The Case Against Ernst & Young: NY AG Cuomo Sues Over LehmanBy Francine • Dec 22nd, 2010 • Category: Latest, Pure Content, The Case Against The Auditors
News broke late Sunday night, December 20, that the New York Attorney General would charge Ernst & Young (EY) with fraud over their involvement as auditors of Lehman Brothers.
Michael Rapoport of the Wall Street Journal, who you may have seen me mention here, teamed up with his fraternal news twin Liz Rappaport, to get the scoop. Rapoport told me in November when we met at the FEI Current Financial Reporting Issues Conference that he had been named the Wall Street Journal’s full time Accountancy reporter. I hope that the Wall Street Journal sees the value in full time coverage of this industry, not only when important news is breaking but when others have gone on to other things. His experience, dogged pursuit of contacts, and the desire for early scoops are what we need to tell the story of the Big 4 audit firms. The Wall Street Journal has been all over this story as it has developed.
I saw the Google Alert on the first Wall Street Journal story very early Monday morning and by 8:30 CST had my story posted at Forbes.
Ernst & Young may find a lump of coal in its Christmas stocking this year.
New York’s Attorney General Andrew Cuomo will file charges as early as this week against auditor Ernst & Young (EY) for its role in the Lehman Brothers collapse, according to the Wall Street Journal. Fraud charges against EY are expected to be focused on its role as enabler of the infamous Repo 105 transactions that Lehman used to “window-dress” its balance sheet…
Charges against EY, the firm, by US federal authorities would be embarrassing at best and catastrophic at worst. Civil charges by the SEC against Ernst & Young could put its bosses, the US Treasury, in a very bad spot. The Treasury is paying EY millions to help clean up the mess left by other firms as contractors to the government’s various bailout programs like TARP. Criminal charges against EY by the DOJ could precipitate a failure of the firm, a la Arthur Andersen. No one in the US federal government has a plan in the event another large audit firm fails and they certainly don’t want to be the ones to cause it.
Better to let New York do the dirty work.
Whether Cuomo is doing this on his own, in defiance of the Feds, or has their implicit blessing in light of the Federal Government’s seeming unwillingness to act, New York’s Attorney General is showing the world he’s the only one in the US with the nerve to shake this tree. He follows the UK House of Lords’ Economic Committee who recently asked UK leaders of all of the Big 4 audit firms – Deloitte, Ernst & Young, KPMG and PricewaterhouseCoopers – about the absence of warnings or “going concern” qualification for banks that failed or were bailed out.
The auditors’ response: The Bank of England told us, in confidence, that they would support the banks financially.
For the sake of justice, let’s hope New York State doesn’t settle for too little too soon. The state certainly could use the money from fines, but we need more illumination of the role of auditors during the financial crisis. The New York Attorney General can shine a bright light on EY – something the SEC, the Department of Justice, and Congress are not yet doing.
I also did an interview with a reporter from Marketplace that ran early Monday morning on NPR. The Street.com wrote a great story that was mostly my quotes. Colin Barr over at Fortune gave me a nice shout out in his story on Monday, too.
I started writing a followup for Forbes very early Tuesday morning, focused on the legal strategies of the New York Attorney General, the SEC, and the Department of Justice. I had to revise the story quickly to include the actual lawsuit information when it hit mid morning. Then I got a call from Dan Bigman, the Forbes Executive Editor for business news: Could I get a story ready asap to put on their online front page?
New York’s Attorney General (NY AG) Andrew Cuomo filed his lawsuit against Ernst & Young (EY) today. We have some answers, for now, about what he’s up to. Cuomo’s following the proud tradition of former NY Governor and Attorney General Eliot Spitzer in using New York’s Martin Act to make the claims...
Why did the NY AG apparently beat the SEC or Department of Justice to the punch with charges? My theory is that Cuomo was pursuing the Lehman executives, along with other bank executives, as part of their overall investigation of the use deceptive balance sheet window-dressing techniques like Repo 105. Maybe the responses to the SEC’s “Dear CFO Letter”, which asked questions about Repo 105 use, gave Cuomo’s office a head start on potential charges of deceptive financial statements. Lehman is just the biggest and most well documented example, but the practice was pervasive.
