Lincoln Savings and Loan Association

Case Summary

A. Charles Keating had been charged with professional misconduct in the late 1970s by the SEC.

B. Keating dominated the operations of both ACC and Lincoln, and was largely responsible for the phenomenal growth experienced by the S&L during the 1980s.

C. The lending activities of Lincoln involved commercial development projects and other high risk ventures.

D. Lincoln’s real estate transactions were complex and thus difficult for its auditors to understand.

E. Arthur Young (AY) accepted Lincoln as an audit client during the course of an intensive marketing effort to attract new clients.

F. Jack Atchison, the initial engagement audit partner on the Lincoln audit, developed a close relationship with Keating and lobbied on Keating ‘s behalf with regulatory officials.

G. AY relied upon real estate appraisals obtained by Lincoln in auditing certain of the S&L’s large real estate transactions.

H. After joining ACC, Atchinson served as an interface between ACC/Lincoln and the AY auditors.

I. After Janice Vincent assumed control of the Lincoln audit, the AY auditors apparently became more aggressive in questioning the validity of the S&L’s lage real estate transactions.

J. Keating and ACC’s chief financial officer eventually admitted that the Hidden Valley transaction was poorly documented in Lincoln’s accounting records.

Charles Keating, Jr., was a scholar-athlete at the University of Cincinnati during the mid-1940s. In 1946, Keating won an NCAA individual championship in the 200-yard butterfly, a swimming event, and two years later graduated from the University of Cincinnati Law School. Over the next 30 years, Keating established himself as the nation’s leading critic of the pornography industry. In 1960, he founded the Citizens for Decency through Law, an organization dedicated to “stamping out smut.” A decade later, Keating was appointed to President Nixon’s Commission on Pornography. Keating became best known nationally for his successful effort to help law enforcement authorities prosecute magazine publisher Larry Flynt, another native of Cincinnati, on obscenity charges.In 1978, Keating began focusing his time and energy on his business endeavors when he founded the real estate firm, American Continental Corporation (ACC). Six years later, ACC acquired Lincoln Savings and Loan Association, which was head-quartered in Phoenix, although its principal operations were in California. In his application to purchase Lincoln, Keating pledged to regulatory authorities that he would retain the Lincoln management team, that he would not use brokered deposits to expand the size of the savings and loan, and that residential home loans would remain Lincoln’s principal line of business. After gaining control of Lincoln, Keating replaced the management team; began accepting large deposits from money brokers, which allowed him to nearly triple the size of the savings and loan in two years; and shifted the focus of Lincoln’s lending activity from residential mortgage loans to land development projects.On 14 April 1989, the Federal Home Loan Bank Board (FHLBB) seized control of Lincoln Savings and Loan, alleging that Lincoln was dissipating its assets by operat-ing in an unsafe and unsound manner. On that date, Lincoln’s balance sheet reported total assets of $5.3 billion, only 2.3 percent of which were investments in residential mortgage loans. Nearly two-thirds of Lincoln’s asset portfolio was invested directly or indirectly in high-risk land ventures and other commercial development projects. At the time, federal authorities estimated that the closure of Lincoln Savings and Loan would cost U.S. taxpayers at least $2.5 billion.Congressional hearings into the collapse of Lincoln Savings and Loan initially focused on the methods Keating used to circumvent banking laws and on disclosures that five U.S. senators intervened on Keating’s behalf with federal banking regulators. Eventually, the hearings centered on the failure of Lincoln’s independent auditors to expose fraudu-lent real estate transactions that allowed the savings and loan to report millions of dol-lars of nonexistent profits. In summarizing the Lincoln debacle, U.S. Representative Jim Leach laid the blame for the costly savings and loan failure on a number of parties, including Lincoln’s auditors and the accounting profession as a whole:

I am stunned. As I look at these transactions, I am stunned at the conclusions of an independent auditing firm. I am stunned at the result. And let me just tell you, I think that this whole circumstance of a potential $2.5 billion cost to the United States tax-payers is a scandal for the United States Congress. It is a scandal for the Texas and California legislatures. It is a scandal for the Reagan administration regulators. And it is a scandal for the accounting profession.

1Creative Accounting, Influence Peddling, and Other Abuses at Lincoln Savings and Loan

Representative Henry Gonzalez, chairman of the U.S. House Committee on Banking, Finance, and Urban Affairs, charged that over the five years Charles Keating owned Lincoln, he employed accounting schemes to divert the savings and loan’s federally insured deposits into ACC’s treasury. Keating was aware that he would be permit-ted to withdraw funds from Lincoln and invest them in ACC or use them for other purposes only to the extent that Lincoln reported after-tax profits. Consequently, he and his associates wove together complex real estate transactions involving Lincoln, ACC, and related third parties to manufacture paper profits for Lincoln. Kenneth Leventhal & Company, an accounting firm retained by regulatory authorities to ana-lyze and report on Lincoln’s accounting practices, used a few simple examples to explain the saving and loan’s fraudulent schemes.

