FDIC case against Ernst & Young dismissed.

A federal court in Texas dismissed the Federal Deposit Insurance Corporation's $560 million claim against Ernst & Young, which arose from the failure of Western Savings Association. Ernst audited Western in 1984 and 1985; in 1986, the thrift was placed into receivership by federal authorities.

Western's problems began in 1982 when Jarrett Woods, Jr., purchased 100% of its stock. Woods, as chairman and chief executive, placed Western on a course of dramatic expansion. Unfortunately, much of this expansion was fueled by risky loans and complex commercial ventures.

By 1984, Western's financial condition had severely deteriorated. This, along with numerous violations of Federal Home Loan Bank Board regulations, caused the board to issue a temporary order to cease and desist. As part of the terms of the order, Western hired Ernst & Young's predecessor firm, Arthur Young & Company, to audit its financial statements.

In March 1990, the FDIC filed suit against Ernst, claiming Western's reliance on Ernst's allegedly faulty audits was the cause of the thrift's demise. Ernst countered that Woods, as sole stockholder, chairman and chief executive officer, knew Western's exact financial condition and at no time relied on Ernst's audits in business dealings.

The court, in granting summary judgment for Ernst, ruled the FDIC, as assignee of Western's claim against Ernst, is subject to all defenses that Western would have been subject to had it sued Ernst. Consequently, the FDIC is charged with Wood's knowledge of Western's precarious financial condition before its closing in 1986. As such, the FDIC could not establish that Western's reliance on the alleged negligent audits was the basis for business decisions that led to the thrift's failure.

If the decision survives an appeal, other regulators' suits against accounting firms could be derailed. However, the decision is expected to have a lesser effect on thrifts owned by publicly held companies, whose directors arguably would be more likely to intervene if an audit revealed irregularities. (FDIC v. Ernst & Young, U.S. District Court for the Northern District of Texas, no. 3-90-0490-H, 9/30/91)