• Liberté, Egalité, Fraternité: Big Lehman Brothers Troubles For Ernst & Young

    By • Mar 15th, 2010 • Category: Latest, Pure Content, The Case Against The Auditors

    I’m not going to repeat Anton Valukas’ superb Bankruptcy Examiner Report, public on March 11, in detail here. I’ll offer my opinion and analysis on the “colorable claims,” Ernst & Young’s (EY) potential defenses, and any details or issues I believe may not have been covered or any questions left unanswered in other reporting.

    EY’s relationship with Lehman continued until the bitter end. So it comes as no surprise to me that EY had a hard time acting independently with their “sticky” client. Lehman Bankruptcy Examiner Anton Valukas, Chairman of Chicago law firm Jenner & Block, sums it up nicely:

    The Examiner concludes that sufficient evidence exists to support colorable claims against Ernst & Young LLP for professional malpractice arising from Ernst & Young’s failure to follow professional standards of care with respect to communications with Lehman’s Audit Committee, investigation of a whistleblower claim, and audits and reviews of Lehman’s public filings. (Bankruptcy Examiner’s Report V3, Pg 1027)

    Ernst & Young, the audit firm, had a long and lucrative relationship with Richard Fuld and Lehman Brothers. Lehman Brothers has paid EY more than $160 million in audit and other fees since fiscal year 2001. Although this isn’t nearly as much as Goldman Sachs and AIG pay PwC – almost $230 million a year combined in 2008 – it was still a huge amount and represented a significant client relationship for Ernst & Young.

    It all started with Shearson Lehman American Express back in 1975.  Lehman Brothers inherited an audit relationship with Ernst & Young when Lehman was spun off from American Express in 1994. Current Ernst & Young Global Chairman Jim Turley cut his teeth on American Express.

    From The Washington Post: “The decision to make Lehman Brothers an independent company again, owned by American Express shareholders and Lehman employees, completes American Express’s effort to rid itself of the draining weight of its extraordinary, and ultimately unsuccessful, expansion in the 1980s…the two companies will share no directors and that Richard S. Fuld Jr. will continue as president and chief executive of Lehman. Fuld, in a brief telephone press conference, said Lehman was vigorously pursuing its plan to cut costs by $200 million but could not say if that would result in further loss of jobs. “It is much more important for us to talk in terms of dollars and not in terms of people,” he said.”

    Ernst & Young was fired by American Express at the end of 2004. After a string of issues with independence that threatened EY’s credibility and their ability to accept new audit work, American Express unceremoniously dumped them and hired PricewaterhouseCoopers.

    From CFO.com: “In 2003, Amex shelled out $23 million to E&Y in audit fees, and $3.5 million for other services. The audit fee was the largest paid by any U.S.-based E&Y client…an E&Y spokesman declined to comment on the reasons the firm was dropped…E&Y has been in the Securities and Exchange Commission’s (SEC) cross-hairs for about a year, including one probe into whether the audit firm violated federal auditor independence rules by entering a so-called profit-sharing agreement in the 1990s with Amex’s travel-service unit…”

    For my first installment in this series, let’s take each “colorable claim” individually and give them a Red (toast) ,Yellow (may be vulnerable), or Green (not likely to be too damaging) rating.

    (There’s a great summary of E&Y’s myriad sins and probably soon-to-be ill-fated Financial Services Office over at Zerohedge. I will be writing more about this story, including looking more deeply into the valuation issues, the impact on the other large audit firms, the role of Lehman’s internal audit function, the specific  accounting for the Repo 105 transactions, the relationship of this bankruptcy to the Lehman bankruptcy case in the UK, and my prior theory about the fraud and additional theories for litigation.)

    Ernst & Young failed to follow professional standards of care with respect to communications with Lehman’s Audit Committee.