Exhibit 1 contains a portion of the Leventhal firm’s testimony before Representative Gonzalez’s committee, which spon-sored the lengthy congressional investigation of Lincoln Savings and Loan.One of the most scrutinized of Lincoln’s multimillion-dollar real estate deals was the large Hidden Valley transaction that took place in the spring of 1987. On 30 March 1987, Lincoln loaned $19.6 million to E. C. Garcia & Company. On that same day, Ernie Garcia, a close friend of Keating and the owner of the land develop-ment company bearing his name, extended a $3.5 million loan to Wescon, a mortgage real estate concern owned by Garcia’s friend, Fernando Acosta. The following day, Wescon purchased 1,000 acres of unimproved desert land in central Arizona from Lincoln for $14 million, nearly twice the value established for the land by an inde-pendent appraiser one week earlier. Acosta used the loan from Garcia as the down payment on the tract of land and signed a nonrecourse note for the balance. Lincoln recorded a profit of $11.1 million on the transaction—profit that was never realized, since the savings and loan never received payment on the nonrecourse note.In fact, Lincoln never expected to be paid the balance of the nonrecourse note. Lincoln executives arranged the loan simply to allow the savings and loan to book a large paper gain. Garcia later testified that he agreed to become involved in the deceptive Hidden Valley transaction only because he wanted the $19.6 million loan from Lincoln.2 Recognizing a profit on the Hidden Valley transaction would have openly violated financial accounting standards if Garcia had acquired the property directly from Lincoln and used for his down payment funds loaned to him by the sav-ings and loan.Fernando Acosta eventually admitted that his company, Wescon, which prior to the Hidden Valley transaction had total assets of $87,000 and a net worth of $30,000, was only a “straw buyer” of the Hidden Valley property. In a Los Angeles Timesarticle, Acosta reported that Wescon “was too small to buy the property and that he signed the documents without reading them to help his friend, Ernie Garcia.”3Exhibit 2 contains a letter that a worried Acosta wrote to Garcia in 1988 regarding the Hidden Valley transaction. In that letter, Acosta encouraged Garcia to assume title to the property so that he could take it off Wescon’s books.Keating and his associates repeatedly used bogus real estate transactions, such as the Hidden Valley charade, to produce enormous gains for Lincoln. In 1986 and 1987 alone, Lincoln recognized more than $135 million of profits on such transactions. That amount represented more than one-half of the savings and loan’s total reported profits for the two-year period.The gains recorded by Lincoln on its real estate transactions allowed ACC to with-draw huge sums of cash from the savings and loan in the form of intercompany dividend payments, funds that were actually federally insured deposits. When the “purchasers” of these tracts of land defaulted on their nonrecourse notes, Lincoln was forced to recognize losses—losses that the savings and loan offset with addi-tional “profitable” real estate transactions. This recurring cycle of events ensured that Lincoln would eventually fail. However, since the Federal Savings and Loan Insurance Corporation (FSLIC) guaranteed Lincoln’s liabilities (i.e., its deposits), and since ACC had little equity capital invested in Lincoln, Keating was not overly con-cerned by the inevitable demise of his company’s savings and loan subsidiary.Lincoln’s convoluted and contrived real estate transactions appalled members of Representative Gonzalez’s congressional committee. One of the Leventhal partners

Exihibit 1:

To illustrate the accounting concepts Lincoln used, let me give you a few simple, hypothetical examples. Suppose you own a house that you paid $100,000 for, and against which you still owe $60,000. Now, suppose you could not find a buyer for your house. Therefore, you go out and find an individual who agrees to pay you the $200,000 you want for your house, but is only willing to give you one dollar in cash and a nonrecourse note for the balance of $199,999. A nonrecourse note means that you cannot get at him personally. If he defaults on the note, your only recourse is to take the house back.So now you have one dollar in your pocket, and a note for the rest. You very likely have not parted company with your house in this situation, because your so-called buyer may be unable to pay you, or he may simply decide that he does not want to pay you. Economically, he has an option to stick to the deal if the price of the house appreciates, or he can walk away from it if it does not. That is not a sale.Now, suppose you have the same house again. Your next-door neighbor has a different house, but it is worth the same as yours, and has the same outstanding mortgage balance. You then swap houses and mortgages with your neighbor.You now have a house which is different, but very similar to the one that you did have. I think that you will agree, there is no profit realized on this exchange. By the accounting theory that Lincoln appears to have followed, you would be able to record a $100,000 profit: the difference between what you originally paid for your house and what you think your neighbor’s house is worth.Really, it could have been more, if you could have found an appraiser to tell you that your neighbor’s house was worth $300,000. And it could have been still more if you and your neighbor had simply chosen to agree upon a stated price which was even in excess of these amounts.As you can see, all sales of real estate are not created equal. Over the years, accountants have had to wrestle with what is economically a sale and what is not. The economic substance of a transaction should of course be the controlling consideration.

