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THE BCCI AFFAIR |
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BCCI AND ITS ACCOUNTANTS Introduction External auditors of banks everywhere play a critical role in the self-regulatory process by which both ordinary depositors as well as players in the financial marketplace evaluate their own business performance, and that of those with whom they may place their savings or do business. In addition, in many foreign jurisdictions, external auditors of banks are relied upon by regulators to provide them with important internal information about bank practices, performing the kind of function in those countries that federal bank examiners do in the United States. In the case of BCCI, there can be no question that the auditing process failed to work. As the Bank of England stated in determining that BCCI be closed: It appears from the Price Waterhouse Report [of June 1991] that the accounting records [of BCCI] have completely failed and continue to fail to meet the standard required of institutions authorised under the Banking Act. It further appears that there is not [a] proper or adequate system of controls for managing the business of BCCI.(1) Given the demonstrable failure of the auditing process, serious questions have been raised about how and why BCCI's outside auditors permitted BCCI to flourish as long as it did, despite fraud and other bad practices which went back many years. The record offers both support for assessing blame on BCCI's auditors, and the suggestion that their work in the spring of 1991 was an essential component of the investigative process that ultimately forced BCCI's closure. One view of the culpability of BCCI's accountants was expressed by BCCI's own chief financial officer, Masihur Rahman. Rahman testified that as BCCI's top financial official, he did not know of BCCI's frauds prior to the spring of 1990. He testified that has the bank's chief financial officer in London, he did not have access to any of the underlying loan information and related files at BCCI's various field offices. Rahman testified that he therefore relied on the work of the outside auditors, operating around the world at the local level, to review BCCI's records at its various offices and branches, and thereby ensure their truth and accuracy. At the other extreme was the position taken by BCCI's principal auditor, Price Waterhouse (UK), that it was completely deceived by BCCI until the spring of 1990, and handled its responsibilities concerning BCCI without any fault whatsoever. As Masihur Rahman expressed his position, regarding the auditors' handling of BCCI's first set of major losses in 1985: I used to tell the Price Waterhouse and Ernst & Whinney to please review these reports and also please keep me informed, because you are more my eyes and ears than my own inspection division . . .[if] Price Waterhouse had been doing its job, there's no way that this $1 billion exposure [in BCCI's Central Treasury] which was taken to $11 billion exposure in the course of 3 or 4 months [in 1985] could have happened.(2) According to Rahman, Price Waterhouse (UK) had signed off on BCCI practices year after year without issuing any red flags, until suddenly, in April, 1990, it found massive deficiencies at the bank, in which, as Senator Kerry put it, "every red flag in the world was flying," raising the question of how Price Waterhouse could have missed all of BCCI's bad practices previously.(3) From Rahman's point of view, local auditors at each of BCCI's locations had the opportunity to review the underlying loan documentation from the beginning. Rahman believed that process of review was precisely what they had been hired to do and failed at. From his point of view, as chief financial officer, his job was to accept the numbers provided him and audited locally the accountants, and from there to put together the overall financial accounts of BCCI. Thus, the deceptions that took place were made possible through the auditors' failure to have looked sufficiently closely at BCCI's customer-by-customer financial records around the world, and especially in the Grand Caymans. As Rahman explained in an annotation to the report prepared by Price Waterhouse to the Bank of England in June, 1991 which helped bring about the closure of BCCI globally: Price Waterhouse should have known from their audit of Grand Cayman over many years that deposits of BCCI were being misused. The 'fictitious' loan accounts were in most cases so obviously fictitious that the year after year audit of PW should have detected most, if not all. PW not only knew about ICIC Overseas accounts [where some $600 million of the fraud had at BCCI had taken place] but irregularly "certified these accounts. . . It all happened in, or were initiated by Grand Cayman. . . done by a few people in an amateurish way, right under the nose of PW (Grand Cayman) and PW (UK), who had done audit of these units from their inception (1975.)(4) Rahman further stated to the British inquiry into BCCI undertaken by Lord Justice Bingham that essentially all of BCCI's serious treasury problems were related to the activities at Grand Cayman, which had taken place in a blatant and repetitive form over many years. According to Rahman, BCCI was paying its auditors $5 million per year to conduct audits which each year took nearly five months. According to Rahman, if properly done, these audits should have uncovered the problems and forced action long before April, 1990. In contrast, as Price Waterhouse expressed their position, BCCI had deceived them through colluding with shareholders and borrowers to create false documentation that mislead them: The auditor's responsibility is to design and execute an audit so as to have reasonable expectation of detecting material misstatement in the financial statements whether due to fraud, irregularity, or error. However, common sense dictates, and it is accepted internationally, that even the best planned and executed audit will not necessarily discover a sophisticated fraud, especially one where there is collusion at the highest level of management and with third parties. Under such circumstances, it is reasonable to expect that it may take a number of annual audits before accumulating concerns change to suspicions and ultimately lead to the identification of fraud; in fact, this is what happened in our audit of BCCI.