Chris Nelson, Big4.com
21 December 2010
Just yesterday, December 20th 2010, Monday morning the Wall Street Journal reported that there could be a case filed by the Attorney General of New York State, Andrew M. Cuomo against Ernst & Young LLP (“E&Y”) as early as this week.
And it appears that Mr. Cuomo did not waste any time and filed a Martin Act lawsuit against E&Y in New York Supreme Court.
The suit charges that E&Y helped Lehman Brothers Holding, Inc. (“Lehman”) engage in an accounting fraud for hiding tens of billions of dollars of fixed income securities from Lehman’s balance sheet to conceal its true liquidity condition from the public and investors. Further, the suit alleges that from 2001 to Lehman’s bankruptcy filing on September 15, 2008, Lehman extensively used “Repo 105” transactions, which were explicitly approved by E&Y. Repo 105 was misused to temporarily park highly liquid, fixed-income securities with European banks with an intent to decrease financial statement leverage.
This was allegedly done with E&Y’s explicit approval, by characterizing these financing transactions as “sales”, which clearly they were not – the only intent was to reduce Lehman’s leverage, thereby deceiving the investing public.
Cuomo indicates E&Y was fully aware of Lehman’s fraudulent Repo 105 transactions, approved their use and provided Lehman an unqualified audit opinion every year from 2001 to 2007, despite knowing that they concealed the Repo 105 transactions. And in 2007 and early 2008, Lehman was using Repo 105 to the tune of $50 billion.
The suit also alleges that E&Y failed to object when Lehman misled analysts on its quarterly earnings calls regarding its leverage ratios. Also that E&Y did not inform Lehman’s Audit Committee about a highly-placed whistleblower’s concerns about Lehman’s use of Repo 105 transactions.
Cuomo wants $150+ million, plus investor damages and equitable relief., being all the fees E&Y collected for work performed for Lehman between 2001 and 2008.
And equally quickly, Ernst & Young shot back with a prepared statement on PR Newswire.
In effect, the firm plans to fully defend against these civil claims, saying there is no factual or legal basis for a claim to be brought against an auditor in this context where the accounting for the underlying transaction is in accordance with the Generally Accepted Accounting Principles (GAAP). Lehman’s audited financial statements clearly portrayed Lehman as a highly leveraged entity operating in a risky and volatile industry.
Further, E&Y contends that Lehman’s bankruptcy happened in the course of huge economic distress due to dramatic increases in mortgage defaults, associated losses in mortgage and real estate portfolios, and a severe liquidity crunch. Lehman was not alone in going bankrupt. There were other bankruptcies, distressed mergers, restructurings, and government bailouts of all of the other major investment banks, as well as other major financial institutions.
E&Y further indicates that this is a misuse of the Martin Act, in asserting claims against an accounting firm, rather than the company that took the alleged actions.
And then, E&Y fires its major salvo by contending, “ In short, Lehman’s bankruptcy was not caused by any accounting issues. We look forward to presenting the facts in a court of law.”
So E&Y contends that Lehman’s bankruptcy was the result of external factors and accounting issues had nothing to do with its collapse. Granted that accounting was used to falsify its leverage reporting, but there were other business / real operating issues which the investment bank was mismanaging, and the general deterioration of economic conditions exposed its lack of good risk control and eventually to its demise. In this grand context, the misreporting of leverage played only a minor part. Repo 105 only hid one part of Lehman’s trickery, there were singular issues elsewhere, which were bigger and more dangerous.
This is a case for the ages. Cuomo could not have let the accountants off the hook in the nation’s largest bankruptcy case, and E&Y is certainly vigorously defending its position. Unless this does get settled before it goes to court, there is impending drama and lots of twists and turns to come. And E&Y’s last sentence indicates it is willing to fight in a court of law, and not agree to disagree outside the confines of a federal court.
We will be watching developments for sure, and the fireworks are yet to start, so hang on for the ride.