CASES

who testified before the congressional committee provided the following overview of his firm’s report on Lincoln’s accounting schemes:

Seldom in our experience have we encountered a more egregious example of misap-plication of generally accepted accounting principles. This association [Lincoln] was made to function as an engine, designed to funnel insured deposits to its parent in tax allocation payments and dividends. To do this, it had to generate reportable earnings. It created profits by making loans. Many of these loans were bad. Lincoln was manu-facturing profits by giving money away.Critics chastised Charles Keating not only for employing creative accounting meth-ods but for several other abusive practices as well. In 1979, Keating signed a consent decree with the Securities and Exchange Commission (SEC) to settle conflict-of-interest charges the agency had filed against him. In 1985, Keating handpicked his 24-year-old son, Charles Keating III, to serve as Lincoln’s president. Along with the impressive job title came an annual salary of $1 million. At the time, the young man’s only prior work experience was as a busperson in a country club restaurant. Years later, the younger Keating testified that he did not understand many of the transac-tions he signed off on as Lincoln’s president.The elder Keating’s gaudy lifestyle and ostentatious spending habits were legend-ary. U.S. taxpayers absorbed many of the excessive expenses rung up by Keating since he pawned them off as business expenses of Lincoln. The bill for a 1987 dinner Keating hosted at an upscale Washington, D.C., restaurant came to just slightly less than $2,500. One of the guests at that dinner was a former SEC commissioner. In another incident, after inadvertently scuffing a secretary’s $30 shoes, Keating wrote her a check for $5,000 to replace them—and the rest of her wardrobe as well, appar-ently. Other Keating excesses documented by federal and state investigators included [This letter was addressed to Mr. E.C. Garcia, E.C. Garcia and Company, Inc., and appeared on Wescon letterhead.]

Re: Hidden Valley Project/PropertyDear Ernie:The time when we should have been out of this project is well past.For various reasons, our discomfort with continuation in the project is growing. Particularly of late, we have been concerned with how to report this to the IRS. We are convinced that all we can do is report as if the corporation were not the true/beneficial owner, but merely the nominal title holder, which is consistent with the facts and the reality of the situation. Correspondingly, it seems you should have, and report, the real tax burdens and benefits arising from this property.Also, we are increasingly uncomfortable with showing this property on our company’s financial statements (and explaining why it is there). We absolutely need to extract this item.In order to expedite relief for us on this matter, in line with your repeated assurances, please arrange for the transfer of this property to its rightful owner as soon as possible.Sincerely,FRA/WesconFernando R. Acosta

who testified before the congressional committee provided the following overview of his firm’s report on Lincoln’s accounting schemes:

safaris, vacations in European castles, numerous trips to the south of France, and lav-ish parties for relatives and government officials.The most serious charges leveled at Keating involved allegations of influence ped-dling. Keating contributed heavily to the election campaigns of five prominent sena-tors, including John Glenn of Ohio and John McCain of Arizona. These five senators, who became known as the Keating Five, met with federal banking regulators and lobbied for favorable treatment of Lincoln Savings and Loan. The key issue in these lobbying efforts was the so-called direct investment rule adopted by the FHLBB in 1985. This rule limited the amount that savings and loans could invest directly in subsidiaries, development projects, and other commercial ventures to 10 percent of their total assets. Because such investments were central to Lincoln’s operations, the direct investment rule imposed severe restrictions on Keating—restrictions that he repeatedly ignored.In 1986, a close associate of Keating’s was appointed to fill an unexpired term on the FHLBB. Following his appointment, this individual proposed an amend-ment to the direct investment rule that would have exempted Lincoln from its requirements. The amendment failed to be seconded and thus was never adopted. Shortly before Alan Greenspan was appointed to the powerful position of chairman of the Federal Reserve Board, Keating retained him to represent Lincoln before the FHLBB. In a legal brief submitted to the FHLBB, Greenspan reported that Lincoln’s management team was “seasoned and expert” and that the savings and loan was a “financially strong” institution. Congressional testimony also disclosed that Keating loaned $250,000, with very favorable payback terms, to a former SEC commissioner, who then lobbied the SEC on Lincoln’s behalf.The charges of influence peddling failed to concern or distract Keating. In respond-ing to these charges, Keating brashly stated that he hoped that his financial support of key governmental officials had, in fact, persuaded them to support his personal agenda.4Federal authorities eventually indicted Keating on various racketeering and securi-ties fraud charges. He was also sued by the Resolution Trust Corporation, the fed-eral agency created to manage the massive savings and loan crisis that threatened the integrity of the nation’s banking system during the 1980s. That agency charged Keating with insider dealing, illegal loans, sham real estate and tax transactions, and the fraudulent sale of Lincoln securities.