    Ernst & Young failed to follow professional standards of care with respect to an investigation of a whistleblower claim

    Lehman’s own Corporate Audit group led by Beth Rudofker, together with Ernst & Young, investigated allegations about balance sheet substantiation problems made in a May 16, 2008 “whistleblower” letter sent to senior management by Matthew Lee. On June 12, 2008, during the investigation, Lee informed Ernst & Young about Lehman’s use of $50 billion of Repo 105 transactions in the second quarter of 2008. At a June 13, 2008 meeting, Ernst & Young failed to disclose that allegation to the Board’s Audit Committee. (Bankruptcy Examiner’s Report V3 page 945)

    As the lawyers would say, the optics are bad here. The Audit Committee asks EY to support Lehman’s internal auditor in investigating a “whistleblower’s” allegations of balance sheet improprieties.  The auditors interview the “whistleblower” and then don’t say anything at any of the Audit Committee meetings. Turns out what Mr. Lee, the “whistleblower”, was alleging is what the examiner believes is the fundamental problem and grounds for “colorable claims” against top officers and EY.

    The word “whistleblower” is tainted with tons of emotion post-Enron. We now look at those called “whistleblowers” and see heroes. But let’s look at what I think may have actually happened. Lehman’s Internal Audit department “naturally” asked their trusted, all-things-to-all-people advisor, EY, to help with the investigation of the “whistleblower’s” claims. The Internal Audit Department, not EY, was in charge of the investigation.

    That was their first mistake. If I’ve said it once, I’ve said it a thousand times: The external auditor should not be conducting or assisting with internal investigations of potential fraud or illegal acts by top executives. I wrote about it at Siemens, subject of the largest ever FCPA settlement in history. KPMG, their auditor, got sued.

    The external auditor should stay the hell away from internal investigations because they may get caught up in something they would rather not know. They may want to claim plausible deniability. And a company should not engage the external auditor to support internal investigations especially involving fraud or illegal acts by top management. Do they do it to be cheap or to keep dirty laundry inside? The external auditor is too often part of the problem, an enabler, instead of part of the solution.

    If Lehman had hired another firm – a law firm or anyone except their external auditor – to perform the investigation, the investigation would have been covered end to end in privilege, the external auditor may or may not (in this case EY would have been better not to) have been included in the “circle of privilege,”  and the investigation would have been completed professionally.

    However, by supporting this investigation, EY was essentially doing internal audit work, a prohibited service under Sarbanes-Oxley for independence reasons. It’s shocking to me that the EY audit partners did not at least turn over the investigation to EY’s Forensic Accounting and Investigations Practice in order to provide some semblance of independence and professionalism.

    Even though EY may have been an unwilling party to knowledge of an ugly situation right before an audit committee meeting, they got stuck. They had an obligation under AU 380, as the external auditor  – not as an investigator – to inform the Audit Committee. They could have been on the other side being informed – or not – instead of being the one supposed to be doing the informing.

    AU 380, the  rules for auditor communication with the Audit Committee, are very clear. But they relate to the auditors’ role as an auditor not the role  of an auditor who is lent as muscle to an internal investigation. By playing the “trusted advisor” they screwed themselves.

    Stoplight?  Yellow. Looks bad, but EY may be able to talk their way out of this one once it gets to court. They need to explain how they were still looking into the issue, doing their “auditor” work and make sure their full but limited role and responsibilities for the process are explained. If they lose on this chalk it up to another case of audit partners wanting to be supermen to their clients, the corporation’s executives, rather than looking out for their own best interests. Unfortunately in this situation, the shareholders were probably going to lose either way.

    Ernst & Young failed to follow professional standards of care with respect to audits and reviews of Lehman’s public filings.
    “The Examiner finds that sufficient evidence exists to support the finding of colorable  claims  against Richard Fuld, Christopher O’Meara, Erin Callan, and  Ian Lowitt in connection with their actions in causing or allowing Lehman to file periodic reports that did not disclose Lehman’s use of Repo 105 transactions and against Ernst & Young for its failure to meet professional standards in connection with that lack of disclosure…While there were credible facts and arguments presented by each that may form the basis for a successful defense, the Examiner concluded that these possible defenses do not change the now final conclusion that there is sufficient evidence to support a finding that claims of breach of fiduciary duty exist against Fuld, O’Meara [CFO 2004-2007], Callan [CFO 12/07 to 6/2008], and Lowitt [CFO 6/2008 to Chapter 11 9/08]  and a colorable claim of professional malpractice exists against Ernst & Young.” (Bankruptcy Examiner’s Report V3, pages 990-991)

    This one is about mandated disclosure and, unfortunately for EY and these Lehman executives, it looks like a prima facie case of securities laws violation for the executives and malpractice for EY.

    Color this stoplight RED for “EY is burnt toast.”

