Chris Nelson, Big4.com
20 December 2010
The Wall Street Journal is reporting today that New York State Attorney General Andrew Cuomo is very close to filing a civil fraud charge suit against Ernst & Young (E&Y) for its role as the company’s statutory auditors in the September 2008 bankruptcy of Lehman Brothers. The charges allege that E &Y did not fully discharge its fiduciary duty to investors in standing by while Lehman continually used its Repo 105 accounting trickery to falsify its leverage.
As many may recall, Anton Valukas came out with a detailed report on the bankruptcy recently where he explained how Lehman abused the Repo 105 to show a lower leverage at the end of each quarter. This led investors to have an incorrect read of the true leverage of the firm, which was multiples higher than what was being reported on its public financial statements.
See our blog post earlier where Valukas noted that E&Y was negligent
And in that blog post we said…
“Valukas is highly critical of E&Y’s work, claiming that they did not perform the due diligence needed by audit firms, the ultimate watchdog of investors’ interests. He believes there is a case of negligence and professional malpractice against the firm. Though in a very limited sense Lehman perhaps followed standard accounting principles, and this is the basis on which E&Y signed off on their annual and quarterly filings, they wrongly categorized a repo as a sale to knowingly report a lower leverage ratio, they exceeded internal limits on the infamous Repo 105, and they found a loophole in the British system to execute these transactions, and keep them off the public eye.
Lehman was clearly at fault and grossly fraudulent in hiding this from investors, and then obfuscating answers to clear questions from analysts. Is Ernst and Young equally culpable?
E&Y should have been more rigorous in pursuing this issue, knowing that it was material, being misrepresented and highly abused. With full knowledge of its usage, and then signing off on SEC documents is definitely negligent.”
So, now it appears that legal authorities have taken note of Valukas’ analysis and proceeding with a suit against the auditors in the Lehman case, the first case against any auditor in the recent financial crisis.
For a long while Lehman Brothers was one of Ernst & Young’s biggest clients with about $100 million in audit fees between 2001 to 2008. (Interestingly, PwC UK is making a lot of money on the Lehman Brothers Europe administration. So it looks like Lehmans pays going in and on the way out!)
While the WSJ says that a case is likely before the end of the week, it is also possible that E&Y will try to settle before any suit is filed.
Valukas found that Ernst & Young specifically approved of Lehman’s use of Repo 105 transactions and provided the investment bank with a complete audit opinion from 2001 through 2007. E&Y claims that Repo 105 was a valid accounting procedure in of itself, but Lehman essentially abused this treatment to the tune of $50 billion.
In our earlier post, we said….”The next few days will reveal how the regulators, erstwhile shareholders of Lehman and other stakeholders will move against E&Y. Valukas’ statement that there is sufficient evidence to show that E&Y was negligent is enough to spur a whole host of law suits.
E&Y is in a very tough spot now, and while it may escape an imploding collapse like Andersen, the long tail of Lehman is sure to create a strong whiplash with painful monetary, reputational and punitive consequences.”
So it took longer than a few days, but the Attorney General intended actions will likely impact E&Y in a quite serious fashion. While the auditor will likely claim its innocence and adherence to strict technical accounting rules, the willful manipulations of accounting procedures to deceive investors should not have escaped the auditors. More so, Matthew Lee, a Lehman employee, did blow the whistle on Repo 105 to Lehman superiors (and was promptly let go) and further did confer with E&Y, but E&Y did not appear to take that quite seriously.
So the next few days will be telling, in that if the case does get filed, it will be quite troublesome for E&Y, and if the case ends up being settled, it will be with some severe financial consequences and constraints on auditing practices. Note that the SEC came down quite hard on E&Y on the Bally Fitness, exacting a number of promises on the firm to strengthen its audit practices.
We’ll keep monitoring this development and sure to be some surprises in the coming days.