Audit History of Lincoln Savings and Loan

Arthur Andersen served as Lincoln’s independent auditor until 1985 when it resigned “to lessen its exposure to liability from savings and loan audits,” according to a New York Times article.5 That same article described the very competitive nature of the Phoenix audit market during the mid-1980s when Lincoln was seeking a replacement auditor. Because of the large size of the Lincoln audit, several audit firms pursued the engagement, including Arthur Young & Company.6 From 1978 through 1984,

Arthur Young suffered a net loss of 63 clients nationwide.7 Over the next five years, an intense marketing effort produced a net increase of more than 100 audit clients for the firm. During the 1980s, critics of the accounting profession suggested that the extremely competitive audit market induced many audit firms to accept high-risk cli-ents, such as Lincoln, in exchange for large audit fees.The savings industry crisis has revived questions repeatedly raised in the past about the profession’s independence in auditing big corporate clients: whether the accounts need more controls and whether some firms are willing to sanction questionable financial statements in exchange for high fees, a practice called “bottom fishing.”8Before pursuing Lincoln as an audit client, Jack Atchison, an Arthur Young partner in Phoenix, contacted the former Lincoln engagement partner at Arthur Andersen. The Arthur Andersen partner told Atchison that he had no reason to question the integrity of Lincoln’s management and that no major disagreements preceded the resignation of his firm as Lincoln’s auditor. At the time of Arthur Andersen’s resignation, Lincoln was undergoing an intensive examination by FHLBB auditors, who were raising seri-ous questions regarding Lincoln’s financial records. Arthur Young was not informed of this investigation by Arthur Andersen. Years later, Arthur Andersen partners denied that they were aware of the examination when they resigned from the audit.Shortly after accepting Lincoln as an audit client, Arthur Young learned of the FHLBB audit. Among the most serious charges of the FHLBB auditors was that Lincoln had provided interest-free loans to ACC—a violation of federal banking laws—and had falsified loan documents. Three years later, officials from the Office of Thrift Supervision testified before Congress that Arthur Andersen and Lincoln employees had engaged in so-called file-stuffing. These charges resulted in formal inquiries by the Federal Bureau of Investigation and the U.S. Department of Justice.9 Arthur Andersen officials denied involvement in any illegal activities but did acknowledge that employees of their firm had worked “under the direction of client [Lincoln] per-sonnel to assist them in organizing certain [loan] files.”10 Later, a representative of Lincoln admitted that “memorialization” had been used for certain loan files.Congressional testimony of several Arthur Young representatives revealed that the 1986 and 1987 Lincoln audits were very complex engagements. William Gladstone, the comanaging partner of Ernst & Young (the firm formed by the 1989 merger of Ernst & Whinney and Arthur Young), testified that the 1987 audit required 30,000 hours to complete. Despite concerns being raised by regulatory authorities, Arthur Young issued an unqualified opinion on Lincoln’s financial statements in both 1986 and 1987. Critics contend that these clean opinions allowed Lincoln to continue engaging in illicit activities. Of particular concern to congressional investigators was that during this time Keating and his associates sold ACC’s high-yield “junk” bonds in the lobbies of Lincoln’s numerous branches. The sale of these bonds, which were destined to become worthless, raised more than $250 million for ACC. The marketing campaign for the bonds targeted retired individuals, many of whom believed that the bonds were federally insured since they were being sold on the premises of a savings and loan.