(5) Price Waterhouse found that BCCI Treasury losses had been concealed and its profits manufactured through BCCI's failure to record deposits and other liabilities; the creation of fictitious loan accounts; the use of funds from ICIC which were controlled by BCCI; use of third party funds which BCCI was managing; circular routing of funds using various BCCI affiliates; the purchase and repurchase of BCCI's own shares through nominees with buy-back arrangements; and the collusion between BCCI and major customers in supplying false confirmations to the external auditors, among other techniques.(6) In fact, many aspects of BCCI's relationship to its auditors, especially Price Waterhouse's partnerships outside the United States, were sufficiently unusual to provide evidence for both the positions expressed by Rahman and by Price Waterhouse. Over BCCI's nineteen year existence, BCCI lent at least two Price Waterhouse partnership's funds for business projects, while those partnerships were auditing BCCI; had an affiliate make substantial payments to at least one key former Price Waterhouse official after he had had handled audits of BCCI; allegedly "took care" of Price Waterhouse partners through providing benefits to them such as the use in the Grand Caymans of a villa; according to federal regulators, made use of BCCI-Hong Kong to handle its routine banking needs in the Far East; and according to one BCCI official, may even have been compromised by mid-level BCCI employees who allegedly provided them with sexual favors for that purpose. Moreover, when Price Waterhouse (UK) discovered massive losses at BCCI in 1985 which the bank falsely characterized as commodities trading losses, Price Waterhouse (UK) accepted BCCI's explanation and did not undertake the kind of comprehensive review of BCCI's Treasury operations in the Grand Caymans which should, even then, according to statements by various BCCI officials, have demonstrated BCCI's fraud. After 1985, Price Waterhouse (UK) made note of and reported to BCCI's directors and officers exceptionally poor practices by many BCCI entities year after year, including BCCI's failure to keep adequate records. Nevertheless, Price Waterhouse (UK) did not inform regulators of this or other problems at BCCI until April, 1990, and continued through 1990 to sign off on BCCI's annual statements that its consolidated audits "give a true and fair view of the financial position of the group." Moreover, Price Waterhouse (UK) according to its own audit reports was told by BCCI officials in years prior to 1990 that they had violated U.S. law in failing to inform the Federal Reserve of changes in ownership by shareholders of CCAH/First American, and in various practices relating to CCAH/First American. Yet the firm took no action to advise any regulator, let alone the Federal Reserve, of what they had knew -- or, alternatively, to resign their position as BCCI's auditors. In defense of the auditors, it should be noted that BCCI's top officials, key major shareholders and some principal borrowers did seek to deceive them through creating false records and documents. The full nature and extent of the fraud would indeed have been difficult to penetrate, given BCCI's far-flung empire and structural complexity, and the bank's decision for its first 15 years of operation to divide responsibility for its audits between Price Waterhouse and Ernst & Whinney, thus ensuring that no one auditor had an overall view of its activities. It is also true that once Price Waterhouse recognized that the hole in BCCI's books had grown so significant that it threatened the solvency of the institution in early 1990, they brought the matter to the attention of the Bank of England. As a result, from that date forward, the Bank of England shared in whatever blame might be attached to Price Waterhouse's decisions following that date, and prior to its final certification of BCCI's books in April, 1990. Difficulties of Investigating BCCI's Auditors A full understanding of what took place between BCCI and its auditors has been severely impeded by the inability to obtain documents and testimony from BCCI's principal auditors, especially Price Waterhouse. While Price Waterhouse's US partnership provided full cooperation regarding its audits of BCCI activities in the United States, it took the position that it had neither any knowledge of, or responsibility for, BCCI's overall auditing, which was handled solely by their affiliated partnership in the United Kingdom, Price Waterhouse (UK). Price Waterhouse (UK), which handled the consolidated audit of BCCI world-wide from 1987 on, and which previously was responsible for over 15 years for the audits of one of BCCI's two flag banks, BCCI Overseas (Grand Cayman), where a substantial portion of the frauds took place, refused to provide the Subcommittee with any of its voluminous audit reports pertaining to BCCI in response to the subpoena of the Committee on Foreign Relations. Price Waterhouse (UK) argued that provision of such material was precluded by British law, and that the British partnership of Price Waterhouse did not do business in the United States and could not be reached by any subpoena. Price Waterhouse (US), which said it did not possess any documents pertaining to BCCI operations outside the United States, explained its relationship with other Price Waterhouse partnerships in other countries as one of a loose affiliation of independent partnerships linked together by a set of agreed-upon standards for audit work, but entirely separate from one another in legal responsibilities. As set forth in a Price Waterhouse (US) letter to Subcommittee staff on October 17, 1991: [T]he 26 Price Waterhouse firms practice, directly or through affiliated Price Waterhouse firms, in more than 90 countries throughout the world. Price Waterhouse firms are separate and independent legal entities whose activities are subject to the laws and professional obligations of the country in which they practice. . . PW-US, like other Price Waterhouse firms throughout the world, is a separate and distinct partnership. For your immediate purposes, it is appropriate to note that no partner of PW-US is a partner of the Price Waterhouse firm in the United Kingdom; each firm elects its own senior partner; neither firm controls the other; each firm separately determines to hire and terminate its own professional and administrative staff. . . each firm has its own clients; the firms do not share in each other's revenues or assets; and each separately maintains possession, custody and control over its own books and records, including work papers. The same independent and autonomous relationship exists between PW-US and the Price Waterhouse firms which practice in Luxembourg and Grand Cayman.