Ernst & Young will pay $335 million to Cendant Corp. shareholders to settle charges that the accounting firm's audits of a predecessor company were inaccurate, the California Public Employees' Retirement System said Friday.
Analysts said the payout is the largest an accounting firm has had to make outside of the settlements with the government in the early 1990s over alleged malfeasance in audits of failed savings and loan institutions.
CalPERS, the nation's largest pension fund, owned 3.1 million shares of Cendant as of September.
"In the realm of settlements by auditors, this may be No. 1 with a bullet," said Joseph Grundfest, a Stanford University law professor and former commissioner with the Securities and Exchange Commission.
Ernst & Young's settlement comes after Cendant on Dec. 7 said it would pay $2.83 billion to shareholders to settle claims that it inflated earnings at CUC International Inc., which combined with HFS Inc. in 1997 to form Cendant. The combined company is the franchiser of such businesses as Century 21 and Coldwell Banker real estate agents and the Days Inn motel chain.
CalPERS said it and the New York state and city pension funds lost about $89 million after Cendant's stock plunged following revelations in 1998 that it overstated earnings.
CalPERS said Friday's settlement, together with Cendant's $2.8-billion payment, resolves all its claims against Cendant. It said Cendant had agreed to pay shareholders half of any funds it may recover from Ernst & Young.
The Ernst & Young accord "sends a strong message that corporate responsibility goes beyond the corporation and extends to accounting firms upon whom pension funds and other investors rely in making investment decisions," said Charles Valdes, chairman of the CalPERS Investment Committee.
Ernst & Young spokesman Larry Parnell said the settlement was "well within the firm's capacity, given our substantial insurance coverage and overall financial strength." He said the firm will continue to "aggressively prosecute" its claims against Cendant "for defrauding us."
Accounting firms generally settle lawsuits regarding audit work to avoid the expense of prolonged trials and the possibility of large jury awards.
Analysts say it is difficult for accounting firms to win lawsuits because they have to argue complicated auditing issues before juries that typically aren't familiar with auditing rules.
The case that led to Friday's settlement stems from irregularities in financial statements at CUC International and the CMS division of Cendant, which were audited by Ernst & Young. The accounting firm was the outside auditor for CUC from 1995 to 1997 and for CMS in 1997, CalPERS said.
"Ernst & Young provided 'clean' audit and review letters in connection with three annual reports, seven quarterly reports and as many as 20 registration statements," CalPERS said. "Each of these documents have subsequently been found to include or incorporate grossly overstated financial statements."
CalPERS said, for example, that Cendant admitted that CUC's operating income was overstated by approximately $500 million--more than one-third of its reported operating income--from 1995 to 1997. Cendant also admitted that CUC's quarterly operating income was inflated by $31 million in 1995, by $87 million in 1996 and by $176 million in 1997, CalPERS said.
Cendant shares tumbled 46% on April 16, 1998, erasing $14 billion in market value, when the company said it would restate earnings because of accounting irregularities.
On Friday, Cendant shares rose $1.50 to close at $24.50 on the New York Stock Exchange.
Cendant shares rose nearly 40% on Thursday after the company said it would get a $400-million investment from Liberty Media Corp. as part of a venture to develop television and Internet programming linked to Cendant's businesses.