The Rules For Savings And Loans

Published Date: 02 Nov 2017

‘The collapse of Lincoln Savings and Loan was the largest contributor to the Savings Industry Crisis in the USA’. (Berg, E.N, 1989) American Continental Corporation, parent company of Lincoln Savings and Loan, went bankrupt in 1989. Federal regulators seized Lincoln Savings and Loan Association after American Continental bankrupt. From the collapse it has been found that chairman of LSL, Charles Keating Jr. was the biggest contributor to its failure with fraud and racketeering actions. He was also involved in ‘The Keating Five’. The Keating Five included five Senators, which received political contributions from Keating and used their political power to interfere with Federal investigations on the company in which could have reduced the severity of the collapse.

The collapse of about 40 percent of savings and loan institutions are because of fraud and other criminal conduct. Hence, the independence of auditors played an important role in these cases. Although more than half of the profits reported by the Lincoln Savings and Loan were the result of sham transactions, Ernst and Young did not identify those transactions that were misstated without substance. Therefore, Ernst and Young were found to have contributory negligence to the company’s collapse.

Methodology

This report has been written by Alishia Farrell and Ma Yu Yu Yin from the review of a large variety of information on the Lincoln Saving and Loan collapse. In collecting our data we have used the text book ‘Auditing & Assurance Services in Australia’ Gay, G & Simnett, R. as well as "Why do Audits Fail? Evidence from Lincoln Savings and Loan" Erickson, M., Mayhew, B. W., & Felix, W. L. We also used various websites and ECU Library database in order to find information about the company and the key personnel involved in the collapse.

The scope of the case study is to identify reasons that caused the collapse of Lincoln Savings and Loan. In doing so we are able to also identify the key personnel involved. Through our research of the company we are to find the most reliable information in order to make informed conclusions and recommendations. Through using the most relevant information we ensure that the report is concise as it is not to exceed 10 pages in length including any Appendices.

Introduction

Lincoln was an enterprise which was running conservatively with almost half its assets in home loans and a quarter of its assets were considered at risk until the early 1980. It made a profit a few million dollars in 1983 after having shown a loss for several years. Chairman of a home construction company, American Continental Corporation, Charles Keating purchased Lincoln in February 1984 and fired the existing management. Lincoln’s assets increased from $1.1 billion to $5.5billion over the next four years as Charles Keating took an advantage of a change which allowed savings and loan associations to make highly risky investments with their depositors’’ money. However, the money that grew was shifted to its parent company, American Continental, and used for speculative investments and personal expenses.

In 1985, the Federal Home Loan Bank Board (FHLBB) instituted a rule whereby savings associations could hold no more than 10 percent of their assets in "direct investments" and prohibited from taking ownership positions in certain financial entities and instruments. In early 1986, Lincoln Savings and Loan were being investigated and audited by the FHLBB for its investment practices. By the end of 1986, the FHLBB had found that Lincoln had $135 million in unreported losses and had surpassed the regulated direct investments limit by $600 million. In 1987, Keating looked for help from U.S. Senators, Alan Cranston, Dennis DeConcini, John Glenn, John McCain and Donald W.Riegle. Keating contributed about $1.3 million to the senators and he called on them to help him resist the regulators.

Corporate governance, whistle blowing, the auditors’ responsibility, independence and negligence, the management’s and directors’ responsibility, independence and negligence, fraud are the main issues in resolving the causes of the Lincoln Savings and Loan collapse. Findings, recommendations, implementation plan and conclusion will also be presented.

Findings

The following is a summary of key areas that we have found contributed to the collapse of Lincoln Savings and Loan:

Corporate Governance – Charles Keating, the CEO of Lincoln Savings and Loan, failed to act honestly, in good faith and in the best interest of the company as a whole.

Whistle blowing – Ernst and Young, the auditor of Lincoln Savings and Loan, did not report on the misstatement of Lincoln’s profit.

Materiality- Sale of land materially misstated and without substance was recorded by the company and not questioned by the company’s auditors Ernst & Young.

Auditors’ responsibilities- The companies auditors have the responsibility to identify risks of material misstatement due to fraud. In this case auditors should have questioned the large profits recorded on sale of land.

