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Mon 27 Dec 2010 01:13 PM

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Ernst & Young is nuts to say Lehman was clean

E&Y must magic up a better defense before it gets to court, says Jonathan Weil

Ernst & Young is nuts to say Lehman was clean
Lehman Brothers filed for bankruptcy protection on September 15 2008, signalling the start of a global financial crash. (Getty Images)

Two
weeks before New York Attorney General Andrew Cuomo’s office sued Ernst &
Young, a prominent US-based consulting firm issued a press release touting its
ability to help others manage the risk of fraud.

“As
companies return to growth, new risks related to fraud and corruption will
emerge, bringing compliance to the forefront for boards of directors, audit
committees and senior management of global companies,” the firm said.

“Dealing
with complex issues of fraud, regulatory compliance and business disputes can
detract from efforts to achieve your company’s potential. Better management of
fraud risk and compliance exposure is a critical business priority -- no matter
the industry sector.”

Talk
about chutzpah. The firm that wrote that was none other than Ernst & Young,
the longtime outside auditor for Lehman Brothers Holdings Inc, which went
bankrupt in 2008 while sporting financial statements that bore little evidence
of the calamity to come. Sure, E&Y may have lots of experience in this
field. Much of it, though, is the wrong kind.

In
its civil lawsuit this week, Cuomo’s office alleged that E&Y helped Lehman
engage in a massive accounting fraud-  and
committed fraud itself in the process. The surprise wasn’t in the suit’s
factual assertions, many of which were contained in a March report by Lehman’s
bankruptcy examiner, Anton Valukas. Allegations of misconduct at E&Y have
become such a routine part of the firm’s business that they’ve come to be
expected.

Rather,
the big news was that anyone filed the case at all, and that it was the
departing New York attorney general who did it instead of the Securities and
Exchange Commission. Finally there’s a sign some outfit at the epicenter of
Lehman’s collapse might be held accountable. Still, it’s more than a bit odd
that the defendants in Cuomo’s suit didn’t include anyone who worked for
Lehman, or any of the E&Y accountants responsible for auditing the
securities firm’s books.

E&Y
had established itself as a repeat offender long before Governor-Elect Cuomo
filed his suit. In recent years we’ve seen four former E&Y partners
sentenced to prison for selling illegal tax shelters, while other partners have
been disciplined by the SEC for blessing fraudulent financial statements at a
variety of companies, including Cendant Corp. and Bally Total Fitness Holding
Corp.

In
the Bally case, E&Y last year paid an $8.5m fine, without admitting or
denying the SEC’s professional-misconduct claims. The SEC also has imposed sanctions
against E&Y three times since 2004 for violating its auditor-independence
rules.

Yet
it seems there’s little anyone can do to keep E&Y on the straight and
narrow. Killing E&Y or any of the other Big Four audit firms - PricewaterhouseCoopers,
Deloitte & Touche and KPMG - would leave just three large survivors, when
the industry has too few competitors already.

We
can’t have another firm go down like Arthur Andersen did after its indictment
in 2002, the conventional wisdom goes. And so these firms are permitted to plod
along, fending off one regulator after another, knowing they will be allowed to
carry on no matter how much they offend the public’s sense of decency.

The
latest case against E&Y stems from Lehman’s use of transactions the
investment bank called Repo 105. Lehman used these deals to move as much as
$50bn of securities off its balance sheet in a given quarter and temporarily
reduce its reported debt, usually for about a week at a time. Lehman got the
assets off its books by treating the transactions as sales rather than
financings for accounting purposes. This let Lehman show lower leverage ratios,
according to Valukas’s report.

That
E&Y hasn’t changed its ways is clear from the press release it issued this
week responding to Cuomo’s suit. “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,” the firm said.

That
isn’t an accurate depiction of the claims Cuomo brought, though. Cuomo’s suit
unambiguously took the position that Lehman violated GAAP. What’s more, it’s
not credible for E&Y to say that Lehman didn’t. (An E&Y spokesman, Charles
Perkins, said he “can’t comment beyond our statement.”)

In
the footnotes to its audited financial statements, Lehman said it accounted for
all its repurchase agreements as financings. This was false, because Lehman
accounted for its Repo 105 transactions as sales, a point the Valukas report
chronicled in exhaustive detail.

Back
to Class

As
any freshman accounting major can tell you, it’s a violation of GAAP for a
company to tell investors it’s using one type of accounting treatment when it’s
actually using another, especially when the method it’s secretly employing
makes its balance sheet look stronger. Yet E&Y still insists that Lehman
followed the rules. It’s hard to tell which is more insane: The notion that
E&Y’s bosses might believe their own spin, or that they think anybody else
will.

It’s
indisputable that E&Y blessed Lehman’s financial statements quarter after
quarter, year after year, falsehoods and all. What the state would need to
prove to win at trial is that the firm’s actions amounted to fraud.

For
the time being, E&Y is saying it looks forward to presenting the facts in a
court of law. If it hopes to prevail there, it will need to come up with a more
believable defense than the nonsense it’s trumpeting now.

 

(Jonathan
Weil is a Bloomberg News columnist. The opinions expressed are his own.)

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Dr. Raj Michael 9 years ago

It has been along time tradition for auditors just to review the books kept by their clients without commenting on the "right" vs. "wrong" aspect of their book keeping.

The term "independent" auditor is a false, since the auditor is being paid by the client.

A true independent audit function would be funded by the SEC and be accountable for their results.