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:
"(I)nvestors who filed the lawsuit have "adequately alleged" that the former Lehman executives...and other defendants misled them about Lehman's financial health, leverage, risk management and exposure to dicey mortgage and real-estate assets."

The article goes on to clarify that the investors "contend (that) Lehman's use of "Repo 105" transactions—repurchase agreements that allowed Lehman to lower its leverage temporarily—falsely allowed the bank to present itself as financially stronger than it really was."

As for the impact of this ruling on EY, the article states that:

(The judge) rejected the defendants' attempt to dismiss the entire case, but he threw out some claims, particularly some of those against Ernst & Young LLP, Lehman's independent auditor. The judge did allow a claim to continue alleging that E&Y made misstatements in July 2008 about Lehman's compliance with accounting rules when in fact E&Y was aware of the bank's use of Repo 105s, which "cast into doubt" whether its balance sheet was consistent with generally accepted accounting principles.

So is this good news or bad news for EY? It sounds like it's both but I believe that the good news is fairly minor and the bad news overshadows any good news. On a good note, it helps that many of the claims against EY have been dismissed. With that said, I'm not even sure what those claims were.

As for bad news, EY still appears to have a big monkey hanging over them in the Repo 105 transactions. In my opinion, those transaction have always been at the heart of EY's risk. In other words, EY's audit of Lehman's use of Repo 105 transactions are still something that a jury could latch onto and rule that EY allowed Lehman to mislead investors. If they did, and that's a big if, the amount of a ruling against EY could be huge since the Lehman bankruptcy was astronomical.

The article provided some quotes that also suggest that EY made some minor headway but is by no means out of the woods yet. For example, an attorney representing the plaintiffs said "(H)e was pleased with the ruling. The 'vast majority' of the case will go forward, he said, including the core allegations, and all of the defendants remain in the case."

Even so, EY made a statement that it was "pleased that Judge Kaplan's ruling dismisses most of the claims against us in this matter, and we strongly believe that we will ultimately prevail on the remaining claim."

Unfortunately for EY, as the plaintiff's attorney said, the "core allegation" still remains. As I've said before, even if the Repo 105 transactions were technically in compliance with the letter of the accounting rules, convincing a jury that it's okay for an auditor to let their client mislead investors through their accounting will be a tough sell.