WASHINGTON - Friday marks one year since First National Bank of Keystone's spectacular blowup.

When the West Virginia bank was seized amid accusations of fraud and mismanagement, federal regulators pointed fingers at each other and then at Keystone's accountant, the auditing firm Grant Thornton.

To recoup some of the estimated $800 million cleanup tab, the Federal Deposit Insurance Corp. is expected to sue Grant Thornton. Though no lawsuit has surfaced yet, there are clear signs that the agency is preparing one.

Ironically, those signs include moves that help Grant Thornton in the short run.

The FDIC has intervened in five lawsuits brought against the auditing firm by former Keystone depositors and shareholders. The agency has persuaded a judge to dismiss two of those cases. That's the good news for Grant Thornton.

The bad news is the reason the FDIC used: If anyone is going to sue Grant Thornton, it will be the government.

The FDIC and Grant Thornton declined to comment, but John L. Douglas, a former FDIC general counsel, said the agency could be clearing the decks for its own lawsuit. "The fact they dismissed the other cases could be an indication that the agency wants to preserve the right to pursue Grant Thornton in the future," said Mr. Douglas, a partner with Alston & Bird in Atlanta.

The FDIC had three years from the $1.1 billion-asset bank's failure - that is, until Sept. 1, 2002 - to file related lawsuits.

In a twist, Grant Thornton has sued the FDIC. In a July filing the firm demanded payment of more than $40,000 in auditing fees owed by Keystone.

TROUBLE FOLLOWS TRANSFORMATION

Founded in 1904, Keystone had just $17 million of assets by the late 1970s. But then J. Knox McConnell came to town with two colleagues from Pittsburgh - Billie Cherry and Terry L. Church - and the trio transformed the bank into one of the nation's most profitable.

In the early 1990s, Keystone began to buy risky loans and then bundle and securitize them. The bank retained an interest in the loans - called a subprime residual - that is counted as an asset. But those residuals are notoriously difficult to value and can be worthless if too many loans default. To keep pace with its rapid growth, the bank also attracted depositors from around the country by paying rates 200 basis points above market.

Bank examiners were wary of Keystone's growth, and in 1991 criticized the bank for poor internal controls and audit deficiencies. During the 1990s, Keystone's supervisory ratings fluctuated dramatically. They started to steadily decline in September 1997, when the Office of the Comptroller of the Currency became suspicious of unauthorized use of loan proceeds by some borrowers and of inaccurate loan applications. The agency transferred responsibility for the bank's oversight to its Special Supervision/Fraud Unit.

The OCC downgraded the bank to a Camels 4 performance rating in December 1998. The FDIC later downgraded Keystone to the lowest rating, a Camels 5, citing its worsening risk profile, poor data integrity, and management's inability to explain how it valued a large portion of the bank's assets.

In May 1998 the OCC forced the bank to hire an external auditor - enter Grant Thornton.

Grant Thornton was required to directly confirm all of the bank's assets serviced by third parties, the Comptroller's Office said in a report to Congress after Keystone failed. In early 1999 Grant Thornton gave Keystone a clean bill of health in the form of an unqualified opinion. The auditing firm told the OCC that Keystone's balance sheet was "the most accurate it has been in three years."

But in August 1999 examiners uncovered a bombshell - approximately half of the bank's assets had been sold. The OCC immediately moved to shut down the bank, charging that bank officials had falsified documents to fool examiners into thinking $515 million of loans were simply being serviced by outsiders.

THE BLAME GAME

The FDIC, facing huge costs, started pointing fingers at the OCC. The insurer had asked to participate in Keystone exams in early 1998, but had initially been rebuffed by the OCC. House Banking Committee Chairman Jim Leach criticized the OCC and introduced legislation that would enable the FDIC chairman to intervene in any bank examination. (The legislation is still pending.)