(7) As Price Waterhouse (US) partners explained to the Subcommittee, when Price Waterhouse, or any auditing firm, signs off on an audit and certifies that its audit represents a true and accurate picture of a company's books, the certification is not made by Price Waterhouse as a single entity, as would be true in a corporate structure. Rather, the certification is made by, and binds only the members of the partnership of the accounting firm in the country in which they themselves are certified as accountants. In the case of BCCI, Price Waterhouse (UK), relying on work performed by its affiliates in a number of locations around the world, conducted the consolidated audit of BCCI from 1987 through 1992. During that time, many other Price Waterhouse partnerships, including Price Waterhouse (US), provided Price Waterhouse (UK) with written summaries of BCCI's financial condition locally, in accordance with their audit instructions from Price Waterhouse (UK), which were then incorporated into the consolidated accounts of the group. Questions about BCCI's activities in the Grand Caymans or Panama or Colombia could be answered only by Price Waterhouse (UK), in connection with its consolidated audits, or by the local partnerships of Price Waterhouse in those countries. Thus, under the partnership system that all the international accounting firms use, Price Waterhouse (US) has maintained that it has no knowledge of, or responsibility for, a consolidated audit certified by any of its partnerships in other countries, including those done pertaining to BCCI. Accordingly, in response to the Committee subpoena to Price Waterhouse, Price Waterhouse (US), provided complete documentation of its work on behalf of BCCI in the United States, but no documents regarding Price Waterhouse's work on behalf of BCCI elsewhere, including its reports to BCCI's board of directors, and the background to its annual certifications of BCCI's books and records. On these critical issues, Price Waterhouse (US) referred all questions to Price Waterhouse (UK), which in turn took the position that it was legally precluded by British bank confidentiality and privacy laws from providing any of the documents subpoenaed by the Committee. In lieu of testimony or documents, Price Waterhouse (UK)'s attorney provided the Subcommittee a copy of the firm's written answers to questions from a Committee of the British House of Commons.(8) It is worth noting, for the record, Masihur Rahman's view that for years, Price Waterhouse has held themselves out to be a global firm with uniform standards and one single responsibility. According to Rahman, Price Waterhouse brochures were submitted to BCCI repeatedly emphasizing Price Waterhouse's global integration as a critical strength of the firm. Due to Price Waterhouse (UK)'s refusal to respond to the subpoena, the Committee has been unable to obtain a complete set of Price Waterhouse's audit reports concerning BCCI, and has had to rely on fragments of such reports obtained from the Federal Reserve and other sources amounting to a small percentage of the total work. As a result, for some years, no audit reports of any kind have been obtained. For other years, the audit reports obtained are limited to fragments of the whole. These fragments do provide some important information about Price Waterhouse's concerns about BCCI from the early 1980's on; unfortunately, the fragments exclude other critical information necessary to evaluate the history of Price Waterhouse's handling of these audits. In reaching its conclusions, the Subcommittee has sought to make use of all available information, including the answers provided by the auditors to questions from the British House of Commons. However, given the incomplete state of the information the Subcommittee has been able to obtain, it is possible that additional documents from the auditors concerning BCCI could have changed the conclusions reached by the Subcommittee on some of these matters. It is therefore especially unfortunate that the foreign auditors refused to honor the Committee's subpoena. Findings As noted above, reaching conclusions concerning the responsibility of the auditors in connection with BCCI's maintenance of its deceptions until July, 1991 have been hampered by the inability to obtain full documentation and any interviews from any of BCCI's foreign auditors. Nevertheless, the information and testimony gathered by the Subcommittee is adequate to find: ** BCCI's decision to divide its operations between two auditors, neither of whom had the right to audit all BCCI operations, was a significant mechanism by which BCCI was able to hide its frauds during its early years. For more than a decade, neither of BCCI's auditors objected to this practice. ** BCCI provided loans and financial benefits to some of its auditors, whose acceptance of these benefits creates an appearance of impropriety, based on the possibility that such benefits could in theory affect the independent judgment of the auditors involved. These benefits included loans to two Price Waterhouse partnerships in the Caribbean. In addition, there are serious questions concerning the acceptance of payments and possibly housing from BCCI or its affiliates by Price Waterhouse partners in the Grand Caymans, and possible acceptance of sexual favors provided by BCCI officials to certain persons affiliated with the firm. ** Regardless of BCCI's attempts to hide its frauds from its outside auditors, there were numerous warning bells visible to the auditors from the early years of the bank's activities, and BCCI's auditors could have and should have done more to respond to them. ** By the end of 1987, given Price Waterhouse (UK)'s knowledge about the inadequacies of BCCI's records, it had ample reason to recognize that there could be no adequate basis for certifying that it had examined BCCI's books and records and that its picture of those records were indeed a "true and fair view" of BCCI's financial state of affairs. ** The certifications by BCCI's auditors that its picture of BCCI's books were "true and fair" from December 31, 1987 forward, had the consequence of assisting BCCI in misleading depositors, regulators, investigators, and other financial institutions as to BCCI's true financial condition. ** Prior to 1990, Price Waterhouse (UK) knew of gross irregularities in BCCI's handling of loans to CCAH/First American and was told of violations of U.S. banking laws by BCCI and its borrowers in connection with CCAH/First American, and failed to advise the partners of its U.S. affiliate or any U.S. regulator. ** There is no evidence that Price Waterhouse (UK) has to this day notified Price Waterhouse (US) of the extent of the problems it found at BCCI, or of BCCI's secret ownership of CCAH/First American. Given the lack of information provided Price Waterhouse (US) by its United Kingdom affiliate, the U.S. firm performed its auditing of BCCI's U.S. branches in a manner that was professional and diligent, albeit unilluminating, concerning BCCI's true activities in the United States. ** Price Waterhouse's certification of BCCI's books and records in April, 1990 was explicitly conditioned by Price Waterhouse (UK) on the proposition that Abu Dhabi would bail BCCI out of its financial losses, and that the Bank of England, Abu Dhabi and BCCI would work with the auditors to restructure the bank and avoid its collapse. Price Waterhouse would not have made the certification but for the assurances it received from the Bank of England that its continued certification of BCCI's books was appropriate, and indeed, necessary for the bank's survival. ** The April 1990 agreement among Price Waterhouse (UK), Abu Dhabi, BCCI, and the Bank of England described above, resulted in Price Waterhouse (UK) certifying the financial picture presented in its audit of BCCI as "true and fair," with a single footnote material to the huge losses still to be dealt with, failed adequately to describe their serious nature. As a consequence, the certification was materially misleading to anyone who relied on it ignorant of the facts then mutually known to BCCI, Abu Dhabi, Price Waterhouse and the Bank of England. ** The decision by Abu Dhabi, Price Waterhouse (UK), BCCI and the Bank of England to reorganize BCCI over the duration of 1990 and 1991, rather than to advise the public of what they knew, caused substantial injury to innocent depositors and customers of BCCI who continued to do business with an institution which each of the above parties knew had engaged in fraud. ** From at least April, 1990 through November, 1990, the Government of Abu Dhabi had knowledge of BCCI's criminality and frauds which it apparently withheld from BCCI's outside auditors, contributing to the delay in the ultimate closure of the bank, and causing further injury to the bank's innocent depositors and customers. BCCI's Early Audit Relationships As specified in the chapter of BCCI's criminal activity, BCCI was from its earliest days made up of multiplying layers of entities, related to one another through an impenetrable series of holding companies, affiliates, subsidiaries, banks-within-banks, insider dealings and nominee relationships. By fracturing corporate structure, record keeping, regulatory review, and audits, the complex BCCI family of entities created by Abedi was able to evade ordinary legal restrictions on the movement of capital and goods as a matter of daily practice and routine. As a result, the records of BCCI's criminal activity were buried beneath a layering that substantially impeded anyone's ability to make sense of them. Yet, this problem was not something which developed slowly, near the end of BCCI's existence in 1991, but rather, a structure which BCCI's head, Abedi, created from the earliest days of the bank, and which was accepted for over a decade by both of BCCI's principal auditors, Price Waterhouse and Ernst & Whinney. According to Masihur Rahman, he recognized the potential for abuse in the system developed by Abedi from the beginning, and insisted on retaining top accounting firms for BCCI as a mechanism to counter Abedi's complexities. As Rahman explained it: Soon after formation of the bank, it started as BCCI S.A. which was the Luxembourg Bank, but within a couple of years, Mr. Abedi decided to restructure it, and the holding company was produced. It was called BCCI Holdings. And the bank underneath it, BCC S.A. was split into two parts, one bank was left with its head office in Luxembourg called BCCI S.A., and another bank was created with its head office in Grand Cayman. The BCC S.A. bank was mostly with European and Middle East locations, and BCC Overseas Bank was mostly Third World countries. . . . Well, the more number of entities there are in any organization, obviously the more isolation you can put each section to. And if you do an intercompany position, then unless you know both companies' position, you could get half a picture. So there was that situation also . . . Because I realized the danger of this evolving structure and the management style, I insisted that we had the best and biggest auditors. And so we from the early days had two of the biggest audit firms, Ernst & Whinney which became Ernst & Young, and Price Waterhouse.(9) Initially, both the holding company and all BCCI's other banks other than its Grand Cayman's banking unit, BCCI Overseas, was handled by Ernst & Whinney, with BCCI Overseas in Grand Caymans as a "flag-ship" bank, handled by Price Waterhouse from its formation in 1975. According to Rahman, in an effort to deal with BCCI's "free-wheeling structure," both firms were instructed by him to notify him, as BCCI's chief financial officer, of any abnormalities they encountered at the local level in the course of their audits, as they found them, and not to wait until the end-of-the-year audit to report them. Moreover, controls were placed on BCCI's Treasury operations requiring the Treasury department of BCCI to maintain 90 percent of its deposits in a liquid form -- such as placements with prime banks and U.S. and European government securities -- and permitting the Treasury to engage in trading on no more than a maximum of 10 percent of BCCI's dollar surpluses, which would limit the exposure to about $100 million in all. Price Waterhouse Audits -- Mid-1980's The earliest audit for which the Subcommittee has been able to obtain any records consists of a few sample pages of audit findings and recommendations from Price Waterhouse Grand Caymans to BCCI dated December 31, 1983, prepared by Price Waterhouse Grand Cayman personnel Richard W. Harris and Richard D. Fear. As of the end of 1983, the auditors found that BCCI's loan portfolio contained: a relatively high concentration of risk to a number of prominent clients. The inherent risk associated with these major exposures is significant in the context of the capital base of the Bank particularly in cases were advances have been made on an unsecured basis.