    EY’s only hope is, perhaps, an “in pari delicto” defense. The Lehman executives will surely be subject to civil and criminal fraud charges. In that case, given the challenges for a Bankruptcy Trustee who, strictly speaking, stands in the shoes of felons whose actions may be imputed to Lehman, the corporation, EY may be able to try what PwC and Grant Thornton/PwC/EY have tried in the AIG and Refco cases coming before the New York Court of Appeals. But if those questions are resolved in favor of the plaintiffs, EY will not be able to count on Fuld, O’Meara, Callan and Lowitt to shield them from accountability.

    Why did this happen? Well, any obfuscation, if intentional, was meant to fool investors, ratings agencies, short sellers, counterparties and anyone else whose confidence the Lehman executives required. They wanted to appear to be in better financial shape than they really were – for as long as possible.

    They may have been prolonging the inevitable, but at some point they knew the inevitable would occur. Liquidity crises are rarely sudden. But they are often suddenly acknowledged. In Lehman’s case, the Bear Stearns failure was probably the bell that tolled hollow, loud and clear.

    So why did EY “fail to meet professional standards” in connection with that lack of disclosure? Brad Hintz, Lehman’s CFO in the late 1990’s told Bloomberg on March 12, “over ten years, a lot of venial sins add up…” I’m assuming Hintz means the mortal sin of accounting manipulation. I think, over the last ten years, EY may have ignored a lot of venial sins until “the drug we’re on,” as Lehman’s McDade calls the now notorious Repo 105 transactions, added up to the mortal sin of accounting manipulation that was hidden from investors by lack of disclosure.

    Brad Hintz told me that the average CFO tenure post-Lehman IPO 1994 was 540 days. The Examiners’s Report refers to three CFOs during the period under examination alone. I’ve already told you what was wrong with the last two, Callan and Lowitt.  You can sense their boredom and disdain for accounting details when you read their testimony.

    The Examiner spent a lot of time trying to ascertain if, when and to what extent EY knew of and had been instrumental in designing and approving the Repo 105 transactions. The evidence he gathered says EY was very involved and very knowledgeable, up to and until the “whistleblower’s” report of the abuses of the Repo 105 accounting treatment at 2007-2008 quarter ends. But the spin that lead partner William Schlich puts on the Repo 105 treatment is different. EY defends the transactions as proper GAAP.

    “According to Schlich, Ernst & Young had been aware of Lehman’s Repo 105 policy and transactions for many years…Schlich stated that Lehman introduced its Repo 105 Accounting Policy on the heels of the FASB’s promulgation of SFAS 140. During that time, Ernst & Young “discussed” the Repo 105 Accounting Policy (including Lehman’s structure for Repo 105 transactions) and Ernst & Young’s team had a number of additional conversations with Lehman about Repo 105 over the years. However, according to Schlich, Ernst & Young had no role in the  drafting or preparation of Lehman’s Repo 105 Accounting Policy. Schlich stated definitively  that  Ernst & Young had no advisory role with respect to Lehman’s use of Repo 105 transactions and  that Ernst & Young did not “approve” the Accounting Policy.

    Rather, according to Schlich, Ernst & Young “bec[a]me comfortable with the Policy for purposes of auditing financial statements.” Following  “consultation  and  dialogue”  about  the  proper interpretation and application of SFAS 140, Ernst & Young “clearly …concurred with Lehman’s approach” to SFAS 140…not based upon an analysis of whether actual Repo 105 transactions complied with SFAS 140. Rather, Ernst & Young’s review of Lehman’s Repo 105 Accounting Policy was purely “theoretical.” In other words, Ernst & Young solely assessed Lehman’s understanding of the requirements of SFAS 140 in the abstract and as reflected in its Accounting Policy; Ernst & Young did not opine on the propriety of the transactions as a balance sheet management tool.” (Bankruptcy Examiner’s Report v3, pages 948-950)

    Lehman initiated its Repo 105 program sometime in 2001, soon after SFAS 14o took effect in September 2000 Lehman’s outside auditors and lawyers participated in the firm’s review ofSFAS 140. Indeed, Lehman vetted the concept of a SFAS 140 repo transaction with its outside auditor, before the firm formalized a Repo 105 accounting policy and approved Repo 105 transactions for use by firm personnel. (Bankruptcy Examiner’s Report V3, page 765)

    That kind of comfort and confidence in your client and their technical competence comes from a long, lucrative relationship.  But it must have been more than that. It could not have possibly come from confidence in the Lehman CFO suite, given its revolving door and the lack of accounting interest and aptitude in later years.

