Ernst & Young and Lehman: A Not-So-Happy New Year is in Store

The Wall Street Journal and other news sources are reporting today that Ernst and Young is about to be hit with a civil lawsuit for its dealings with Lehman Brothers before the investment bank filed the largest bankruptcy in history ($691 Billion). We posted a few times earlier in the year on Lehman's use of Repo 105 and 108 transactions (hereafter Repo transactions) and how EY will be perceived in these transactions but it's been quiet for some time now and I was starting to wonder what would become of it. The lawsuit will certainly claim that EY was helping Lehman be obscure in their financial reporting by allowing them to hide debt through the Repo transactions. Here is an excerpt from the Wall Street Journal article:

New York prosecutors are poised to file civil fraud charges against Ernst & Young for its alleged role in the collapse of Lehman Brothers, saying the Big Four accounting firm stood by while the investment bank misled investors about its financial health, people familiar with the matter said...

Lehman Brothers was long one of Ernst & Young's biggest clients, and the accounting firm earned approximately $100 million in fees for its auditing work from 2001 through 2008, say people familiar with the matter.

The suit, led by Mr. Cuomo, New York's governor-elect, could come as early as this week. It is part of a broader investigation into whether some banks misled investors by removing debt from their balance sheets before they reported their financial results to mask their true levels of risk-taking, a person familiar with the case said. The state may seek to impose fines and other penalties.

The article points out that the case "would mark the first time a major accounting firm was targeted for its role in the financial crisis." Apparently, Cuomo is also investigating other investment banks and their use of Repo transactions as well. Unfortunately, I don't think the audit firms will look like they fulfilled their role very well in these cases. If so, this development could lead to a huge blow to all the Big Four auditors, not just EY. However, EY has the unfortunate honor of being the auditor of the largest bankruptcy in U.S. history so they are likely to face the worst consequences.

When the initial report was released detailing Lehman's use of Repo transactions, it was the day after I had a discussion in my fraud class where I said that it looked like the audit firms were going to avoid having the finger pointed at them in this financial crisis. When we talked about it in the next class period, I made the comment that I worried that a lawsuit against Ernst and Young would not be defendable in court because it just looks too shady. As such, I said that EY will have to settle if anyone sues them. I still believe that assessment will hold true.

My prediction is that Ernst and Young will need to settle out of court and the settlement will be huge. By the time all the interested parties get their share of EY, it will likely be the largest settlement against an auditing firm ever. I hope I am going out on a limb here and live to see my prediction fail but I think Cuomo and others will know that EY will have a very difficult time defending themselves in court so they will not take anything less than $500 million and a $1 billion settlement would not surprise me at all.

Adding to EY's troubles is evidence that a whistleblower at Lehman tried to warn EY that the Repo transactions were shady but they apparently went along with Lehman anyway. I'm guessing that they had already signed off on the transactions by rationalizing that they met the letter of law in GAAP. This is the stand EY has taken since the bankruptcy examiner said EY had some liability in Lehman's bankruptcy; EY has tried to calm it's stakeholders by saying that these transactions are allowed under GAAP, therefore they are not at fault.

Unfortunately for EY's sake, I don't believe the issue of whether GAAP allows these transactions is going to factor much into this case. The issue isn't whether or not they are acceptable under GAAP rules, it's whether the Repo transactions at year-end are transparent and, more importantly, whether a jury would believe they are above board. Auditors need to realize that when their clients are using technicalities in GAAP to window dress, that can come back to bite the auditor--especially if the client goes bankrupt and almost takes the world economy down with them.

Enron is a classic example of a client using GAAP technicalities to hide losses. At Enron, the SPE transactions were technically allowed under GAAP. The main issue was that Enron was using the transactions to keep what was happening behind the scenes from the eyes of investors. Try explaining to a jury that it's good accounting to take billions of dollars of debt off your books at the end of each year so you can look good to regulators and investors. I don't believe EY has a chance to defend this against a jury.

I hope my estimate of the magnitude of this lawsuit isn't understating the case. I would not find it totally surprising if this was much bigger than I'm estimating. After all, the Lehman bankruptcy was almost seven times WorldCom's bankruptcy filing at $691 billion! If a jury can be convinced that EY was responsible for 1% of Lehman's failure that is enough to wipe out all EY's equity and put them out of business. Actually, 0.5% would be over $3 billion and that would also be a tough pill for any auditing firm to swallow. I don't believe EY will have to swallow that pill though since they won't let this go to a jury trial...

The real question to me is whether auditing firms will learn that when they have clients who are hiding losses behind accounting rules they ought to run fast and far from those clients. In addition, they ought to be lobbying the FASB and SEC to get the rules changed so shady business executives are not able to use accounting rules to window dress or play other accounting games.

I hope we don't need to be down to the Big Three before auditors learn those lessons...