(10) Accordingly, the auditors recommended that BCCI consider limiting the maximum loan exposure to individual clients or groups, and increasing its loan loss provisions. The pages provided the Subcommittee do include references to other problems with the bank, but the full explanation of those problems was apparently set forth on pages not obtained by the Subcommittee. Excerpts from a report prepared in 1984 by Price Waterhouse provides a fuller account of the nature of the problems Price Waterhouse had previously found. While again the documents provided are fragmentary, they contain the following: Although there have been marked improvements in the quality of the credit files maintained at Head Office [Grand Cayman's] we have again noted instances where the files contain inadequate financial information such that the credit worthiness of the borrow cannot be readily established.(11) Portions of an internal control report prepared by Price Waterhouse dated April 26, 1986 concerning BCCI's Grand Caymans office described numerous additional problems pertaining to BCCI's lending practices and documentation: We noted instances where funds had been disbursed . . . prior to the perfection of the security arrangements required . . . Instances were noted in which items of security were not supported by independent valuations . . . We have noted some instances where the documentation received by the Bank to create a charge or pledge over security had been accepted without any evidence of consideration having been given to its legal enforceability in the jurisdiction in which the enforcement would be made . . We noted instances where exposure exceeded authorized limits, occasionally by significant amounts, and also that in many such cases such excesses were caused by the accrual of interest. . . During the course of our audit we had several requests from local auditors to review loans for which documentation was not available locally . . . No regular reporting procedures exist at Head Office whereby senior management, the Central Credit Committee or the Board of Directors are notified of non-compliance with the terms and conditions of borrowing, particularly in relation to the non-payment of principal and interest . . . We noted instances whereby the interest rate being applied to an account differed from that quoted . . . We noted instances, where for general reasons of confidentiality, certain borrowers were designated with a numbered account reference rather than the account being entitled with the full name of the borrower. Whilst we have no particular objection to this practice, we found that in most instances none of the officers of the Grand Caymans office were able to correctly identify either the name of the borrower or the credit officer responsible for monitoring the account at other locations. . .(emphasis added) We noted instances of errors occurring in the accounting records at Head Office accounting to ensure their completeness and accuracy. . . We have noted during the past few years that the level and number of staff loans booked at Head Office has steadily increased but that regular monitoring is not carried out to ensure that the terms and conditions of such loan are being followed.(12) Asterisks adjacent to a number of these concerns were placed by the auditors to indicate issues which they had previously raised with BCCI, in some cases for several years. Many of the concerns taken independently might not be cause for unusual concern. But taken together, they demonstrate at minimum that as early 1986, BCCI's auditors knew of a significant number of exceptionally poor practices at BCCI concerning its record keeping, treatment of interest to borrowers, handling of numbered accounts, and handling of accounts where customers were failing to pay interest or principal or both. While Price Waterhouse may have considered BCCI's poor banking practices to be a demonstration of a lack of sophistication or professionalism on the part of BCCI, in fact, these practices, taken together, were essential mechanisms by which BCCI maintained its global frauds. For example, BCCI's practice of simply tacking on interest to principal in cases in which loans were non-performing was necessitated by its practice of using nominees to disguise transactions in which BCCI was the real party at interest, such as BCCI's secret ownership of First American. The nominees understood from the beginning that they were not responsible for paying interest, and that BCCI would take care of it. The simplest means for BCCI to take care of it, was, so long as the auditors permitted it, to just add the interest to the principal. Then, when BCCI was ready, it would proceed against the borrower, its nominee, and "acquire" the property secured by these loans. Accordingly, BCCI often would not want any independent valuation of the secured property, because its intention from the beginning was to own or control the secured property -- such as First American -- rather than to sell the property if its "borrower" did not pay BCCI back its "loan." Similarly, the practice of BCCI officials not being able to identify the borrower behind a numbered account, or the BCCI officer responsible for monitoring the account at other locations, would have been a logical means of compartmentalizing knowledge about accounts in order to limit the possible criminal exposure of the officials and the bank for irregular loans or drug money laundering. To the extent that an official monitoring a numbered account cannot identify a customer, he cannot very well know the quality of his credit or the source of the customer's funds. To the extent that the official cannot identify the other bank officials involved in monitoring the account, they can each claim that they are not responsible for the recovery of this loan, or in a drug-related case, did not possess adequate knowledge to recognize that the funds they were moving were laundered funds. Without speculating on the possible reasons for these deficiencies, or expressing any concerns that these deficiencies might not be inadvertent on the part of BCCI, the auditors made a number of recommendations to BCCI in 1986 on how to correct them: We recommend that efforts be made to obtain current financial and other supporting information in respect to all borrowers. . . We recommend that, except