Management and directors’ responsibilities – Lincoln Savings and Loan’s management overstated the profit and cheated the investors.

Auditors negligence - Auditor failed to provide duty of care by not following standards required of them which contributed to the amount of loss suffered by the plaintiff.

Contributory negligence – Lincoln’s management failed to act in the best interest of the company as a whole under Charles Keating’s control which resulted contributory negligence.

Fraud - The money grew from Lincoln was drawn off from Lincoln to the parent company, American Continental Corporation under a variety of schemes and American Continental spent generously on speculative investments and personal expenses. Auditors failed to question the substance of transactions which are an indication of fraudulent activity.

Detailed Findings and Implications

Corporate Governance is the system by which companies are directed and managed, and covers the conduct of the board of directors and the relationship between the board, management and shareholders. Hence, corporate governance consists of auditors, management and board of directors. In Lincoln Savings and Loan Association case, Lincoln invested heavily in real estate, high-yield "junk bonds" and other non-traditional investment under the guidance of American Continental’s chairman, Charles H. Keating Jr. After acquiring Lincoln in February 1984, he fired the existing management. In 1987, American Continental begins selling $200 million worth of bonds through Lincoln Branches and duped investors into buying junk bonds without properly disclosing the risks. Keating made contribution of about $1.3 million to various U.S Senators, and he called on those Senators to help him resist regulators. Alan Cranston, Dennis DeConcini, John Glenn, John McCain and Donald W.Riegle, who received large political contribution from Keating, meet with bank examiners probing Lincoln. It can be seen that Keating had run Lincoln in an unsound manner and had violated laws and regulations and hence he had failed to act honestly, in good faith and in the best interests of the company as a whole.

The Corporation Act 2011, s 311 of Australia imposes a responsibility on auditors to inform ASIC of any significant contraventions of the Act discovered in the normal course of their duties and any other contraventions that cannot be remedied by comment in the audit report or by bringing the matter to the attention of directors. Whistle-blowing requires resolution of the conflict between the principles of independence, objectivity, integrity and public interest on the one hand and client confidentiality on the other. An auditor does not have to actively look for contraventions of the Corporation Act as the decision to blow the whistle is not easy for an auditor. However, in Lincoln’s case, the auditor should report the fraud that management is committing as this fraud can affect many innocent investors.

Charles Keating and the management of Lincoln Savings and Loan had a social responsibility to the investors in showing good judgement in ethical behaviour when running Lincoln’s daily operations. The value of the assets held within Lincoln, and the trust investors place upon its management is extremely important in the social and ethical responsibility of Keating and the management of Lincoln Savings and Loan. The ineffectiveness and improper decision making of Keating leads to the downfall and bankruptcy of Lincoln.

The rules for savings and loans (S&L) were very firm in the 1970s. The rules allow the strict policy of payment to depositors and certain types of investments allowable at certain times. These types of restrictions marked the savings and loan industry as uncompetitive in comparison to traditional banks and financial institutions. Eventually, in the early 1980s, Congress recognized the need for deregulation and revitalization within the S&L industry. This was followed by the elimination of interest rate limitations on deposits, and lesser restrictions, such as, investments into other venues besides single-family home mortgages. In the end, this became a disastrous move and an opening for Charles Keating, Jr. to take hold of the savings and loan industry.

After acquiring by Charles Keating, Lincoln Savings and Loan was set up and ran by Keating and ACC's very own management team. Although Keating may have been seen as the leader of his organization, he became more of a personal money manager, eventually using his company's assets to aid in his and others better interest. Millions of dollars were funneled into ACC to cover its losses from real estate projects that had turned sour. Lincoln S&L was used as a medium to sell hundreds of millions of dollars of ACC bonds to depositors, and more than 20,000 people, many of whom were retired and investing in their pension, bought ACC junk bonds from salesmen who told them that the bonds were federally insured, when, infact, they were not.