When called to testify before the U.S. House Committee, SEC Commissioner Richard Breeden was asked to explain why his agency did not force ACC to stop sell-ing the junk bonds in Lincoln’s branches. Congressman Hubbard: Didn’t the SEC have not one, not two, but actually three or more opportunities to stop the sale of the ACC subordinated debt?Commissioner Breeden: We did not have any opportunity—the only way in which the SEC can stop the sale of securities is if we are able to prove those securities are being distributed based on false and misleading information. And we have to prove that in court. We cannot have reasons to be concerned about it, we cannot have suspicions, we cannot just have cause to be concerned; we have to be able to prove that in court. And remember that this is a situation in which one of the Big Eight accounting firms is certifying that these accounts comply fully with generally accepted accounting principles, without caveat or limitation in any way. That is an important factor in that kind of decision.Following the completion of the 1987 Lincoln audit, the engagement audit part-ner, Jack Atchison, resigned from Arthur Young and accepted a position with ACC. Exhibit 3 contains the memorandum Atchison wrote to William Gladstone, who at the time was Arthur Young’s managing partner, to inform Gladstone of his resigna-tion. Gladstone later testified that Atchison earned approximately $225,000 annu-ally as an Arthur Young partner before his resignation. ACC records revealed that Atchison’s new position came with an annual salary of approximately $930,000.The close relationship that Atchison developed with Keating before resigning from Arthur Young alarmed congressional investigators. Testimony before the congressio-nal committee disclosed that Atchison, while he was serving as the engagement part-ner on the Lincoln audit, wrote several letters to banking regulators and U.S. senators vigorously supporting the activities of Keating and Lincoln. “Atchison seemed to drop the auditor’s traditional stance of independence by repeatedly defending the practices of Lincoln and its corporate parent to Congress and federal regulators. . . . Since when does the outside accountant—the public watchdog—become a propo-nent of the client’s affairs?”11Congressman Gonzalez’s committee also questioned Arthur Young representatives regarding Atchison’s relationship with the Arthur Young audit team after he joined ACC. The committee was concerned that Atchison may have been in a position to improperly influence the auditors he had supervised just weeks earlier. Congressman Lehman: Did anyone at AY have any contact with Mr. Atchison after he left and went to work for Lincoln? Mr. Gladstone: Yes, sir. Congressman Lehman: In the course of the audit? Mr. Gladstone: Yes.Congressman Lehman: So he went from one side of the table to the other for $700,000 more? Mr. Gladstone: That is what happened. Congressman Lehman: And he—just tell me what his role was in the audits . . . when he was on the other side of the table.

This memorandum appeared on Arthur Young letterhead.]TO: Office of Chairman FROM: Phoenix Office William L. Gladstone Jack D. Atchison Hugh Grant, West Regional Office Al Boos, Phoenix OfficeSUBJECT:Several weeks ago, Charles H. Keating, Jr., Chairman of American Continental Corporation, asked me to consider joining his company at a senior executive level. Because we were in the process of conducting an audit, I informed Mr. Keating that any discussions regarding future employment would have to await the conclusion of the audit. I also informed Hugh Grant of Mr. Keating’s overtures to me.Knowing Mr. Keating would raise the subject again at the conclusion of the audit, I began to seriously consider the possibility of leaving Arthur Young to join American Continental. Arthur Young has been my professional home for over 24 years, providing a comfortable source of income and rewarding professional environment. My closest personal friends are also my partners. To even consider no longer being a part of Arthur Young was difficult and traumatic, since serving as a partner in Arthur Young has been my single professional goal since 1962.On April 8 and 11, 1988, I had discussions with Mr. Keating wherein he presented an employment offer which was very rewarding economically and very challenging professionally. His offer addressed all of my economic, job security and position description requirements and concerns. American Continental offers some unique challenges and potential rewards not presently available in Arthur Young. It also presents some risks not present in the Arthur Young environment.Based on American Continental’s offer and my perception of the future there, I have decided to accept their offer and seek to withdraw from the Arthur Young partnership at the earliest possible date. Since American Continental is an SEC client and active issuer of securities requiring registration, and Arthur Young’s consent to the use of its report is needed in such filings, an expedited withdrawal arrangement would protect against any real or apparent conflicts of interest between Arthur Young and American Continental.