in the most exceptional circumstances, funds should not be disbursed prior to the perfection of any required security arrangements. . . We recommend that independent valuations be obtained on a regular periodic basis to enable the adequacy of security to be properly monitored. . . We recommend that all charge or pledge documentation be approved by the legal department before funds are disbursed . . . We recommend that loans should not be allowed to be drawn down in excess of approved limits prior to increased facilities being sanctioned in writing. . . We again recommend that, in accordance with the group policy, interest on loans against which there is a specific loan loss provision is always created to reserve and not to income . . . We again recommend that the Central Credit Division take positive steps to ensure that branch managers throughout the Bank are fully aware that they are responsible locally for maintaining complete credit files for all loans. . . We recommend that procedures be introduced to enable management to readily identify non-performing loans. . . We recommend that all credit files contain written authorization to support the interest rate being applied to an account. . . We recommend that the Head Office manager maintain a private register of borrowers using numbered accounts. . . We again recommend that procedures be introduced to monitor and control staff loans and advances.(13) These recommendations, if followed by BCCI, and if insisted upon by Price Waterhouse, backed up by the threat of qualifying the accounts, or by the threat of resignation, would have limited BCCI's ability to continue to engage in many of the deceptions that were essential for its continued survival -- including the use of nominees to own BCCI's secretly-held subsidiaries, such as First American and the Independence Bank. In practice, BCCI continued over its remaining five years of life to abide by few of these recommendations, with the result that the auditors repeated them year after year, with ever greater specificity, while continuing to sign off year after year on BCCI's accounts, concluding that their audit reports represented a "fair and true" picture of BCCI's actual financial status when in fact they did not. BCCI's 1985 Treasury Losses In 1985, BCCI and its auditors faced the first major crisis of the bank. The crisis came in one of BCCI's flag-ship operations -- BCCI Overseas (Grand Caymans), which had been audited from its inception by Price Waterhouse. The crisis was acute and involved BCCI's Central Treasury. It required the recognition of a loss of approximately $500 million, the equivalent of the bank's entire capitalization. BCCI characterized the loss as due to as trading losses in the securities and commodities markets, ostensibly brought about through unauthorized trades by a junior BCCI officer, Ziauddin Akbar, who had been placed to run the Treasury Department by BCCI CEO Abedi. By the account of BCCI chief financial officer Rahman, Abedi and Naqvi had permitted Akbar to take "very, very large exposures," in securities and commodities trading, in what was actually a Ponzi scheme, in which front-end commissions received, representing offsets against liabilities under open futures contracts, were treated as profits rather than as offsets, and actual losses were hidden through BCCI taking ever-larger futures positions in securities and commodities trades to create offsets against the past losses; plus additional "profit" as and when required; until by the autumn of 1985 the forward exposures had become $11 billion against a board approved limit of $1 billion. According to Rahman: This was done by not more than two or three of the executives in the treasury division directly under Mr. Naqvi.(14) These huge losses imperiled BCCI on several accounts. First, they had nearly wiped out the capital of the bank, and BCCI would have to find ways to recapitalize. Second, they suggested recklessness on the part of BCCI's top officials, and made many wonder what had prompted the recklessness. But most dangerous of all, these losses could have prompted a thorough review of all BCCI's books and records from the beginning by BCCI's auditors, a review which would have brought down the bank if the auditors had discovered the frauds involved. As Ziauddin Akbar later told associates, the truth was that the losses had taken place over a number of years and were in fact not really losses at all, but falsified bookkeeping instituted by Abedi and Naqvi to inflate BCCI's books and show phony profits. According to Akbar, he agreed to be the scapegoat for the losses in an effort to avoid a situation in which the auditors would conclude that there been systematic fraud at BCCI, conducted at the top. In fact, the auditors wrongly concluded that the losses had taken place over a short period, and that did not force the further review of BCCI documents which would likely have revealed the years of systematic and massive fraud in the bank's books.(15) Instead, Price Waterhouse, working closely with Abedi and Naqvi, agreed to the shift of $150 million from the ICIC Staff Foundation/Trust to meet part of this loss, and then splitting the balance of the loss into three years on technical grounds. Akbar was fired, and BCCI was saved. Nevertheless, recognition of the losses was costly for BCCI. The losses became a significant factor in the decision soon thereafter of BCCI's regulators in Luxembourg, the Institut Monetaire Luxembourgeois (IML) to notify BCCI's other regulators that the Luxembourg authority was unhappy with its responsibility for monitoring BCCI while BCCI actually was headquartered in London. Moreover, it brought about a crisis among the auditors themselves. According to Ernst & Whinney, the Treasury losses had caused it to doubt whether the auditors could trust BCCI and Naqvi, although Price Waterhouse's confidence in Naqvi remained unshaken. As Ernst & Whinney told the British House of Commons: PW say that "Until Price Waterhouse exposed him [in 1990], Naqvi enjoyed the respect and engendered the confidence of all those who met him". E&W's confidence in Mr Naqvi was shaken when it was told for the first time on 13 February 1986 of the problems in the Treasury Division of BCCI Overseas and of his involvement therein.