Lincoln and Loan and Savings case had a few property sales, which recorded large profits for the company. The extremely high profits on these sales were often what made the difference between an overall loss and profit for the year. These real estate profits on undeveloped land in Arizona recorded as over 400% on cost price which can be seen in figure 1, suggests that the demand for real estate in Arizona was high. Erickson, Mayhew & Felix, state that this was not the case and details of the Arizona real estate market published by University of Arizona suggested that there was a decline in demand and a reduction in value of Arizona real estate at that time.

Figure 1.

These large transactions were often complicated for example purchase of Arizona real estate by LSL subsidiary was sold to a company called Wescon which indirectly received the money to purchase the land from Lincoln Savings and Loan. Erickson, Mayhew & Felix describe that Wescon received a loan for $3.5 million for the down payment on the land from Mr Garcia, who himself had received a loan from Lincoln Savings and Loan just prior to the sale of land. On top of this the net worth of Wescon was only $100,000 and with the purchase of the land being $14 million it would seem that Wescon would struggle to repay this purchase. Erickson, Mayhew & Felix also stated that one of these requirements was a minimum capital to avoid interference by federal agencies. The knowledge that there were external pressures to avoid accounting losses and that one or two large transactions resulted in changing an overall loss to an overall profit should be facts taken into consideration by auditors.

Under ASA 240 section 48 provides indicators to auditors that fraudulent financial reports or transactions have been recorded. One indicator is that "The transactions involve … parties that do not have substance or the financial strength to support the transaction without the assistance from the entity under audit". Through review of the case the transaction between Lincoln Loan and Savings subsidiary and Wescon should have indicated the possibility of fraud as Wescon relied on a loan indirectly borrowed from the audited entity itself. There is possibility that Wescon would not be able to repay the $3.5 million borrowed indirectly from Lincoln Loan and Savings or the $10.5 million still owing to the Lincoln Loan and Savings subsidiary and it is therefore questionable whether recognition of the entire sale was a material misstatement of profit for the year. Where risk of fraud is found to exist it is required for Auditors to inform management or those in governance of the finding whether through verbal or written communication. Auditors must take additional steps to reduce risk or materially misstatement when the possibility of fraud occurs and in this case may require more information from Wescon to decide whether they will be able to repay their debts.

The auditors had a duty of care to Lincoln Savings and Loan as per the contract relating to the auditing services. The auditors did not exercise reasonable care and skill as they did not adhere to professional standards, including ASA 240 (Gay & Simnet, 2012). The auditors did not maintain professional scepticism throughout the audit, as it did not question the materiality of the transactions required under ASA 200. They even claimed that they are only responsible to ensure that the firm’s accounts complied with generally accepted accounting principle (GAAP) and not to determine the safety and soundness of the firm, although more than half of the profits reported by the Lincoln Savings and Loan were the result of sham transactions. ASA 315 section 11 also requires that auditors obtain an understanding of the environment, which would include the Arizona property market. We have also found that the auditors were negligent as the following four elements existed:

Duty was owed to the plaintiff

There was a breach of the duty of care

Loss or damage was suffered by the plaintiff

A casual and reasonably foreseeable relationship existed between the breach of duty by the defendant and the harm suffered by the plaintiff.

However, we find that the auditor will only be found of contributory negligence as the defendant did not provide a standard care to protect itself as it is the one who recorded transactions without substance. The complicated transactions were well planned and always linked back to Lincoln Savings and Loan as the funder of the transactions.

Implications and Findings

Through analysis of the case it is found that there were large transactions by Lincoln Loan and Savings, which could be materially misstated. The organisation should be careful to ensure it is not recording transactions in which repayments are unlikely to be repaid as although they appear to have made a profit in their financial statements this could not be a true representation. The particular transactions of the case might suggest that Lincoln Loan and Savings should not have been selling assets to companies that would not be able to purchase it without the indirect financing of Lincoln Loan and Savings itself.

Conclusions and recommendations

Recommendations of Auditors:

Auditors should not rely on information from the company and where necessary exert the use of independent experts (such as to verify the correct value of land sold).

Auditors are required to be aware of an entities environment therefore they should have queried the state of the Arizona land market.

Auditor should consider risk of fraud in the planning stage of the audit, which would have given rise to possible fraudulent financial reporting involving recording of transactions without substance.