A report by the Treasury Department's inspector general in March agreed that the Comptroller's Office could have done more. "Alleged fraudulent accounting practices, uncooperative bank management, and reported high profitability may have all served to mask the bank's true financial condition from OCC examiners," according to the 51-page report. "Despite this, indicators existed throughout the period that may have dictated a more aggressive supervisory response from the OCC."

But the OCC has repeatedly insisted that it was deceived by the bank's officers.

"The fraud was very large in this case, but its very nature makes it difficult to detect," said Ann Jaedicke, OCC's director of special supervision. "These people worked hard so that we would not discover fraud. They produced documents which were altered to give erroneous impressions."

Both Ms. Church and Keystone Mortgage president Michael Graham were convicted in May of obstructing federal examiners, including burying truckloads of bank documents in a 100-foot long ditch dug in Ms. Church's back yard. Each was sentenced in July to more than four years in federal prison.

That month the FDIC sued Ms. Church, Mr. Graham, Ms. Cherry, and the estate of the late Mr. McConnell, claiming the four defrauded the bank and embezzled almost $20 million. The lawsuit seeks $500 million in damages. Five former bank directors were also accused of "gross negligence" in allowing Mr. McConnell and Ms. Church to control the bank's activities despite repeated warnings from examiners that problems existed.

In separate civil trials, former bank shareholders have sued Keystone directors and officers as well as Grant Thornton. The shareholders argue that they would never have purchased stock if not for the firm's unqualified opinion. They claim that Grant Thornton should have been able to discover the fraud during its audit.

West Virginia Banking Commissioner Sharon G. Bias agrees, pointing to the bank's high concentration of subprime residuals as a cause for concern. "Why didn't Grant Thornton question the value of all those residuals?" she asked. "Just seeing them on the balance sheet should have caused Grant Thornton to be alarmed."

The Comptroller's Office, too, tried to shift blame from examiners to the accounting firm. "Grant Thornton was required to perform direct confirmations with the servicers," the OCC said. "The audit firm did not detect, and did not report, any fraud in this confirmation process."

A QUIET DEFENSE

Though Grant Thornton officials refused to comment for this article, the firm has asked that two Keystone-related cases be dismissed, arguing that it performed a "perfectly proper audit." The auditor said failure to find fraud did not make it liable for Keystone's closing.

"A properly planned and executed audit cannot guarantee discovery of management fraud," the firm said in court documents. "Unless auditors are hired for the specific purpose of conducting a forensic audit (which Grant Thornton was not), generally accepted auditing standards do not require them to employ procedures that are guaranteed to detect fraud.

"A failure to discover a fraud perpetrated by management does not mean that the audit was even negligent - let alone fraudulent."

Legal analysts agreed. "There is a common misperception that auditors check for fraud," said Richard D. Bernstein, a partner at Sidley & Austin in Washington, who has defended auditors against the FDIC in the past. "Usually, one of the main goals of people committing fraud is to keep it from auditors."

If auditors were responsible for detecting fraud, Mr. Bernstein said their fees would skyrocket. "Every honest bank in the country would have to pay more in fees if auditing firms were liable," he said. "First, the firms would have to have liability protection, and they would have to add staff and extra procedures to detect fraud."

But these concerns have not stopped the FDIC from successfully pursuing auditors. The most prominent cases ended in settlements; the agency netted more than $1 billion from four accounting firms that worked for failed savings and loans in the 1980s.

Regardless where the blame settles, the fallout from Keystone's failure will be felt for years to come.

In addition to Rep. Leach's legislation, which could tilt the balance of power among the regulators, new rules are being written to crack down on subprime residuals. The four banking and thrift regulators this month proposed requiring institutions to hold $1 in capital for every $1 in residuals, and to limit these assets to only 25% of Tier 1 capital.

Examiners are also on the lookout for fraud, FDIC Supervision Director James L. Sexton said.

Ms. Jaedicke said the OCC now requires confirmation of assets serviced by third parties to come directly from those companies. The OCC is working on a better way to value residual assets, and training examiners on how to investigate them.


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