hennigan promised.

The county is already pursuing a $2-billion lawsuit in U.S. Bankruptcy Court against Merrill Lynch & Co., the Wall Street brokerage which sold billions of dollars worth of exotic securities to Citron. The former treasurer has pleaded guilty to securities fraud charges for misrepresenting the safety of his investments to other pool participants, and also to embezzlement for skimming interest from their accounts into a county account. He is scheduled to be sentenced Feb. 23.

Other “litigation targets” of Orange County are said to include C.S. First Boston Corp. and Nomura Securities International, prominent firms that sold risky securities to the pool on credit. Shortly after the county declared bankruptcy, it filed and then withdrew a $1-billion damage suit against Nomura, reserving the right to refile it at a later date.

The county is also crafting a case against the New York law firm of LeBoeuf, Lamb, Greene & McRae, the county’s legal counsel on a controversial $600-million note offering that pumped borrowed money into the county’s fast-collapsing investment pool and left critics complaining of woefully inadequate disclosures.

Officials with Peat Marwick released a statement in response to the lawsuit Wednesday, saying that they plan to vigorously defend the lawsuit and “we will prevail.”

“It spotlights the county’s pattern of trying to find others to blame and to pay for the outcome if its own investment decisions,” the statement said.

“The California State Senate, the State Auditor and the Orange County Grand Jury have all studied the events leading up to the bankruptcy of the county,” it continued. “All have blamed the county and its officials, not KPMG, for the outcome. The county’s losses are the result of its investment decisions and KPMG did not serve as an investment advisor to the county.”

John R. Miller, Peat Marwick’s director of governmental services, said he believed the county was merely trying to go after the accounting firm’s “deep pockets. It’s an abusive lawsuit,” he said.

Merrill Lynch also weighed in on the lawsuit Wednesday, with company spokesman Tim Gilles saying that “we haven’t seen this lawsuit, but what we have seen is a pattern of Orange County officials blaming everyone but themselves for the county’s bankruptcy.”

Merrill Lynch also vigorously denies the county’s allegations that it extended Citron credit in excess of state constitutional limits, and sold the county inappropriate securities.

The lawsuit against Peat Marwick, which had been expected for weeks, alleges in great detail how the accounting firm missed the warning signs of impending disaster and “repeatedly reported to the county that [Citron’s heavily leveraged investment strategy was] legal.”

The firm, which the lawsuit states took in $6 billion from its worldwide operations in its most recent reporting year, was engaged by Orange County from 1992 to the close of 1994 to ensure that the county’s books were in order.

In bidding for the contract to become the county’s outside auditor, Peat Marwick boasted that it audited more cities and governmental agencies in Southern California “than any other firm, local or international. Our background in the audits of local government provides the County of Orange an experienced resource in such areas as Investment Practices,” the lawsuit quotes the firm’s proposal as saying.

County leaders relied on these promises when they asked the auditors to report “on problems of risks and internal controls that might threaten the stability of the treasurer’s office,” according to the lawsuit.

But the accounting firm failed to live up to its promises, the suit added.

The lawsuit cited Peat Marwick’s 1993 audit as evidence of the firm’s professional negligence. In reviewing the county’s investment portfolio for that year, auditors excluded from the analysis any securities whose market value was described as unknown.

By failing to audit these entries, the firm “excluded about 80% of the portfolio’s book value and 100% of the trouble,” Hennigan said.

According to the lawsuit, the firm claimed that Orange County’s portfolio was reviewed by an expert on portfolio management, identified in the lawsuit as Bud Titus of Peat Marwick’s Cleveland office.

The firm claimed in a report that Titus spoke at length with then Assistant Treasurer Matthew Raabe and had no concerns about the riskiness of the portfolio.

But Titus, according to the lawsuit, had a single telephone conversation with Raabe.

“It is inconceivable that a knowledgeable expert with the responsibility to conduct an audit would have been satisfied with a mere telephone conversation relating to a $13-billion portfolio, especially after being expressly informed--as was Mr. Titus--that the county had a practice of” borrowing billions of dollars to gamble on risky securities, the lawsuit states.

In the next two years, the auditors continued to give Orange County a clean bill of health.

Said Hennigan: “I look at their audits and keep shaking my head. How do you miss these warning signs?”

Even after John M.W. Moorlach, then a candidate running against Citron for his elected position, raised concerns about his opponent’s risky investments, “the county was lulled, by KPMG’s representations and omissions, into believing that Moorlach’s allegations were merely exaggerated campaign rhetoric,” the lawsuit states.

In July 1994, when Auditor-Controller Steve E. Lewis asked the auditors to ensure that Citron’s investments were safe and fair to all parties, the firm still failed to notify the county of its problems with the county’s portfolio. It was Lewis who notified Peat Marwick in November of that year of potential “losses and lack of liquidity in the county’s investment portfolio, not vice-versa,” the suit charges.

The lawsuit against Peat Marwick could become a “black eye” to the firm, according to Arthur Bowman, editor of Bowman’s Accounting Report, an industry newsletter based in Atlanta.

Bowman noted that the firm had to pay nearly $200 million last year to settle government charges that lapses by its auditors contributed to more than a dozen bank and savings and loans failures.

“This is going to cause some disruption to their business because they will have to devote lots of time and resources to defend this [Orange County] lawsuit,” Bowman said. “I will not be surprised if they decide to settle for a reasonable figure instead of spending time behind this litigation.”

* GROWING NUMBERS: Big accounting firms increasingly are targeted in suits. A35

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County’s New Suit

A $3-billion suit filed by Orange County against KPMG Peat Marwick accuses the firm of violating at least 20 “generally accepted auditing standards.” Among the charges were that the firm failed to identify and report that:

* Then-County Treasurer-Tax Collector Robert L. Citron was borrowing billions of dollars in violation of state laws

* The county-run investment portfolio was illiquid

* Pool participants’ funds were being misallocated

The suit also alleges KPMG falsely represented in its “unqualified audit opinions”:

* That “the risk of a material decline in the county’s investment portfolio was minimal, when in fact [it] was at enormous risk from an increase in market interest rates.”

* That KPMG “evaluated the county’s overall financial statement presentation, when in fact the overall financial presentation was grossly misleading.”

Source: U.S. Bankruptcy Court

Researched by DAVAN MAHARAJ / Los Angeles Times