    No.

    Ernst and Young’s confidence in Lehman’s CFO leadership was rooted in fraternity. Both Christopher O’Meara and David Goldfarb, his predecessor who was CFO from 2000 to 2004, are Ernst and Young alumni. Prior to joining Lehman Brothers in 1994, Mr. O’Meara worked as a senior manager in Ernst & Young’s Financial Services practice. Prior to joining Lehman Brothers in 1993, Mr. Goldfarb served as the Senior Partner of the Ernst & Young’s Financial Services practice, where he worked from 1979 to 1993.

    Mr. Goldfarb, the former EY Senior Partner, was the Lehman CFO who created the Repo 105  transactions.



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    23 Responses »

    1. Nice post.

      Back in my day, we had something called a “10a investigation” that took place when there was an allegation of client management wrongdoing. We took those very seriously. Basically, the question was whether we would fire the client or not. Importantly, we did not participate in the investigation; instead, we reviewed the scope, procedures, and results of the company’s investigation. The investigation was handled by third parties reporting to the audit committee.

      I found a nice paper on the topic here. http://skaddenpractices.skadden.com/fcpa/index.php?documentID=34&sectionID=32 Those unfamiliar with the topic might want to read it for kicks.

      Here’s a couple of quotes from the paper–

      The statute requires a registered public accounting firm (“auditor”or “independent public accountant”) to take certain actions when, during the course of an audit, the auditor becomes aware of information that indicates that an illegal act, whether or not material to the issuer’s financial statements, has or may have occurred. Specifically, upon becoming aware of such an act, the auditor must:
      – determine whether it is “likely” that an illegal act has in fact occurred;
      – if so, determine and consider the possible effect of the illegal act on the issuer’s financial statements;
      – inform the appropriate level of management; and
      – ensure that the audit committee of the issuer is adequately informed with respect to the illegal act, unless the illegal act “is clearly inconsequential.”

      An “illegal act” is very broadly defined in Section 10A to mean “an act or omission that violates any law, or any rule or regulation having the force of law.” The provision is activated by the possibility of an illegal act, and any potential illegal act must be scrutinized unless it is “clearly inconsequential,” rather than immaterial. Moreover, the SEC interprets Section 10A to apply to illegal acts beyond financial misconduct and even beyond an employee’s business responsibilities: Staff Accounting Bulleting 99, notes that in contrast to audit literature the definition of “illegal act” in Section 10A does not exclude “‘personal misconduct by the entity’s personnel unrelated to their business activities.”

      Based on SAS 54, independent public accountants generally take the position that determining whether an act is illegal is outside of their professional scope and must be based “on the advice of an informed expert qualified to practice law.”AU § 317.03. Accordingly, when an auditor becomes aware of information to suggest that an illegal act has or may have occurred, it is common for the burden of conducting an investigation into the conduct identified by the auditor to be shifted to the company, through internal legal resources or outside legal counsel.

      Section 10A mandates reporting by an auditor to a company’s board under specific circumstances (if the auditor concludes that there has been a material illegal act that affects the company’s financial statements, that management and the board failed to take timely and appropriate remedial action and that this failure is reasonably expected to warrant a departure from a standard auditor’s report), and the company’s board of directors must disclose such a report to the SEC within one day of receiving it from the auditor.

      I guess they do things differently now.

    2. Francine,

      I’d be interested in your take on the examiners discussion about likely strategies under SOX (covered in appendix 9, I believe)

    3. […] are entirely happy being lumped in with Tweedledum and Tweedledumber. I doubt it; Francine's article on Lehmans is pretty good, as you'd expect. Not for her the dribbling conspiracy theories beloved of our old […]

    4. So glad to see EY get burned. The is the consequence of laying off people who really looking into client documents rather than just producing litigation defense paperwork. No wonder when I told a partner that EY was sued in fall 2008, that partner was so nervous that he immediately jump on to the computer to check….