Mr. Gladstone: He was a senior vice president for American Continental when he joined them in May 1988. COngressman Lehman: Did the job he had there have anything to do with interfacing with the auditors? Mr. Gladstone: To some extent, yes. Congressman Lehman: What does “to some extent” mean? Mr. Gladstone: On major accounting issues that were discussed in the Form 8-K, we did have conversations with Jack Atchison. Congressman Lehman: So he was the person Mr. Keating had to interface with you in major decisions? Mr. Gladstone: Him, and other officers of American Continental.During the summer of 1988, the relationship between Lincoln’s executives and the Arthur Young audit team gradually soured. Janice Vincent, who became the Lincoln engagement partner following Atchison’s resignation, testified that disagreements arose with client management that summer over the accounting treatment applied to several large real estate transactions. The most serious disagreement involved a pro-posed exchange of assets between Lincoln and another corporation—a transaction for which Lincoln intended to record a $50 million profit. Lincoln management insisted that the exchange involved dissimilar assets. Vincent, on the other hand, stubbornly maintained that the transaction involved the exchange of similar assets and, consequently, that the gain on the transaction could not be recognized. During the congressional hearings, Vincent described how this dispute and related disputes eventually led to the resignation of Arthur Young as Lincoln’s auditor.These disagreements created an adversarial relationship between members of Arthur Young’s audit team and American Continental officials, which resulted in Mr. Keating requesting a meeting with Bill Gladstone. . . . While in New York at that meeting, Mr. Keating turned to me at one point and said, “Lady, you have just lost a job.” That did not happen. Rather, he had lost an accounting firm.Following Arthur Young’s resignation in October 1988, Keating retained Touche Ross to audit Lincoln’s 1988 financial statements. Touche Ross became ensnared, along with Arthur Andersen and Arthur Young, in the web of litigation following Lincoln’s collapse. Purchasers of the ACC bonds sold in Lincoln’s branches named Touche Ross as a defendant in a large class-action lawsuit. The suit alleged that had Touche Ross not accepted Lincoln as an audit client, ACC’s ability to sell the bonds would have been diminished significantly.

Criticism of Arthur Young Following Lincoln’s Collapse

Both Arthur Young and its successor, Ernst & Young, were criticized for the former’s role in the Lincoln Savings and Loan debacle. One of the most common criticisms was that Arthur Young readily accepted questionable documentary evidence pro-vided by Lincoln employees to corroborate the savings and loan’s real estate trans-actions. During the congressional hearings into the collapse of Lincoln, William Gladstone commented on the appraisals that Arthur Young obtained to support those transactions. “All appraisals of land [owned by Lincoln] were done by apprais-ers hired by the company, and we had to rely on them.” Certainly, these apprais-als were relevant evidence to be used in auditing Lincoln’s real estate transactions. However, appraisals obtained by Arthur Young from independent third parties would have been just as relevant and less subject to bias.12Among Arthur Young’s most vocal critics during the congressional hearings was the newly appointed SEC commissioner, Richard Breeden. Commissioner Breeden berated Arthur Young for failing to cooperate with an SEC investigation into Lincoln’s financial affairs.Commissioner Breeden: We subpoenaed the accountants [Arthur Young] to provide all of their workpapers and their backup. Congressman Hubbard: Do you know if they were forthcoming and helpful in helping you resolve some of these questions, or helping the SEC resolve some of these questions?Commissioner Breeden: No. I would characterize them as very unhelpful, very unforthcoming, and very resistant to cooperate in any way, shape or form.Earlier, Commissioner Breeden had testified that many of the subpoenaed docu-ments that Arthur Young eventually produced were illegible or obscured: “The firm [Arthur Young] ultimately, after much discussion, produced legible copies of the doc-uments, but not before the Commission [SEC] was forced to prepare court enforce-ment requests to overcome Arthur Young’s uncooperative stance. Unfortunately, a

substantial amount of staff time and resources was devoted unnecessarily to over-coming this resistance to the Commission’s subpoenas.”When given an opportunity to respond to Commissioner Breeden’s charges, William Gladstone maintained that the delays in providing the SEC with the requested documents were not intentional: “We did not stonewall the SEC. There are Arizona state privilege statutes and ethics rules which prohibit our producing our workpapers without a client consent…. I also take issue with the allegation that we obliterated some papers…. The SEC itself requires a confidentiality stamp on all papers on which confidentiality was requested.”The most stinging criticism of Arthur Young during the congressional hearings was triggered by the report prepared by Kenneth Leventhal & Company on Lincoln’s accounting decisions for its major real estate transactions. Although the Leventhal report served as the basis for much of the criticism directed at Arthur Young, the report did not mention Arthur Young or, in any way, explicitly criticize its Lincoln audits. Nevertheless, since Arthur Young had issued unqualified opinions on Lincoln’s financial statements, many parties, including Ernst & Young officials, regarded the Leventhal report as an indictment of the quality of Arthur Young’s audits.The key finding of the Leventhal report was that Lincoln had repeatedly violated the substance-over-form concept by engaging in “accounting-driven” deals among related parties to manufacture illusory profits. Ernst & Young representatives con-tested this conclusion by pointing out that Leventhal reviewed only 15 of the hun-dreds of real estate transactions that Lincoln engaged in during Arthur Young’s tenure. The Ernst & Young representatives were particularly upset that, based upon a review of those 15 transactions, Leventhal implied that none of Lincoln’s major real estate transactions were accounted for properly. In Leventhal’s defense, a congress-man noted that the 15 transactions in question were all very large and, collectively, accounted for one-half of Lincoln’s pretax profits during 1986 and 1987.At times, the debate over the Leventhal report became very heated. William Gladstone maligned the report, stating that it was gratuitous; contained broad, sweeping generalizations; in certain cases was “flatly wrong”; and in his opinion, was unprofessional. In responding to these charges, Congressman Leach questioned the professionalism of Gladstone’s firm.Congressman Leach: [addressing William Gladstone] I am going to be very frank with you, that I am not impressed with the professional ethics of your firm vis-á-vis the United States Congress. Several days ago, my office was contacted by your firm and asked if we would be interested in questions to ask of Leventhal. We said, “Surely.” The questions you provided were of an offensive nature. They were to request of Leventhal how much they were paid, implying that perhaps based upon their payment from the U.S. Government that their decisions as CPAs would be biased. I consider that to be very offensive.Now, in addition, one of the questions that was suggested I might ask of the Leventhal firm was: Could it be that their firm is biased because a partner in their firm did not make partner in your firm?I consider that exceedingly unprofessional. Would you care to respond to that? Mr. Gladstone: I do not know who contacted you, and I certainly do not know how the questions were raised.Later in the hearings, the individual who had submitted the questions to Congressman Leach’s office was identified as an Ernst & Young employee.

