Lehman Brothers and the U.S. Department of InJustice

60 Minutes aired what is likely to be the last segment on the global mortgage meltdown and how the U.S. Department of Justice has essentially given the key players a "Get out of Jail Free" card. The latest segment focuses on the Lehman bankruptcy and the fraud involved in that case. Steve Kroft of 60 Minutes says that he has given up hope that the Department of Justice or the SEC will bring any charges against the key players. He says that he is "astounded" that the government has failed to bring cases against the key individuals. In the main video...

Deloitte and Taylor Bean: Real Money is on the Line

Another of the Big 4 is being sued regarding their audit of a firm that was allegedly committing serious fraud during the mortgage meltdown, Taylor Bean. Here is an excerpt from an article on Bloomberg which describes the lawsuit involving Deloitte:

Ernst & Young and Lehman Case is Still Cooking

Fox News published a short article about litigation involving Lehman and its executives and mentioned that the lawsuit against EY is still progressing. The article says that testimony may be recorded in the near future about the motivation for Lehman's extensive use of Repo 105 transactions. Here are a few quotes:

An Update on Lehman and EY

According to an article in the Wall Street Journal:

A lawsuit contending that Lehman Brothers Holdings Inc.'s former officials, underwriters and auditors are responsible for investor losses should go forward for the most part, a federal judge ruled Wednesday.

According to the article, the judge ruled that:

Lehman Update

A few days ago my dad and I were wondering when we were going to hear additional news about the status of the Lehman Bros Repo 105 case.  It turns out we missed a Bloomberg article about the issue a few weeks ago.  According to the article the SEC is having a hard time finding sufficient evidence to sue Lehman for their use of Repo 105 transactions.  Here is an excerpt from the article:

Is EY and Lehman a Red Flag for the Auditing Industry?

An article in the Wall Street Journal discusses Cuomo's EY-Lehman fraud case and quotes some very prominent observers of the auditing profession as saying that this is a sign that auditors are not holding the line. To be fair, the article quotes others as saying the profession has been vigilant; I'm hoping they are right! Here are a few key quotes by Lynn Turner and others who believe the profession has let down their guard:

More on Ernst and Young and Lehman Brothers (links)

Going Concern recently interviewed us about E&Y and Lehman--check it out here.  The accounting news source also has a great roundup of other thoughts and opinions on the case from around the blogosphere.  I would also encourage readers to check out David Zaring's thoughts on the matter over at The Conglomerate.

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:

The latest news on the investment banks

If you're tuned into the news these days, you probably have heard today that the SEC has charged Goldman Sachs with fraud regarding the subprime mortgage fiasco that is blamed for the "great recession." Some observers are speculating that this fraud case could be as significant as Enron was. If so, I would expect Goldman's stock to tank over the next few days as a complete picture of the fraud comes to light.

As for now, here is what we know. Both the WSJ and the LA Times reports that Goldman was essentially passing profits to a hedge fund known as Paulson & Co. The LA Times article explains Goldman's fraud as follows:

The SEC's lawsuit alleges that Goldman did not tell investors in the securities that they were based on a portfolio of mortgage bonds selected by a hedge fund. The investment bank subsequently helped the hedge fund, Paulson & Co., place bets against the same bond portfolio, the suit says.

Meanwhile, earlier in the week, The NY Times reported that Lehman's accounting methods are looking shadier by the minute. In particular, the Times article explains:

In the years before its collapse, Lehman used a small company — its “alter ego,” in the words of a former Lehman trader — to shift investments off its books.

The firm, called Hudson Castle, played a crucial, behind-the-scenes role at Lehman, according to an internal Lehman document and interviews with former employees. The relationship raises new questions about the extent to which Lehman obscured its financial condition before it plunged into bankruptcy.

While Hudson Castle appeared to be an independent business, it was deeply entwined with Lehman. For years, its board was controlled by Lehman, which owned a quarter of the firm. It was also stocked with former Lehman employees.

None of this was disclosed by Lehman, however.

I wonder which investment bank will be in the news for fraud tomorrow?

Lehman not the only firm using the repo markets to obscure risk levels

According to the WSJ, the Federal Reserve Bank of New York has released data showing that several major banks masked their risk levels over the past five quarters.  How did they do it?  Perhaps unsurprisingly, the banks were using repo transactions.

A group of 18 banks—which includes Goldman Sachs Group Inc., Morgan Stanley, J.P. Morgan Chase & Co., Bank of America Corp. and Citigroup Inc.—understated the debt levels used to fund securities trades by lowering them an average of 42% at the end of each of the past five quarterly periods, the data show. The banks, which publicly release debt data each quarter, then boosted the debt levels in the middle of successive quarters.

...

The data highlight the banks' levels of short-term financing in the repurchase, or "repo," market. Financial firms use cash from the loans to buy securities, then use the purchased securities as collateral for other loans, and buy more securities. The loans boost the firms' trading power, or "leverage," allowing them to make big trades without putting up big money. This amplifies gains—and losses, which were disastrous in 2008.