      Nice~

    5. Great post, Francine.

    6. Bye bye EY. Partners running for cover.

    7. Wonderful post, Francine. To be frank, its more to the point and sincere than any of the internal correspondence we have received inside the firm. I’d like your thoughts on the counter-points – namely, would the market tolerate EY failing? Three global audit firms is probaly three too few, wouldn’t you agree? And if EY survives, what kind of future do all audit firms face? Super regulation?

    8. @jak25

      You’ll like what’s coming up today @Going Concern. It addresses specifically EY litigation and failure. I will explore post- potential failure in a post next week.

      Thanks for the feedback.

    9. I would like to hear from EY partners about the communications you are receiving from leadership on the Lehman issue. If you or any Senior Managers/Directors that have been privileged to see this correspondence would like to share this information, please get in touch. I am particularly interested in talking to former Andersen partners who are now with EY. I’d like to get your thoughts, feelings about going through this scrutiny and uncertainty once again.

      fm

    10. Great post. Most insightful. BTW, if you’re still coveting Erin Callan’s Louboutins, you should probably watch for her upcoming garage sale.

    11. […] Every two-bit journalist and blogger on the business beat is spitting out stories to keep up and one-up each other. It’s not every day that the accounting firms provide so much gossip about spectacular criminal and civil penalties. Well, actually, it is every day. There’s almost a thousand stories at re: The Auditors pointing to just such an outcome if any of the Big 4 ever looked down the barrel of a litigation shotgun like Lehman. […]

    12. […] Liberté, Egalité, Fraternité: Big Lehman Brothers Troubles For Ernst & Young […]

    13. Talk of EY closure. I have heard of the big 4 being called the final four due to Alberto Gonzalez reportedly intending to close down KPMG a’ la AA during the tax shelter thing. I was told (can’t get more reliable than that) the Alberto was advised by someone somewhere in D.C. that you cannot have a big 3 and avoid conflicts of interest. Four is the minimum, so Alberto reluctantly took alternative action towards KPMG.

      That would suggest EY does not close its doors regardless of how things play out. That big sign in midtown stays. This realization may have created yet another morale hazard internally at EY.

      Moral hazard as malicious intent to exploit an insurance or legal advantage, morale hazard as gross negligence due to reliance on insurance or some technicality. I was told that too, by the same guy.

    14. […] a full (serious) and interesting dissection of the issues check out this post from re: The Auditors. Related PostsBankruptcy Bill – Strip #8 – General Motors […]

    15. […] a new batch of Ernst & Young auditors arrived at Lehman Brothers each year, Repo 105 transactions must have caused debate. After all, a transaction that’s called a “Repo,” short for […]

    16. […] by Paul Barrett, an Assistant Managing Editor at Business Week on Anton Valukas.  Valukas is the Lehman Bankruptcy Examiner, a Chicago guy, and Managing Partner of law firm Jenner & […]

    17. […] the Lehman bankruptcy examiner report came out this past March, with fingers pointing clearly at executives and auditors Ernst & […]

    18. […] Every two-bit journalist and blogger on the business beat is spitting out stories to keep up and one-up each other. It’s not every day that the accounting firms provide so much gossip about spectacular criminal and civil penalties.  Well, actually, it is every day.  There’s almost a thousand stories in the re: The Auditors pointing to just such an outcome if any of the Big 4 ever looked down the barrel of a litigation shotgun like Lehman. […]

    19. […] is an insider’s and a trader’s perspective. It was published in July of 2009, before the Lehman Bankruptcy Examiner’s Report shed so much light on Repo 105 and the rest of the sins of Fuld and Co. In particular, Anton […]

    20. […] questions were asked about Ernst & Young’s potential lack of independence or objectivity as developers and approvers of the Repo 105 technique used for […]

    21. […] client and its CFO during the period leading up to the fraud was an Ernst & Young alumnus, just like that other financial institution, Lehman that failed later that year. (S. Blair Abernathy, who settled immediately with the SEC and had […]

    22. […] & Block chairman, non-armchair prosecutor, and corporate defense attorney Anton Valukas, the Lehman Bankruptcy Examiner, provide unequivocal evidence for prosecutors of “colorable claims” against Lehman executives […]

    23. […] Well, that’s changed post-financial crisis.  In addition to the big frauds like Satyam, Glitnir, the Madoff feeder funds and garden variety accounting malpractice claims, the auditors are named in high profile subprime cases where fraud is alleged such as New Century and Lehman. […]

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