Congressman Leach also took issue with the contention of Ernst & Young repre-sentatives that Leventhal’s report contained angry and vengeful comments regarding their firm.Congressman Leach: I read that report very carefully, and I found no angry, vengeful sweeping statements. But I did find a conclusion that Arthur Young had erred rather grievously.In any regard, what we are looking at is an issue that is anything but an accounting kind of debate. One of the techniques of Lincoln vis-á-vis the U.S. government was to attack the opposition. You are employing the same tactics toward Leventhal…. I think that is unprofessional, unethical, and, based upon a very careful reading of their statement, irresponsible.Now, I would like to ask you if you would care to apologize to the Leventhal firm. Mr. Gladstone: First, Mr. Leach, I stated in my opening remarks that I believed that their report was general and sweeping and unprofessional, because what I would call unprofessional about it is the statement that looking at 15 transactions, that therefore they would conclude that nothing Lincoln did had the substance—Congressman Leach: I have carefully read their report, and they note that they have just been allowed to look at 15 transactions. They could not go into more detail, but they were saying that ACC batted 15 for 15, that all 15 transactions were unusual, perplexing, and in their judgment in each case breached ethical standards in terms of generally accepted accounting principles. Your firm in effect is saying, “We think that there may be some legal liabilities. Therefore, we are going to stonewall, and we are going to defend each and every one of these transactions.”I believe that you are one of the great firms in the history of accounting. But I also believe that big and great people and institutions can sometimes err. And it is better to acknowledge error than to put one’s head in the sand.I think before our committee you have rather righteously done that.

EPILOGUE

Anthony Elliot, a widower and retired accoun-tant in his 80s, was one of thousands of elderly Californians who invested heavily in the junk bonds of Lincoln Savings and Loan’s parent company, ACC. In fact, Elliot invested prac-tically all of his life savings, approximately $200,000, in the ACC bonds. Like many of his friends who had also purchased the bonds—which they, along with Elliot, believed were federally insured—Elliot was forced to scrape by each month on his small Social Security check after ACC defaulted on the bonds. On Thanksgiving Day 1990, Elliot slashed his wrists and bled to death in his bathtub. In a suicide note, he remarked that there was “nothing left for me.”13 Elliot’s story is just one of many personal tragedies resulting from the Lincoln Savings and Loan scandal.The estimated losses linked to the demise of Lincoln Savings and Loan eventually rose to $3.4 billion, making it the most costly sav-ings and loan failure in U.S. history at the time.

