Banks rely on various professionals to help them assess the financial health of their borrowers. But sometimes these professionals make mistakes. As experts in quantifying economic damage, we at MDD are often asked to quantify the losses sustained by lenders as a result of professional negligence. The following case study illustrates some of the issues we consider.
Bankco has advanced a line of credit to BorrowCo. The decision to lend money to BorrowCo was based on an analysis of BorrowCo’s financial health. The limit on the line of credit was set at 75 per cent of BorrowCo’s accounts receivable (AR).
Bankco grows suspicious of the AR balances that BorrowCo has been reporting. It turns out that, without its accountant’s knowledge, BorrowCo is in deep financial trouble and has been manipulating its AR balances. Bankco calls its loan, forcing BorrowCo into receivership; it also sues the accountant for negligence for having failed to detect the manipulation. Bankco’s losses resulting from the accountant’s alleged negligence will be the difference between:
- a) The amount of money it actually lost on its loan, and
- b) The amount of money it would have lost had it been provided with accurate financial information.
There are three steps to calculating this second amount.
- The first step is to determine if a loan would have been issued based on correct information. We may find that BorrowCo’s finances were in horrible shape from the beginning, and that Bankco would have never advanced any money had it known that. If so, this is the end of the analysis: Bankco’s loss is the amount it actually lost.
On the other hand, we may find that BorrowCo was in good shape when the line of credit was first set up, and that it would have met the bank’s lending criteria. It was only later that things took a turn for the worse. If so, we proceed to the second step in the analysis.
- The second, two-stage step is to look at:
- a) when the bank would have called the loan based on accurate information, and
- b) how much money would have been owed to the bank when it called the loan.
- The final step i to determine what Bankco’s recovery would have been had it called the loan at the earlier date. A starting point for this analysis is the actual recovery achieved when the loan is called. However, the money that the bank would have recovered if it had called the loan earlier will likely differ from the bank’s actual recovery following the discovery of the misstatements.
In cases involving lenders, figuring out how much money was lost is comparatively easy. The more challenging part is estimating what would have happened if correct information had been provided.
By Ephraim Stulberg. Published in the November 2017 edition of Insurance People.