I am interested in seeing how disclosure of the repo transactions varied across these firms.  Assuming some firms were forthright in the effect that the repo transactions were having on their financial statements, did investors punish firms for being honest?  I wonder if industry analysts were aware of the practice, and if so, did they expect most/all firms in the industry to engage in such transactions, regardless of whether or not the transactions were disclosed?

More on Repo 105

This article in the Economist has a very interesting note about the questionable Repo 105 transactions that Lehman used to improve its balance sheet (thanks, Brian White, for the link):

Mr Valukas marshals plenty of evidence to back up his claim that “Lehman painted a misleading picture of its financial condition”. The effect of Repo 105 was material: the firm temporarily removed around $50 billion-worth of assets at the end of the first and second quarters of 2008, a time when market jitters about its leverage were pervasive (see table below). Mr Valukas can see no legitimate business reason to undertake the transaction, which was more expensive than a normal repo financing and had to be done through its London-based arm because Lehman was unable to get an American lawyer to agree that Repo 105 involved a true sale of assets. [emphasis added]

This doesn't necessarily mean the transactions were in violation of U.S. GAAP, but it definitely makes the Repo 105 transactions look even more shady (I am not an expert on SFAS 140, the accounting rule Lehman used to justify the reclassification of Repo 105 transactions as a "true sale of assets", but it is very possible that the transactions only needed to qualify as a sale of assets in the country where they were being conducted).

Lehman and EY: Maybe I spoke too soon...

In my Fraud Examination yesterday we talked about how the audit profession appears to have learned from the last economic crisis when it was heavily criticized for inadequate audit work in the frauds that came to light around the turn of the millennium. My comment was that so far, it appears that the fingers of blame for the fiascoes leading to the "Great Recession" were not pointing much toward the audit profession. Some potential exceptions include the Madoff feeder fund audits and the New Century/KPMG situation but I concluded that the auditor finger pointing is not nearly as serious this time as it was at the turn of the millennium.

Today I'm wondering if I should have waited a few hours to make such a comment since a new report was issued about the time I was in class yesterday. This report details the Lehman Brothers collapse and is very critical of EY's audits.

(You can read the 2,200 page report online; I've search for Ernst and found the examiner is very critical of the EY's audits. Also, there are numerous articles about the report and EY's role in the collapse including the WSJ and Huffington Post.)

Suffice it to say that this report says EY failed to meet professional auditing responsibilities. The issue revolves around inappropriate repurchase transactions, known as Repo 105 transactions, used to make Lehman look like it was in better condition than it really was. The report says that Lehman used these Repo 105

... transactions to temporarily remove $50 billion of assets from its balance sheet at first and second quarter ends in 2008 so that it could report significantly lower net leverage numbers than reality.

Lehman did so despite its understanding that none of its peers used similar accounting at that time to arrive at their leverage numbers, to which Lehman would be compared...

The examiner alleges that EY was told about concerns that these transactions were inappropriate but they failed to report the concerns to the Board or to adequately investigate the propriety of the transactions.

One of many damaging quotes from the report is:

There are colorable claims against Lehman's external auditor Ernst & Young for, among other things, its failure to question and challenge improper or inadequate disclosures in those financial statements.

The report explains:

In May 2008, a Lehman Senior Vice President, Matthew Lee, wrote a letter to management alleging accounting improprieties; in the course of investigating the allegations, Ernst & Young was advised by Lee on June 12, 2008 that Lehman used $50 billion of Repo 105 transactions to temporarily move assets off balance sheet and quarter end.

The next day ‐- on June 13, 2008 ‐- Ernst & Young met with the Lehman Board Audit Committee but did not advise it about Lee's assertions, despite an express direction from the Committee to advise on all allegations raised by Lee.

Ernst & Young took virtually no action to investigate the Repo 105 allegations. Ernst & Young took no steps to question or challenge the non‐disclosure by Lehman of its use of $50 billion of temporary, off‐balance sheet transactions.

Colorable claims exist that Ernst & Young did not meet professional standards, both in investigating Lee's allegations and in connection with its audit and review of Lehman's financial statements.

My guess is that now that the report has been out for more than half a day now, 25 or more class action lawsuits have been filed against EY. A report this critical is an invitation to file such lawsuits.

I was hoping that since these particular transactions were not part of last annual audit opinion (since Lehman imploded before the 2008 financial statements were issued), that EY's role may be limited. However, it appears that the transactions date back to the 4th quarter of 2007 and affected the amounts that were audited by EY (see chart at this link). In addition, quarterly 2008 filings that were reviewed by EY were involved. As such, the question to be resolved is what should EY have done when told about these transactions? Apparently, the examiner felt they didn't do their job.

This report is definitely unsettling and the ultimate responsibility of EY in the Lehman situation will likely take months, or even years, to determine. In the meantime, I'll be more careful with my comments about the audit profession's role when the next round of economic turmoil comes to light.