Cuomo sues E & Y over Lehman

Cuomo sues E & Y over Lehman

Peter Lattman, The New York Times

The New York attorney general, recently, sued Ernst and Young, accusing the accounting firm of helping its client, Lehman Brothers 'engage in a massive accounting fraud' by misleading investors about the investment bank's financial health.

The lawsuit, filed more than two years after Lehman collapsed and the global economy buckled, is the first major legal action stemming from Lehman's demise.
Ernst & Young, certified the bank's financial statements from 2001 until it filed for bankruptcy in September 2008. The suit focuses on Ernst & Young's approval of a much-criticised accounting maneuver that shifted debt off the books before the close of financial quarters.

The transactions involved "the surreptitious removal of tens of billions of dollars of securities from Lehman's balance sheet to create a false impression of Lehman's liquidity, thereby defrauding the investing public," the complaint said.

The lawsuit seeks the return of more than $150 million in fees that Ernst & Young collected for work performed for Lehman from 2001 to 2008, plus investor damages.
Among the world's largest accounting firms — and one of the Big Four auditors — Ernst & Young audits the financial statements of many of the world's largest corporations, including Coca-Cola and Google.

In a statement, Ernst & Young denied the lawsuit's claims. "There is no factual or legal basis for a claim to be brought against an auditor" when the transactions at issue followed generally accepted accounting standards, the firm said.

"Lehman's audited financial statements clearly portrayed Lehman as a highly leveraged entity operating in a risky and volatile industry," it added.

With just 10 days left as the attorney general of New York, Andrew M Cuomo, the governor-elect, will hand off the lawsuit to Eric T Schneiderman, who is succeeding him.

Eric Schneiderman and his yet-to-be-announced legal team will have to bone up on an accounting maneuver known inside Lehman as Repo 105.

This tactic temporarily removed as much as $50 billion of assets from Lehman's balance sheet to give the appearance that the firm had reduced its debt levels. It often did this just before the end of a financial quarter, the lawsuit said.

"This practice was a house-of-cards business model designed to hide billions in liabilities in the years before Lehman collapsed," Cuomo said in a statement. "Just as troubling, a global accounting firm, tasked with auditing Lehman's financial statements, helped hide this crucial information from the investing public."

The 32-page complaint, filed in New York Supreme Court, follows the contours of the claims made in a 2,200-page report by a bankruptcy court examiner, Anton R Valukas, a lawyer. The attorney general's investigation of Ernst & Young began after the release of the report in March.

"As we said in the report and as I testified before Congress, we believe that the underlying facts of the report would support charges against E&Y (Ernst & Young), but it was up to the government to decide whether they would bring them," Valukas said. The New York lawsuit could spur other regulators to act. Both the Justice Department and the Securities and Exchange Commission have been investigating the demise of Lehman but have not filed charges against any of the firm's executives.

Repo 105, the transaction at issue, was a variation on a corporate finance tool used by every Wall Street bank. In such a transaction, known as a repurchase and sale, or "repo" agreement, an investment bank like Lehman would typically raise cash by selling assets and buying them back a few days later.

But in the case of the Repo 105 transactions, Lehman moved assets that represented 105 percent or more of the cash it raised, which it claimed that it could treat as a "sale" rather than a "financing" under accounting rules. Ernst & Young approved Lehman's Repo 105 transactions, the lawsuit said.

"We believed their conclusions were acceptable under the accounting literature," Kevin Reilly, the Ernst & Young partner at one point in charge of the Lehman work, said in a deposition with the attorney general.

The attorney's general lawsuit, however, asserted that the transactions were nothing more than accounting sleight of hand.

"These Repo 105 transactions had no independent business purpose and were designed solely to enable Lehman to manage the company's financial balance sheet `metrics'," the lawsuit said.

To execute Repo 105 agreements, Lehman also needed legal opinion that the transaction could be treated as a "sale" rather than as a "financing"," the lawsuit said.

Because it couldn't get the opinion in the United States, the suit said the firm approached Linklaters, a British law firm, to seek an opinion under English law. Linklaters issued an opinion that Lehman could characterize the Repo 105 transactions as a "sale" but that the transactions had to be executed in Britain.
"Armed with the Linklaters letter," Lehman transferred securities to banks in Britain to execute the Repo 105 transactions, according to the lawsuit.

Lehman aggressively ramped up its use of Repo 105 transactions in the year before it collapsed, the attorney general contends. Because the investment bank was saddled with billions of dollars of hard-to-sell soured mortgages and real estate assets on its books, Repo 105 gave Lehman a way to improve the appearance of its balance sheet.

A Lehman document from February 2007 said, "Repo 105 offers a low-cost way to offset the balance sheet and leverage impact of current market conditions," according to the lawsuit.

It also detailed how Lehman's use of these transactions more than doubled to $50.4 billion in May 2008, from about $24 billion at the end of 2006.

At least one Ernst & Young auditor grew concerned over the firm's use of Repo 105, according to the lawsuit. In 2006, Bharat Jain, an Ernst & Young auditor on the Lehman account, noted to his manager that he would "like to know what is our thought process behind how much of these Lehman should do from reputational risk etc, perspective. Are we comparing to other competitors, are we referring to any industry publications, any regulatory guidance etc"

Jain's manager told him that she would raise the issue of "reputational risk" with the senior Ernst & Young partner on the account, but that conversation appears never to have taken place, according to the suit.

Cuomo's lawsuit was brought under the Martin Act, a 1921 New York state law that gives the attorney general broad powers to pursue financial corruption. The controversial law has been aggressively employed by Cuomo and his predecessor, Eliot Spitzer, in bringing cases against Wall Street firms and their executives.