Cuomo’s move to the Governor’s mansion may have prompted his team to put a charge, if not a settlement, with at least one of the banks on the board regarding Repo 105. The NY AG has a convenient tool, the Martin Act, to use to do this more quickly than the SEC. They can potentiallysqueeze a settlement soon, paving the way for others to fall like dominoes for Mr. Cuomo’s successor.
Why did the New York Attorney General choose to charge Ernst & Young rather than Lehman executives? Many of the conclusions and footnotes to interviews in Jenner & Block Chairman Anton Valukas’ Lehman Bankruptcy Examiner report allude to the difficulty in getting EY’s Schilch and Hansen to give straight answers. The EY partners don’t come across, to me, as very cooperative and forthcoming.
On the subject of materiality, for example, EY’s Schlich refused to do what an audit firm gets paid to do – opine:
(3) Ernst & Young Would Not Opine on the Materiality of Lehman’s Repo 105 Usage
Ernst & Young, through Schlich, was unwilling to comment to the Examiner on the materiality of the volume of Lehman’s quarter‐end Repo 105 transactions. Asked whether, as part of its responsibility to ensure Lehman’s financial statements were not materially misstated, Ernst & Young should have considered the possibility that strict technical adherence to SFAS 140 or any other specific accounting rule could nonetheless lead to a material misstatement in Lehman’s publicly‐reported financial statements, Schlich refrained from comment.
From page 954 of Volume 3 of the report
There were a lot of “I don’t recall” and “That was not part of our audit scope” responses from EY in the Valukas report. There were also fingers pointed at each other between between EY partners Schlich and Hansen. But most telling is this conclusion, included as a footnote on page 991 ofVolume 3 of the report, which focused on the Repo 105 transactions:
Prior to this invitation and during Schlich’s four‐day interview as an Ernst & Young representative, the Examiner invited Ernst & Young to opine on why Repo 105 transactions were proper and did not result in Lehman filing materially misleading financial statements…Schlich replied that the transactions were proper if they complied with Lehman’s self‐defined Accounting Policy. Id. Despite an additional invitation from the Examiner, Ernst & Young has not offered any further explanation.
I think the NY AG’s investigators questioned EY and its partners first as part of building a case against Lehman executives. When EY was as difficult and non-cooperative as they seem to have been with Valukas, the NY AG decided to redirect their energies to the auditors. They had the Lehman Bankruptcy Examiner’s report as a road map, an almost-ready for prime-time template for a complaint against the auditors.
How could they resist?
Lesson: Don’t try to play Cuomo. He hates that.
There’s more in both of my stories at Forbes, including why no EY individual partners were charged by Cuomo, so please go there and read them. (Felix Salmon also writes about the “no individual accountability” issue at his blog on Reuters. Worth a read.)
There’s been plenty of other great coverage of the story. Caleb Newquist has done a yeoman’s job compiling blurbs from other journalists, some of whom only report on the accounting industry “once during a lunar eclipse on the winter solstice.”
EY finally came out with an official response late yesterday. As you may recall, they waited quite a long time to respond to the Lehman Bankruptcy Examiner’s report, too. They wrote letters to Audit Committee members – their bread and butter clients – members defending their actions, first.
The EY response to the New York Attorney General’s lawsuit:
What’s the big deal?
The Wall Street Journal’s Deal Journal Blog has the text of their official response.
(WSJ continues to kick tail on this story.)
We intend to vigorously defend against the civil claims alleged by the New York Attorney General.
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.
Lehman’s bankruptcy occurred in the midst of a global financial crisis triggered by dramatic increases in mortgage defaults, associated losses in mortgage and real estate portfolios, and a severe tightening of liquidity. Lehman’s bankruptcy was preceded and followed by other bankruptcies, distressed mergers, restructurings, and government bailouts of all of the other major investment banks, as well as other major financial institutions. In short, Lehman’s bankruptcy was not caused by any accounting issues.
What we have here is a significant expansion of the Martin Act. Although the Martin Act is almost 90 years old, we believe this is the first time that an Attorney General is attempting to use this law to assert claims against an accounting firm, rather than the company that took the alleged actions.
We look forward to presenting the facts in a court of law.