(16) In May 1986, Ernst & Whinney advised BCCI that unless they were permitted to assume responsibility for the whole audit and BCCI's management style were changed and its record keeping systems were improved, they would resign from their commission as auditors for BCCI. In addition to the Treasury losses, Ernst & Whinney were concerned about "a marked reluctance by both Mr. Abedi and the board of BCCI Holdings to take prompt action to disclose these [Treasury losses] to the regulators, to disclose them in the group accounts in a manner satisfactory to E&W and to discipline those responsible." Finally, Ernst & Whinney had advised BCCI that if it were to continue to act as the bank's auditors, BCCI needed to achieve "a marked improvement in the financial and managerial controls exercised throughout the group."(17) Over the following several months, BCCI, Ernst & Whinney and Price Waterhouse had extensive discussions about the changes which needed to be implemented, and had mutually agreed about the nature of the changes to be put into effect.(18) Nevertheless, for reasons which Ernst & Whinney has declined to specify, it resigned from further work auditing for BCCI, leaving Price Waterhouse for the first time in the position of being BCCI's sole global, consolidated auditor. At the time of Ernst & Whinney's withdrawal, it was auditor to 12 of BCCI's various subsidiaries and affiliates, and Price Waterhouse was auditor for the remaining 19.(19) 1987 Audits Year after year, BCCI's auditors continued to find evidence of poor banking practices and imprudent lending on issues unrelated to the massive Treasury losses. In its end of year report for 1987, Price Waterhouse noted numerous concerns on accounts involving close to $1 billion of exposure to BCCI involving many of the accounts which regulators would later conclude involved front-men. Yet no action was taken by Price Waterhouse, by BCCI's directors, or by regulators who later received these reports, to require any concrete action by BCCI, backed up by sanctions for any failure to comply, to correct the obvious banking irregularities. For example, in its 1987 audit of accounts pertaining to the Gokal brothers and their shipping empire, the Gulf Group, Price Waterhouse found that exposure to the group amounted to $318 million -- or 23 percent of BCCI's capital base, with exposure rising every year, repayment performance "below expectations," security held against the lending likely unenforceable, and financial information regarding the loans "inadequate." Three years later, Price Waterhouse would conclude that on many of the Gokal related loans, the financial information was not merely "inadequate" but non-existent. Price Waterhouse also found that "cash allocations to [some Gokal] accounts appear to be arbitrary and, as a result of this and the lack of formal repayment schedules, it is difficult to assess the underlying performance of each account."(20) In the same set of audits, Price Waterhouse found that BCCI faced exposure on loans to former Saudi intelligence chief Kamal Adham of over $200 million, involving large, unsecured exposures, "poor interest repayment performance," "no evidence of long term repayment schedule," "other related exposures with BCCI/ICIC," and that bank documents showed little evidence of regular contact between BCCI and Adham.(21) Worse, Price Waterhouse found that many of the shares Adham had in the First American Bank, CCAH, were pledge as security for loans BCCI had made to other BCCI borrowers. Nevertheless, Price Waterhouse did not require that the loans to Adham -- or to the Gokal brothers -- be classified or that BCCI make "provision" against them, so long as BCCI promised to correct the problems in the account in the future, which BCCI of course did not do. The audit of the Adham accounts mirrored that of the audit of the accounts of his successor at Saudi intelligence, Abdul Raouf Khalil. In its end of the year audit for 1987, Price Waterhouse described the situation in the following terms: AR Khalil is a Saudi Arabian national who has had facilities with the bank for a number of years. In the past the bank operated a large investment trading portfolio on his behalf, however this ceased in 1985 and he now channels his trading activities into Capcom Financial Services Limited, an independently managed investment house with a paid up capital of f25m of which he owns 20%. Little is known publicly about Khalil, however he is the owner of a substantial museum of Arabian artifacts in Jeddah reputed to be worth some $350m. This value is inherently subjective, but it is understood that he is attempting to arrange the sale of the museum to the Saudi Arabian authorities. MAJOR CONCERNS. - Lack of documented evidence of contact with borrower for 1987 - Balance confirmation outstanding -Interest unpaid -Lack of evidence of long term repayment schedule -Lack of formal documentation to secure CCAH shares . . .(22) Price Waterhouse expressed its anxieties about the Khalil account, but once again, decided that it would not force BCCI to classify any of the loans to Khalil as doubtful or bad, or require BCCI to make provision in a manner that would be reflected in its public audit, again so long as BCCI promised to clean up the problems in the future: We remain concerned about his account however no provision will be required for 1987 providing: - the account balance is confirmed to us by the borrower - interest for 1987 is fully repaid For the future we require: - full loan files to be maintained to include all details of correspondence, meetings and other pertinent evidence of the monitoring the account - adherence to an agreed repayment schedule - formalization of security arrangements.(23) In the months that followed, BCCI did not undertake any of the promised reforms, but Price Waterhouse took no action to force BCCI's hand for another two years. 1989 Audit The Subcommittee was not able to obtain any of Price Waterhouse (UK)'s reports to BCCI covering the period between December, 1987 through December, 1988, which includes the date of the indictment of BCCI and seven of its officers on drug money laundering charges by the U.S. Attorney in Tampa in October 1988, following a "sting" by the Customs Service. Audit reports to BCCI from Price Waterhouse dated November 17, 1989, demonstrate that BCCI had made very little progress in responding to any of Price Waterhouse's expressed concerns, but that relations between Price Waterhouse and BCCI had remained cordial and cooperative, and that Price Waterhouse felt at the time that BCCI was actually "performing reasonably." The audit report begins with the following sanguine assessment: Overall the bank has performed reasonably over the past year considering the significant repercussions that could have resulted from the US indictment. The Group has continued to remain relatively liquid and also attract some new business.