In March 1991, Lincoln’s remaining assets were sold to another financial institution by the Resolution Trust Corporation, which had been operating the savings and loan for more than one year. One month later, Lincoln’s par-ent company, ACC, filed for protection from its creditors under the federal bankruptcy laws.In late 1992, Ernst & Young paid $400 million to settle four lawsuits filed against it by the fed-eral government. These lawsuits charged Ernst & Young with substandard audits of four sav-ings and loans, including Lincoln Savings and Loan. In a similar settlement reported in 1993, Arthur Andersen paid $85 million to the fed-eral government to settle lawsuits that charged the firm with shoddy audits of five savings and loans, including Lincoln. Finally, although Touche Ross served as Lincoln’s auditor for only five months, that firm’s successor, Deloitte & Touche, paid nearly $8 million to the federal government to settle charges filed against it for its role in the Lincoln debacle.Ernst & Young agreed to pay the California State Board of Accountancy $1.5 million in April 1991 to settle negligence complaint s that the state agency filed against the firm for Arthur Young’s audits of Lincoln. An Ernst & Young spokesman noted that the accounting firm agreed to the settlement to “avoid protracted and costly liti-gation” and insisted that the settlement did not involve the “admission of any fault by the firm or any partner.”14 In August 1994, Arthur Andersen agreed to pay $1.7 million to the California State Board of Accountancy for its alleged negligence in auditing Lincoln. Andersen personnel were also required to perform 10,000 hours of com-munity service. Like Ernst & Young, Andersen denied any wrongdoing when its settlement with the California State Board was announced.In October 1990, Ernie Garcia pleaded guilty to fraud for his involvement in the Hidden Valley real estate transaction. His plea bargain agree-ment with federal prosecutors required him to assist them in their investigation of Charles Keating, Jr. In March 1991, the Lincoln executive who oversaw the sale of ACC’s junk bonds through Lincoln’s branches pleaded guilty to eight state and federal fraud charges that he had misled the investors who purchased those bonds. Two years later, Charles Keating III was sentenced to eight years in prison after being convicted of fraud and conspiracy charges.In a California jury trial presided over by Judge Lance Ito, Charles Keating, Jr., was con-victed in 1991 on 17 counts of securities fraud for his role in marketing ACC’s junk bonds. While serving a 10-year prison term for that con-viction, Keating was convicted of similar fraud charges in a federal court and sentenced to an additional 12 years in prison.In April 1996, a federal appeals court over-turned Keating’s 1991 conviction. The appel-late court ruled that Judge Lance Ito had given improper instructions to the jurors who found Keating guilty of securities fraud. Several months later, a U.S. District judge overturned Keating’s federal conviction on fraud charges. The judge ruled that several jurors in the federal trial had been aware of Keating’s 1991 conviction. According to the judge, that knowledge had likely prejudiced the federal jury in favor of convicting Keating. For the same reason, the judge over-turned the 1993 conviction of Charles Keating III.With both of his convictions overturned, Charles Keating was released from federal prison in December 1996 after serving four and one-half years. In January 1999, federal pros-ecutors announced that they would retry the 75-year-old Keating on various fraud charges. Three months later, the federal prosecutors and Keating reached an agreement, an agreement that gave both parties what they wanted most. In federal court, Keating admitted for the first time that he had committed various fraudulent acts while serving as ACC’s chief executive. In return, Keating was sentenced to the time he had already served in prison. Even more important to Keating, his plea bargain arrangement required federal prosecutors to drop all charges still out-standing against his son, Charles Keating III.

Questions

1. Arthur Young was criticized for not encouraging Lincoln to invoke the substance-over-form principle when accounting for its large real estate transactions. Briefly describe the substance-over-form concept and exactly what it requires. What responsibility, if any, do auditors have when a client violates this principle?

2. Explain how the acceptance of large, high-risk audit clients for relatively high audit fees may threaten an audit firm’s de facto and perceived independence. Under what circumstances should such prospective clients be avoided?

3. How is an auditor’s examination affected when a client has engaged in significant related-party transactions? What measures should an auditor take to determine that such transactions have been properly recorded by a client?

4. Professional standards require auditors to consider a client’s “control environment.” Define control environment. What weaknesses, if any, were evident in Lincoln’s control environment?

5. What was the significance of Lincoln receiving nonrecourse notes rather than recourse notes as payment or partial payment on many of the properties it sold?

6. Professional auditing standards identify the principal “management assertions” that underlie a set of financial statements. What were the key assertions that Arthur Young should have attempted to substantiate for the Hidden Valley transaction? What procedures should Arthur Young have used for this purpose, and what types of evidence should have been collected?

7. Do you believe that Jack Atchison’s close relationship with Lincoln and Charles Keating prior to his leaving Arthur Young was proper? Why or why not? After joining Lincoln’s parent company, ACC, should Atchison have “interfaced” with the Arthur Young auditors assigned to the Lincoln and ACC engagements? Again, support your answer.

8. Does the AICPA Code of Professional Conduct discuss the collegial responsibilities of CPA firms? In your opinion, were representatives of either Ernst & Young or Kenneth Leventhal & Company unprofessional in this regard during their congressional testimony?

9. What responsibility does an auditor have to uncover fraud perpetrated by client management? Discuss factors that mitigate this responsibility and factors that compound it. Relate this discussion to Arthur Young’s audits of Lincoln.

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