John McDermott at FT Alphaville does a superlative job of telling us why EY may have a harder time than they think. Andrew Cuomo is the New York Attorney General who is headed to the the Governor’s mansion any day now a la Eliot Spitzer – his model for aggressive prosecution of those who cheat investors. He ripped EY to shreds in the complaint:
Breaking this down, there are three main allegations related to the way E&Y did not follow GAAS and therefore ‘permitted Lehman to engage in an accounting fraud.’
First, E&Y was required to discuss with Lehman’s Audit Committee the quality of Lehman’s accounting principles as applied to financial reporting.
What were they supposed to discuss? Um, unsurprisingly, quite a lot.
In particular, E&Y allegedly did not communicate known concerns about the legality of using American-based securities in Repo 105 transactions. As we noted in March, the UK law firm Linklaters provided a “True Sale” opinion covering non-USoperations, led by Lehman Brothers International Europe (LBIE), which naturally took the lead on Repo 105 transactions. But no US law firm had approved Repo 105. E&Y were supposed to mention this — but allegedly did not…
Other issues that Cuomo alleges E&Y should have brought to the audit committee and didn’t, include the spiralling volumes of Repo 105 transactions in 2007-08, concerns over “reputational risk” to Lehman that were made internally in E&Y, and misleading public statements from Lehman about its leverage.
Next allegation of non-GAAS activity:
Second, upon learning that Lehman intended to embark on Repo 105 transactions for no reason other than to “manage balance sheet metrics,” and the increased use of these transactions in 2007 and 2008, E&Y was required by GAAS to conduct a bona fide investigation of Repo 105 and inform management and the Audit Committee of the relevant issues.
This refers to there being no investigation into the well known (now at least) uses of Repo 105 — obfuscating “sales” and “loans”, pumping up balance sheets at reporting times, facilitating higher leverage, and so on.
And the final one:
Third, AU §§ 336 and 9336 address an auditor’s use of a legal opinion as evidential matter supporting, for instance, a management assertion that a financial asset transfer meets the “isolation” criterion in FASB 140. AU § 9336 states that a legal letter that includes conclusions using certain qualifying language would not provide persuasive evidence that a transfer of financial assets has met the isolation criterion of FAS.
Not only was the Linklaters letter replete with qualifying statements, but E&Y knew that no United States law firm had approved the Repo 105 transactions and that Lehman had to conduct the Repo 105 transactions through a United Kingdom-based affiliate, LBIE. E&Y failed to consider whether it could rely on the Linklaters opinion letter at all, much less in connection with securities that originated in the United States.
So, again the complaint comes back to the Linklaters opinion letter — or more specifically E&Y’s alleged failure to raise its narrow focus as an objection to Repo 105 practices…
Finally, the Martin Act is the law used by Cuomo to bypass all the other constraints mere mortals have in suing the Big 4 audit firms. It’s quite a powerful tool, as Eliot Spitzer showed us. Again, the Wall Street Journal is all over it. Their Law Blog explains to us how “Jedi warrior” powerful this law really is.
In the lawsuit filed against accounting firm Ernst & Young, Andrew Cuomo brought four claims, three of them under New York’s Martin Act, one of the most powerful prosecutorial tools in the country.
Technically speaking, the Martin Act allows New York’s top law enforcer to go after wrongdoing connected to the sale or purchase of securities. Nothing too noteworthy there.
But what is noteworthy is the power the act confers upon its user. It enables him to subpoena any document from anyone doing business in New York and, if he so desires, keep an investigation entirely secret. People subpoenaed in Martin Act cases aren’t afforded a right to counsel or the right against self-incrimination. “Combined, the act’s powers exceed those given any regulator in any other state,” wrote Nicholas Thompson in this 2004 Legal Affairs article.
And we haven’t even gotten to the kicker. Courts in civil Martin Act cases have held that “fraud” under the Martin Act “includes all deceitful practices contrary to the plain rules of common honesty and all acts tending to deceive or mislead the public, whether or not the product of scienter or intent to defraud.”
In other words, in order to prove a Martin Act violation, the attorney general is not required to prove that the defendant intended to defraud anyone, only that a defrauding act was committed…
Ernst & Young leadership had better hire some powerful lawyers to defend the firm.
Oh wait…They have.
At least the lawyers are talking, even if EY is pretty much speechless.
Ernst & Young’s spokesperson Charlie Perkins has not yet responded to any of my requests for comment.