(24) While over the course of the report, Price Waterhouse reiterated several of the concerns it had previously expressed in various other audit reports taking place over the previous six years, its overall tone was of an auditor reporting that outstanding issues were in the process of being resolved. While not free of all warnings and caveats, this 1989 interim report did indeed, consistent with Masihur Rahman's testimony, imply that no obvious major problems existed. 1990 Audit: Price Waterhouse Puts Out Red Flags The Subcommittee does not have any coherent account of why, suddenly, Price Waterhouse began in the spring of 1990 to shift from its previous position of politely making recommendations to BCCI to change its behavior, to aggressive criticism of practices at the bank that for the most part it had already been aware of for years. However, the consequences for both Price Waterhouse and BCCI were obvious. Under British law, Price Waterhouse in finding gross irregularities at BCCI, would now be able to report these findings to the Bank of England, and thereby share any responsibility for BCCI's future. In the April 1990 audit report, Price Waterhouse found that all the previous practices it had condemned and recommended be corrected, had instead persisted and worsened. Among Price Waterhouse's findings was the recognition that BCCI's lending in connection was among serious problems facing BCCI. As Price Waterhouse noted: ** BCCI faced more than $850 billion of exposure in connection with lending for First American (CCAH). BCCI's practices regarding these loans were atrocious. The number of shares pledged by some borrowers had been changing from year to year. BCCI held blank transfer deeds and powers of attorney on the shares that allowed it to transfer them at will, against lending that had been for First American itself, or any other lending to First American's shareholders. Worse, BCCI's were giving conflicting stories about whether BCCI itself owned First American or not. In past years, Price Waterhouse stated, they had been told that BCCI held all the shares of First American, and not simply those pledged as security on lending. This year, they were saying the reverse.(25) ** Many of the loans for First American had never been reduced to writing with loan agreements involving the shareholders, so there was no real way to determine what the terms of the lending were supposed to be, or whether the shareholders had actually authorized them. ** The files maintained by the bank concerning the $850 billion in lending against First American were sparse, with little evidence of customers acknowledging decisions concerning their "investments," let alone directing them. ** Interest was not being serviced on loans for First American. And the interest charges BCCI was crediting on the First American loans were substantial, without evidence that the shareholders had agreed to the interest charges. ** Audits of two companies, Midgulf and Rubstone, who had secured loans from BCCI against their ownership of stock in First American, had been certified by representatives of BCCI shareholder Mohammed Hammoud, yet now BCCI was stating that Hammoud did not own those companies, and it was not clear who, if anyone, did. ** In the past, management had told the auditors that they had not reported all the changes in share holdings in First American to federal regulators as required by law. Price Waterhouse thus acknowledged for the first time that there were serious questions as to who owned First American, and that it had known from past representations by BCCI management that the bank was violating U.S. laws in failing to tell regulators about changes in ownership when they occurred. Other findings of the new audit reports by Price Waterhouse were equally damning. Price Waterhouse found that there had been little or no direct contact with Saudi intelligence figure A. R. Khalil since 1985. Yet Khalil had still somehow purchased an additional 57,748 shares of BCCI in April 1989 in a rights offering, with money loaned by BCCI. Price Waterhouse found this disturbing, given "an apparent breakdown in the relationship between the borrower and the bank," and the fact that Khalil had not made any interest payments in five years on previous borrowing from BCCI. Price Waterhouse also found that documentation to support Khalil's borrowings from BCCI was absent, and representations by various BCCI officers about his relationship with the bank were "inconsistent." Price Waterhouse found it impossible to determine whether Khalil still owned the 13,250 shares of First American/CCAH attributed to him, which BCCI held as security against $120 million it had ostensibly lent Khalil.(26) The new Price Waterhouse reports on BCCI's relationship with the Gokal brothers and their Gulf shipping group, who together owed BCCI over $400 million, were similarly dismal. Price Waterhouse noted in addition to the kind of problems described above, violations of Indian and Pakistani exchange control violations in connection with loans to the Gokals, and statements by BCCI management that the auditors should look to the relationship of trust between the Gokals and BCCI's top officials rather than to any documents in determining BCCI's ability to recover its lending to the Gokals.(27) Concerning BCCI's banking arm in Kuwait, the Kuwait International Finance Company (KIFCO), Price Waterhouse found that placements recorded by BCCI with KIFCO were inconsistent with Kifco's financial statements regarding the same transactions. Price Waterhouse noted that the principal mechanism for repaying Kifco's loans from BCCI was a mysterious Kuwaiti entity called "the IZ company for Exchange," and that "we now have suspicions as to the propriety of the transactions." Price Waterhouse noted that it had requested access to KIFCO's records which had been denied.(28) Concerning BCCI's relationship with its Swiss banking representative (and secretly held subsidiary) Banque de Commerce et de Placements SA (BCP), Price Waterhouse stated "Swiss secrecy laws have prevented us from being provided with information relating to customer accounts by the incumbent auditors," and described a number of transactions involving BCCI, its affiliates, and BCP, which Price Waterhouse could not penetrate.(29) |