Complex derivatives are unnerving that part of the accounting industry that audits mutual funds.

Principal-only SMBSs - stripped mortgage-backed securities that entitle the owner to a return based on the repayment of the principal from home mortgages - was one type of a handful of derivatives in the Piper Institutional Government Income Fund in the early 1990s. The fund's ownership of those derivatives proved to be unfortunate because the investments were particularly sensitive to rising interest rates. When rates rose in 1994, the derivatives lost value.

Now, a group representing about 8,000 shareholders who invested in the fund between 1991 and 1994 wants the Institutional Government Income Fund's auditor, KPMG Peat Marwick LLP of New York, to pay approximately $200 million to cover alleged losses arising out of the derivative investments. The principal-only SMBSs and other derivatives in the Institutional Government Income Fund violated the fund's investment restrictions and did not belong in the fund, according to a lawsuit pending in federal court in Minneapolis, Minn. KPMG had a duty to identify the derivatives, conclude that they violated the fund's investment restrictions and disclose that fact, according to investors suing the firm.

Much to the consternation of the accounting profession, a federal district court judge last month refused KPMG's request to throw out the case before trial. It is now up to a jury to decide whether KPMG's accountants made a mistake in their audits of the Piper Institutional Government Income Fund, U.S. District Court Judge Donovan W. Frank ruled in a nine-page decision Aug. 4. The trial is scheduled for Feb. 1.

A KPMG spokesperson said the firm is disappointed with Frank's ruling and that KPMG executives expect to prevail at trial. He declined to comment further.

Frank's decision is without precedent and poses a threat for the accountants who audit mutual funds, according to accountants and lawyers in the mutual fund industry. Frank's opinion and a May, 1998 decision in the same case issued by the federal appeals court in St. Louis, Mo. have the effect of inappropriately expanding the duties of accountants, according to fund industry lawyers and accountants.

The courts now want the accountants - whose primary duty is to identify and quantify the value of a fund's holdings - to render a legal opinion on whether those holdings are consistent with a fund's investment restrictions, fund industry accountants and lawyers said. That, they say, is wrong.

Accountants "are not lawyers," said Larry Friend, an accountant at PricewaterhouseCoopers of New York and former chief accountant for the SEC's Division of Investment Management. "They don't make those kinds of legal judgements."

Vernon Vander Weide, however, a lawyer with the firm of Head, Seifert & Vander Weide in Minneapolis, disagreed with accountants' contentions that the KPMG case is inconsistent with the accounting industry's standards.

"I don't view (the Aug. 4 decision) as an expansion at all," Vander Weide said. "This whole case is predicated on the accounting profession's own rules."

The Audit and Accounting Guide for the American Institute of Certified Public Accountants of New York requires accountants to obtain "reasonable assurance" that a fund's holdings comply with its investment restrictions. That standard has been in effect since 1986, accountants say. Facts uncovered in the KPMG case so far support the allegation that KPMG failed to meet that industry standard, according to Vander Weide.

The issue of how far an accountant's duty reaches is under scrutiny outside the KPMG case. As part of an update of the Audit Guide, the accounting industry is considering a change in the "reasonable assurance" language. Proposed revisions to the Audit Guide state that an auditor ordinarily does not have a sufficient basis to recognize violations of a fund's investment restrictions. The revised Audit Guide is expected to go into effect next year, an AICPA spokesperson said.

"They're diluting the rules," Vander Weide said.

Accountants' oversight of publicly-traded companies' financial statements help provide transparency and reliability to financial markets, Vander Weide said. Changes that reduce accountants' oversight diminish investor protection, he said. Accountants' oversight has become even more important as more and more average citizens invest in the financial markets, Vander Weide said. And new laws have made it harder to sue for alleged fraud in financial statements, a fact that further erodes investor protection, he said.

The combination "has the makings of a real fiasco," Vander Weide said. "We're moving in the wrong direction as far as I'm concerned."

Accountants rejected the criticism. The Audit Guide proposals reflect changes in securities themselves, according to accountants. In 1986, securities were comparatively easy to evaluate, accountants say. During the past 13 years, the development of derivatives has made it difficult for accountants to assess whether some complex securities satisfy or violate a fund's investment restrictions, the accountants said.

"You've got securities out there that look like one thing but are another," said Anthony Evangelista, an accountant at PricewaterhouseCoopers.

That, and the fact that accountants are not legal experts, is driving the proposed change in the Audit Guide, according to the accountants.

A fund's portfolio manager is the first defense against a fund violating its investment restrictions, said Paul Kraft, an accountant at Deloitte & Touche LLP of New York. In addition to the portfolio manager, the compliance executives at a fund's investment adviser are responsible for overseeing compliance with investment restrictions, accountants said.

Pamela Wilson, a lawyer at Hale & Dorr of Boston who advises fund companies, also said compliance with investment restrictions is a fund company's responsibility and not the accountants'. "It simply, flatly, isn't their job," Wilson said. Expanding accountants' duties to cover compliance with investment restrictions would dramatically increase the cost of audits, Wilson said.

For now, KPMG faces the prospect of explaining its work to a jury that will listen to weeks of testimony on highly technical matters about such things as principal-onlys before rendering a verdict. Some observers find the prospect disturbing.

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